Presenting a live 90-minute webinar with interactive Q&A Advanced Trust Drafting for Income Tax Minimization: Including Capital Gains in DNI, Push-Outs and More Managing the Disparity in Income Tax Treatment Between Beneficiary and Trust WEDNESDAY, MAY 17, 2017 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Robert S. Barnett, Partner, Capell Barnett Matalon & Schoenfeld, Jericho, N.Y. Albert Dumaual, Attorney, Capell Barnett Matalon & Schoenfeld, Jericho, N.Y. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.
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Advanced Trust Drafting for Income Tax Minimization: Including Capital Gains in DNI, Push-Outs & More Robert S. Barnett CPA, JD, MS (TAXATION) CAPELL BARNETT MATALON & SCHOENFELD LLP ATTORNEYS AT LAW (516) 931-8100 rbarnett@cbmslaw.com Albert Dumaual CAPELL BARNETT MATALON & SCHOENFELD LLP ATTORNEYS AT LAW (516) 931-8100 adumaual@cbmslaw.com 5
RELEVANCE TO ESTATE PLANNING There are many intersections between good planning and income tax consequences 6
ESTATE SEPARATE legal entity for tax purposes Entity handling D s affairs Governed by laws of state D resided in Comes into existence and starts tax year at death For reasonable period of administration Tax year chosen with filing of first 1041 7
TRUSTS SEPARATE legal entity for tax purposes Divides ownership and management from beneficial enjoyment Inter vivos/testamentary Revocable/Irrevocable Generally use calendar year Many different types 8
Tax and Payments Deductions Income Form Department of the Treasury Internal Revenue Service 1041 U.S. Income Tax Return for Estates and Trusts Information about Form 1041 and its separate instructions is at www.irs.gov/form1041. A Check all that apply: Decedent s estate Simple trust Complex trust Qualified disability trust ESBT (S portion only) Grantor type trust Bankruptcy estate-ch. 7 Bankruptcy estate-ch. 11 Pooled income fund B Number of Schedules K-1 attached (see instructions) 2016 OMB No. 1545-0092 For calendar year 2016 or fiscal year beginning, 2016, and ending, 20 Name of estate or trust (If a grantor type trust, see the instructions.) C Employer identification number Name and title of fiduciary Number, street, and room or suite no. (If a P.O. box, see the instructions.) City or town, state or province, country, and ZIP or foreign postal code D Date entity created E Nonexempt charitable and splitinterest trusts, check applicable box(es), see instructions. Described in sec. 4947(a)(1). Check here if not a private foundation... Described in sec. 4947(a)(2) F Check applicable Initial return Final return Amended return Net operating loss carryback boxes: Change in trust's name Change in fiduciary Change in fiduciary's name Change in fiduciary's address G Check here if the estate or filing trust made a section 645 election...... Trust TIN Sign Here 1 Interest income........................... 2a Total ordinary dividends........................ b Qualified dividends allocable to: (1) Beneficiaries (2) Estate or trust 3 Business income or (loss). Attach Schedule C or C-EZ (Form 1040)......... 4 Capital gain or (loss). Attach Schedule D (Form 1041).............. 5 Rents, royalties, partnerships, other estates and trusts, etc. Attach Schedule E (Form 1040). 6 Farm income or (loss). Attach Schedule F (Form 1040).............. 7 Ordinary gain or (loss). Attach Form 4797.................. 8 Other income. List type and amount 9 Total income. Combine lines 1, 2a, and 3 through 8............. 10 Interest. Check if Form 4952 is attached............... 11 Taxes.............................. 12 Fiduciary fees........................... 13 Charitable deduction (from Schedule A, line 7)................ 14 Attorney, accountant, and return preparer fees................ 15a Other deductions not subject to the 2% floor (attach schedule)........... b Net operating loss deduction. See instructions................ c Allowable miscellaneous itemized deductions subject to the 2% floor......... 16 Add lines 10 through 15c...................... 17 Adjusted total income or (loss). Subtract line 16 from line 9... 17 18 Income distribution deduction (from Schedule B, line 15). Attach Schedules K-1 (Form 1041) 19 Estate tax deduction including certain generation-skipping taxes (attach computation)... 20 Exemption............................ 21 Add lines 18 through 20....................... 22 Taxable income. Subtract line 21 from line 17. If a loss, see instructions........ 23 Total tax (from Schedule G, line 7).................... 