Trusts have significant income-tax implications because their tax brackets are compressed: they can reach the highest income tax bracket with much less income than an individual taxpayer.
Flexibility in the drafting of trusts will be even more important in 2022, when tax brackets are likely to be affected by rising inflation, the cost-of-living adjustment, and President Biden’s stimulus package. Income tax planning may not always be the first thing that comes to mind when drafting a trust, but the current political climate is causing clients to be concerned about rising income tax rates.
When drafting a trust as part of a comprehensive estate plan, you must keep track of many moving parts, the most important of which is helping clients achieve their goals by planning for all of their assets and beneficiaries. Fortunately, you can employ some strategies to draft trusts that allow flexibility and options for minimizing your clients’ income tax liability. Here are four ways that you can draft an income tax-sensitive trust.
1. Toggle Grantor Trust Status
You can draft a trust that allows the trust protector to toggle the grantor trust status on and off. The trust is a grantor trust when established, so the grantor, rather than the trust, pays income tax. This is an optimal way for the grantor to make a free gift to the trust without using the grantor’s gift tax exemption or incurring a tax bill, saving income tax if the grantor is in a lower tax bracket than the trust.
In addition, toggling the grantor trust status off allows flexibility if the grantor moves to a higher tax bracket than that of the trust or if the grantor relocates to a state with a high income tax rate.
The grantor or the trust could also sell a highly appreciated asset in a certain year, which would be another good time to consider whether it is appropriate or necessary to toggle off the grantor trust status of the trust.
2. Change Situs and Governing Law of the Trust
Another way to add flexibility to a trust is to allow the trust protector to change its situs and the corresponding laws that govern it. Important state law considerations include the obvious abilities to avoid, defer, or minimize state income taxes as well as creditor protection and administrative privacy. If appropriate, the trust protector can even move a portion of the property from one jurisdiction to another and appoint an independent trustee to manage the asset in the new situs. If an independent trustee is not appointed, the beneficiaries have the option of appointing a fiduciary in the new situs by a majority vote.
3. Decant the Trust
The trustee or trust protector can also decant the trust into a new trust in a more favorable jurisdiction. The drafter should consider whether the term of the new trust should be allowed to extend beyond the period of perpetuities under the law of the original trust. The governing state’s law may grant the trustee the authority to decant the trust if the trust instrument is silent.
Decanting a trust may have implications based on the state laws involved. For example, state laws differ as to whether the fiduciary duty of impartiality requires a trustee to consider a beneficiary’s outside resources when making distributions according to an ascertainable standard, such as for the beneficiary’s health, education, maintenance, or support. Decanting a trust from a state that does not require consideration of outside resources to one that does may prevent the trustee from making discretionary distributions to a surviving spouse and expose the trustee to liability for a breach of duty.
Though some states require a trustee to provide notice to beneficiaries, the trustee should minimize the beneficiaries’ involvement in the decanting process to the extent possible to avoid the tax implications of the beneficiaries affirmatively consenting to the decanting process. This is particularly important if the decanting process includes a change in the powers of appointment or the beneficiaries’ rights.
4. Sever the Trust
Allowing the trustee to sever the trust can also provide flexibility. This process creates one or more subtrusts to separate income and assets that are “good” and “bad” from an income tax liability standpoint.
The funding of the new trust must be based on the total fair market value of the assets on the funding date. The terms, conditions, and trustee of the severed trust would remain the same.
Other Income Tax Considerations
Keep in mind that states can tax the undistributed income of a trust. The state may base this tax burden on the following factors:
- A trustee lives in the state
- The trust is administered in the state
- A beneficiary who has a sufficient level of control over the trust property lives in the state
When selecting the governing state law of a trust, also consider whether the state’s principal and income act allows the trustee to allocate capital gains to the trust income.
The most obvious way to reduce a trust’s income tax liability is to distribute its income to the beneficiaries, who will presumably be in a lower tax bracket than the trust. One issue with this approach, however, is that clients often use trusts to avoid automatic or mandatory distributions to beneficiaries who may be minors or have special needs. The trustee may also be concerned about a beneficiary's risk of divorce, protecting assets from the beneficiary’s creditors, and minimizing inheritance and estate taxes.
Selecting the right trustee is another important aspect of reducing trust income tax liability. The client will ideally choose a trustee who lives in a state with no or low state income tax. If that is not possible, the client can consider appointing a corporate co-trustee who lives in a low-tax state. This co-trustee could have a limited administrative role. However, your client may already have one or two trustees in mind and could decide not to go this route.
Planning for income taxes while drafting trusts will keep your clients happy, and they will recommend you to their friends and family to do the same for them. To learn more about drafting income tax-sensitive trusts, watch the on-demand webinar, Grantor Trusts: What Are They and When Should You Use Them. The webinar is CLE eligible!