24 Payments: a 2016 estimated tax payments and amount applied from 2015 return.... b Estimated tax payments allocated to beneficiaries (from Form 1041-T)........ c Subtract line 24b from line 24a..................... d Tax paid with Form 7004. See instructions.................. e Federal income tax withheld. If any is from Form(s) 1099, check........ Other payments: f Form 2439 ; g Form 4136 ; Total 25 Total payments. Add lines 24c through 24e, and 24h............. 26 Estimated tax penalty. See instructions................... 27 Tax due. If line 25 is smaller than the total of lines 23 and 26, enter amount owed..... 28 Overpayment. If line 25 is larger than the total of lines 23 and 26, enter amount overpaid.. 29 Under Amount penalties of of line perjury, 28 to I declare be: a Credited that I have examined to 2017 this estimated return, including tax accompanying schedules and statements, ; b Refunded and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge. Paid Preparer Use Only May the IRS discuss this return with the preparer shown below Signature of fiduciary or officer representing fiduciary Date EIN of fiduciary if a financial institution (see instr.)? Yes No Print/Type preparer's name Preparer's signature Date Check if PTIN self-employed Firm's name Firm's EIN Firm's address Phone no. For Paperwork Reduction Act Notice, see the separate instructions. Cat. No. 11370H Form 1041 (2016) 1 2a 3 4 5 6 7 8 9 10 11 12 13 14 15a 15b 15c 16 18 19 20 21 22 23 24a 24b 24c 24d 24e 24h 25 26 27 28 29 9
INCOME TAX RATES RATE TAXABLE INCOME NOT OVER Married Filing Separately Individual Head of Household Married Filing Jointly 10% $9,325 $9,325 $13,350 $18,650 15% $37,950 $37,950 $50,800 $75,900 25% $76,550 $91,900 $131,200 $153,100 28% $116,675 $191,650 $212,500 $233,350 33% $208,350 $416,700 $416,700 $416,700 35% $235,350 $418,400 $444,550 $470,700 39.6% Over $235,350 Over $418,400 Over $444,550 Over $470,700 10
ESTATE & TRUST INCOME TAX RATES Income Tax & Capital Gain: 39.6% and 20% rates apply when trust taxable income over $12,500 Medicare: 3.8% surtax on lesser of (i) undistributed net investment income; or (ii) excess of AGI over $12,500 = 43.4% income tax rate or 23.8% capital gain tax rate 2016 ESTATE & TRUST INCOME TAX RATES Taxable Income Income Tax Rate Capital Gain Rate Not over $2,550 15% 0% $2,550 - $6,000 25% 15% $6,000 - $9,150 28% 15% $9,150 - $12,500 33% 15% Over $12,500 39.6% (+ 3.8% surtax) 20% (+ 3.8% surtax) 11
PLANNING CONSIDERATIONS Decedent s Losses how to utilize IRD Avoid installment sales S Corps: Grantor Trusts, QSST, ESBT Separate Shares Draft to permit severance Allocation of GST Life Insurance Trust for grandchildren Elect Reverse QTIP 12
PLANNING CONSIDERATIONS Drafting for Charitable Bequests Passive Activities DNI Define income Trustee powers and discretion IRAs and QTIP Trusts Distribute income of the retirement plan : plan s internal investment income OR unitrust amount In kind distribution avoid specific bequests PASS THE GAIN 13
DECEDENT S LOSSES Decedent s Losses only deductible on Final 1040 (ex. worthless securities) NOL s two year carryback PAL s Special Rules Capital losses not passes to estate Casualty losses three year carryback Remaining loss is disregarded- does not pass to estate 14
MEDICAL EXPENSES Paid before death: 1040 deduction Paid after death: Deduct on 706, or Elect to take deduction on 1040 if paid by estate within 1 year of death & File duplicate statement with 1040 stating did not take as a estate tax deduction and estate waives right to take as a deduction 15
SIMPLE TRUST Governing instrument controls Trust provides ALL income be distributed currently Does not pay, permanently set aside or use any amounts for charitable purposes AND NO principal distributions actually made Annual exemption: $300 16
COMPLEX TRUST Any trust that is NOT a simple trust Annual Exemption: $100 17
1411 MEDICARE SURTAX: TRUSTS/ESTATES 3.8% surtax on the lesser of: Undistributed net investment income OR Excess, if any, of AGI (as defined in 67(e)) over Dollar amount which the highest tax bracket in section 1(e) begins (2017 - $12,500) 18
NET INVESTMENT INCOME Gross income from interest, dividends, annuities, royalties, and rents, other than from an ordinary trade or business; Gross income from passive activity or trade/business involving trading in financial instruments/commodities; and Net gain from disposition of property, other than property held in trade or business Gain from passive activity or trade/business trading in financial instruments/commodities Less allocable deductions 19
INDIVIDUALS VS. TRUSTS/ESTATES Surtax applies to Trust/Estates on amounts over $12,500 Individuals threshold amount varies Taxpayer filing joint return - $250,000 Married filing separately - $125,000 All other cases - $200,000 Greater exposure for trust/estate 20
INDIVIDUALS VS. TRUSTS/ESTATES Trust/Estate surtax on undistributed net investment income Distributions to beneficiaries - may avoid surtax at trust/estate level Tax spread over many beneficiaries vs. tax to trust/estate Governing instrument must allow for distributions 21
WHAT IS INCOME? Treasury definition Income in respect of decedent (IRD) discussed later Fiduciary accounting income Governing instrument & state law control (NY- EPTL) 22
FIDUCIARY ACCOUNTING INCOME (FAI) Different from taxable income Income the settlor intended the income beneficiary to receive Governing instrument & local law control allocations 23
INCOME & PRINCIPAL State Law defers to governing instrument Principal: Property held for remainder B Includes capital gain Income: Return from principal assets Rent from property Interest Corporate distributions classification varies Extraordinary distributions Principal Business income 24
NY EPTL 11-A-1.2: INCOME & PRINCIPAL Defers to governing instrument Principal: Property held for remainder B Includes capital gain Income: Return from principal assets Rent from property (Sch. E) Interest Corporate distributions classification varies Extraordinary distributions Principal Business income (Sch. C) 25
TREASURY REG 1.643(b)-1 Income determined under governing instrument and applicable local law Trust provisions that depart fundamentally from traditional principles of income and principal will generally not be recognized. 26
CALCULATING TAX LIABILITY Gross income Less deductions/expenses Less income distribution deduction Less special exemption 27
INCOME IN RESPECT OF DECEDENT 28
IRD Income D earned prior to death Not included in D s income Recipient taxed in year receives income Retains same character Accrued income, accrued vacation, treasury bond interest; Annuities; IRA (watch beneficiary designations!!!!) Use to fund charitable bequests 29
IRD No basis step up Installment sale proceeds(same GP %) Controversy was closing certain to occur Sale of building (was contract subject to contingences?) Were conditions other than ministerial? 30
DEDUCTIONS 32
DEDUCTIONS Interest (Note: Expenses allocated to tax exempt interest are not deductible) Taxes Charitable Deductions special rules Attorney, Accounting, and Fiduciary Fees NOL active NOL from trade or business may offset other income but generally do not pass through to the B s during administration 1041- NOL carryback 2 years and carryover 20 years Depreciation (no Sec. 179 Election) may be apportioned Casualty losses if exceed 10% of AGI 33
1041 SPECIAL DEDUCTIONS Income Distribution Deduction Estate Tax Deduction for IRD Personal Exemption Estate $600 Simple Trust $300 All other trusts $100 34
DISTRIBUTION DEDUCTION Estate/Trust is a pass through entity Avoids double taxation Deduction for income paid, created or required to be distributed to B B reports income (based on K-1) Income retains same character Calculated on Sch. B of 1041 35
SPECIFIC BEQUESTS No distribution deduction 1. Required by Will; 2. Specific sum of money or property; and 3. Three or fewer installments under the Will 36
642(g) - DOUBLE DEDUCTIONS Administrative expense deduction on EITHER 706 OR 1041 Elect on 1041: file statement and waiver Statement item not allowed as 706 deduction Waiver waive right to take as 706 deduction Can waive until finally allowed on 706 Exception: 691 (b) deductions- can claim on both 37
642(g) - FILING Timely election Filed with 1041 for year the deduction is claimed Anytime before the statute of limitations for that year expires Even if taken on 706- if not finally allowed on 706 Election irrevocable 38
DISTRIBUTABLE NET INCOME CONDUIT PRINCIPLE 39
HYPOTHETICAL Trust realizes $12,500 of dividends and $60,000 of capital gain Traditional trust income taxation: $12,500: Income taxed to B $60,000: Capital Gain taxed to Trust Trust s Income Tax > $14,000 (approx.) ALTERNATIVELY, if all is taxed to B and B has no other income: B s Income Tax < $3,800 40
PLANNING OPPORTUNITY Potential significant savings if shift income tax burden from trust to beneficiary Avoid condensed trust income tax brackets Utilize Beneficiary s tax bracket Avoid 3.8% Medicare surtax 41
REDUCE TAX BURDEN: Beneficiary-Level Taxation Include capital gain in Distributable Net Income Treas. Reg. 1.643(a)-3 In Kind Distribution IRC 643(e)(3) 65 Day election IRC 663(b) 42
DISTRIBUTABLE NET INCOME Governs allocation of trust taxable income between trust and beneficiaries Limits trust s distribution deduction Limits beneficiary-level taxation, even if a greater amount is distributed Determines character and amount of distribution 43
CALCULATING DNI TAXABLE INCOME, modified as follows: No deduction for distribution No deduction for personal exemptions Generally exclude capital gains Generally exclude capital losses Simple trusts: Exclude extraordinary dividends and taxable stock dividends allocated to corpus and not distributed Include tax-exempt interest paid on state and local bonds, reduced by allocable disbursements 44
DNI EXAMPLE 1 Complex Trust; income distribution required Interest $7,500 Dividend $14,500 Capital Gains $5,000 Admin Expenses $5,000 Distributions $27,000 45
DNI EXAMPLE 1 (cont.) Total Income 27,000 Expenses -5,000 Distribution Deduction* -17,000 Exemption -300 Taxable Income 4,700 * Limited to DNI 46
WHAT IS INCLUDED IN NII, BUT NOT IN DNI? ANSWER: CAPITAL GAIN 47
DNI & NII 3.8% surtax imposed on undistributed net investment income (NII) Reduce trust taxes: Distribute NII 48
DNI & NII Allocate DNI distributions EXAMPLE DNI: $50,000 interest & dividends Distribution: $10,000, or 20% Distributed NII = $10,000 (20% of $50,000) Undistributed NII = $40,000 49
CAPITAL GAINS Allocated to principal Generally excluded from DNI Taxed to trust (capital gain rate + NII) Treas. Reg. 1.643(a)-3: Capital gain included in DNI if fiduciary utilizes one of two prerequisites and one of three methods Result: Beneficiary-level taxation 50
TWO PREREQUISITES Inclusion is pursuant to: (1) Governing instrument and local law; OR (2) Reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by local law or by governing instrument if not prohibited by local law) 51
THREE METHODS (1) Allocated to income (unitrust exception); (2) Allocated to corpus but treated consistently by the fiduciary on the trust s books, records, and tax returns as part of a distribution; or (3) Allocated to corpus, but actually distributed or utilized by the fiduciary in determining the amount that is distributed or required to be distributed 52
GOVERNING INSTRUMENT Allocation according to trust terms? Discretion and power to: Distribute trust principal Allocate receipts and disbursements between income and principal Include capital gains in income If silent, must rely on local law 53
STATE PRINCIPAL & INCOME ACTS Allocates receipts and disbursements between income and principal Duty of impartially between income and principal beneficiaries Coordinates with Prudent Investor Acts 54
STATE PRUDENT INVESTOR ACTS Governs investment and management of trust property Overall investment strategy Facilitates investing for total return Standard of conduct, not outcome or performance *Discretionary power to adjust 55
POWER TO ADJUST Transfer between income and principal To administer trust impartially, fairly, and reasonably among all beneficiaries Trust must allow income distributions 56
POWER TO ADJUST Consider all relevant factors Expected tax consequences Beneficiaries circumstances Asset type 57
POWER TO ADJUST Prohibited in certain circumstances Reduces spouse s income interest (marital deduction) Trustee is beneficiary Affects amounts devoted to charity 58
DNI & CAP GAINS METHOD 1 (INCOME) YEAR 1: Trust earns $60,000 of capital gain; Trustee wishes to include in DNI Look to governing instrument If silent, review discretion and powers E.g.: Income to B; discretion to distribute principal (standard provision) Look to local law 59
DNI & CAP GAINS METHOD 1 (INCOME) Local law grants power to adjust to transfer between principal and income T considers relevant factors Income & remainder beneficiaries needs, trust assets, economic conditions, anticipated tax consequences, etc. T allocates capital gain to income Sufficient? 60
DNI & CAP GAINS METHOD 2 (CONSISTENCY) Governing instrument is silent as to allocation of capital gain Grants discretion to distribute principal Grants discretion to include capital gain in distribution 61
DNI & CAP GAINS METHOD 2 (CONSISTENCY) YEAR 1: T intends to follow regular practice of treating discretionary distributions of principal as paid first from capital gain Evidence this by including capital gain in DNI on Trust s 1041 FUTURE: T must treat all discretionary distributions as being made first from any realized capital gain 62
DNI & CAP GAINS METHOD 3A (ACTUALLY DISTRIBUTED) Trust contains stock of Corp M Governing instrument: At age 35, distribute one-half of principal At 35, T sells one-half of stock T actually distributes the proceeds and attributable capital gain 63
DNI & CAP GAINS METHOD 3B (UTILIZED) Trust contains Blackacre and other property Governing instrument: After 10 years, sell Blackacre and distribute proceeds T uses sale proceeds (which includes any realized capital gain) to determine amount required to be distributed 64
IRC 643(e) IN KIND DISTRIBUTION B reports capital gain on sale of appreciated property received from trust/estate B s basis: lesser of carry-over or FMV Avoids trust-level taxation Does not apply to specific bequests Governing instrument should expressly grant discretion to distribute in kind Avoid IRC 643(e)(3) election 65
IRC 643(e)(3) ELECTION Property treated as sold at FMV Trust/estate pays tax B receives property, basis = FMV New holding period Can only revoke with IRS consent 66
BEST PRACTICE Clearly describe settlor s intent Expressly grant fiduciary discretion to: Distribute principal Allocate receipts and disbursements between income and principal Include capital gains in income Distribute in cash or in kind, or partly in cash and partly in kind 67
65 DAY ELECTION IRC 663(b) Distributions paid/credited within first 65 days of any taxable year of estate or trust treated as paid on last day of previous year Cannot exceed: 1) Entity's accounting income for year of election or 2) DNI MUST ELECT (P. 2, Other information, Line 6) Election irrevocable once period for filing return expires (including extensions) 68
PLR 201115004 Trust was granted an extension to file IRC 663(b) election Taxpayer acted reasonably and in good faith 69
PASSIVE ACTIVITY LOSSES 71
PASSIVE ACTIVITY LOSSES Any activity involving a trade or business Taxpayer does NOT MATERIALLY PARTICIPATE Material Participation REGULAR, CONTINUOUS and SUBSTANTIAL 7 Tests Treas. Reg. 1.469-5T More than 500 HOURS is favorite Limited partner has only 3 methods 72
DNI & PASSIVE LOSSES Beneficiary income is limited to DNI Trustee/executor allocates deductions against income classes Typically, beneficiary cannot deduct estate/trust losses Generally, excess deductions and losses pass through in final year 73
DNI & PASSIVE LOSSES Disallowed passive losses not included in DNI Disallowed passive losses not allocated to other income classes 74
ESTATE AND TRUST DISTRIBUTIONS 469(j)(12) If any interest in a passive activity is distributed by an estate or trust- (A) the basis of such interest immediately before such distribution shall be increased by the amount of any passive activity losses allocable to such interest, and (B) Such losses shall not be allowable as a deduction for any taxable year. Consider sale- gain will free suspended losses 75
ACTIVE PARTICIPATION (REAL ESTATE) $25,000 deduction if: Taxpayer (natural person) actively participates Estate ends less than 2 years after D s death, if D actively participated Reduced by amount claimed by surviving spouse Income phase-out limits After 2 years, rental real estate becomes passive 76
MATERIAL PARTICIPATION Reg. 1.469-5T does not provide guidance for Trusts and Estates Controversy exists 77
CONTROVERSY Mattie K. Carter Trust: Participation measured by activities of all who conduct business on trust s behalf 256 F. Supp.2d 536 78
CONTROVERSY IRS disagrees TAM 200733023: Estate/Trust participation measured by activities of fiduciaries Fiduciary must participate on regular, continuous, and substantial basis 79
Frank Aragona Trust Court held Trust Materially Participated Trustees activities as employees of SM LLC counted Trustee Duties of Loyalty Trust met 469(c)(7) exception 142 T.C. No. 9 (2014) 80
FRANK ARAGONA TRUST continued Tax Court recognized Trustee-Employee activities Did not need to consider activities of other employees Trust met 469(c)(7) exception Trust materially participated in rental activity 81
FRANK ARAGONA TRUST & TRUSTEE OWNERSHIP IN ACTIVITY Trustees also owned interests personally IRS said could not allocate participation to Trust Not in this case because: Personally owned small, minority interest; Combined ownership never exceeded Trust; Compatible goals; and Trustee involved in day-to-day management 82
WHAT FRANK ARAGONA TRUST DID NOT SAY Whether non-trustee employees count Hours of personal services rendered Whether one trustee s activity alone sufficient What test used to find material participation Whether 5% ownership rule applicable Court did not apply > 50% test What if trustee owned > % 83
REAL ESTATE PROFESSIONALS May treat rental real estate losses as NONPASSIVE 469(c)(7)(B) May use passive losses to offset active income SUBJECT TO material participation requirements Employee must be more than 5% OWNER 84