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ASNPPractical Tax Considerations of Grantor v. Non-Grantor Trusts
Vincent J. Russo Vincent J. Russo & Associates, PC
Long Island, New York
What You Need To Know About Grantor Trusts? Grantor is treated as the owner for income
tax purposes If Trust uses Grantor’s TIN, then no trust
income tax return If Trust uses its own TIN, then trust income
tax return will have to be filed
What You Need To Know About Non-Grantor Trusts? All Trusts other than “grantor trusts” Trust must file income tax return Tax Consequences to the trust or the
beneficiaries of the Trust
Examples of Grantor Trusts
All Revocable Trusts
Optional First Party Special Needs Trust Irrevocable Life Insurance TrustGrantor Retained Annuity TrustQualified Personal Residence TrustThird Party Irrevocable Special Needs Trust
Examples of Non-Grantor Trusts
AllTestamentary Trusts
Optional Irrevocable Life Insurance TrustGRATS and QPRTS after the term expiresThird Party Irrevocable Special Needs Trusts
Advantages of a Grantor Trust
Income tax consequences stay with the grantor Beware of the exception
Lower income tax brackets than a trust Single Individual reaches 35% at $357,700 for 2008 Trust reaches 35% bracket at $10,700 for 2008
Simpler tax filings Easier to explain to the client
Advantages of a Non-Grantor Trust
Spread out the income tax consequences Grantor does not have to come up with
funds to pay tax on “phantom income” Beneficiary who receives the income pays
the income tax Qualified Disability Trust
Disadvantages of a Non-Grantor Trust If not careful, higher overall taxes Beneficiary does not understand that they
need to come up with income tax payments
Need to pay attention to calendar year end distributions
First Party Special Needs Trust Set up by parent, grandparent, legal guardian or a
Court To or for the sole benefit of a person who is
disabled and under age 65 Funded with the assets of the person who is
disabled Payback required to reimburse the State for
Medicaid Paid 42 U.S.C. § 1396p (d)(4)(A)
Drafting for a Grantor Trust Tainting the Trust as a Grantor Trust IRC Sections 671 – 678 Favorite Taints
Power to remove Trustee and replace with a non-adverse party who is related to or subservient to Grantor (IRC §672, §674)
Use Trust income to pay premiums of insurance on life of Grantor or grantor’s spouse (IRC §677)
Grantor may exchange property of equivalent value in non-fiduciary capacity (IRC §675)
Drafting for a Grantor Trust Grantor Trust Taints (continued)
Income payable by non-adverse party to the grantor (IRC §677)
Adverse Party - any person who has a substantial beneficial interest in the trust which would be adversely affected (IRC §672)
Taints Not To Be Used Ignore IRC §676 - Power to Revoke
What The Grantor Needs To Know
Tax Consequences of the Trust Impact on the Grantor and Beneficiaries, if
any Filing of Tax Returns
Trust Grantor Beneficiary
Gift and Estate Tax Consequences
What the Trustee Needs To Know
Fiduciary Record Keeping Year End Income Tax Planning Filing of Tax Returns
Due April 15th (for Tax Years ended 12/31) Six-Month Extension Available
Extension of time to file (not to pay)
Who is Doing What?
Determine who is going to do what Be the “quarterback” Who is taking the “tax football”?
Role of Tax Practitioner
Offer tax planning strategies Keep client/attorney apprised of need for
estimated tax payments Provide list of tax related information
needed in a timely manner Prepare tax returns Manage tax deadlines
Working With The Accountant Provide the Accountant with:
Copy of Trust Instrument (or Will) Attorney Letter Summarizing Tax Treatment of Trust Necessary Information
Names, addresses and SS# of fiduciaries and beneficiaries TIN for Trust, if applicable List of Trust Assets (to know what 1099 forms, etc. to expect)
Copy of the Estate Tax Return If Trust Assets were included in Grantor’s Estate Form 706 will reflect “step-up” in basis of assets
Reviewing the Fiduciary Income Tax Return – Form 1041, Page 1
Trust Name and TIN Tax Year
General Rule: Trusts are calendar year filers Trap for unwary:
In year of Grantor’s death – there may be 2 returns: Grantor trust through DOD Complex Trust from DOD through 12/31
Fiduciary Name and Address Date entity created
Ex: Date of trust; DOD if testamentary trust
Reviewing the Fiduciary Income Tax Return – Form 1041, Page 1
Type of Entity – which box was checked? Ex: Grantor Trust, Complex, Qualified Disability Trust If Grantor Trust - Page 1 should reference IRC §671-
678
Number of K-1 Forms Complex Trust - Attach a K-1 if distribution was made
and if there is DNI (Distributable Net Income) Grantor Trust - Attach a Grantor Information
Statement (in lieu of a K-1)
Reviewing the Fiduciary Income Tax Return – Form 1041, Page 1
Checkbox for Initial Return/Final Return Checkbox - “May IRS discuss return with
preparer?” Issues to consider if attorney is not the
preparer How well do you and your client know the
preparer? What if the tax preparer contacted the IRS about
the return without your knowledge?
What to Look For When Reviewing Fiduciary Income Tax Returns
Request the Diagnostic Reports generated by the Accountant’s tax preparation software Ensure there were no “Overrides”
If found, ask preparer why the override was necessary What other areas of the return may have been affected
Was a state/local fiduciary return also prepared (if necessary) Be aware there are some differences between
Federal and State tax treatment of certain income/expense items
What to Look For When Reviewing Fiduciary Income Tax Returns
Reminder – Trust is a Cash Method Taxpayer Were all income items reported?
Any missing Bank or Brokerage accounts? Compare 1099 forms to income summary
Were all expenses taken on the return? Legal Fees Trustee Commissions Investment Advisory Fees
Knight v. Commissioner of Internal Revenue, US Supreme Court (decided 1/16/08), 2008-1 USTC ¶50,132
Real Estate Taxes if real property
What to Look For When Reviewing Fiduciary Income Tax Returns
Page 2, Schedule B – Distributions Do the distributions listed on the return coincide with
the distribution made by the Trustee? Page 2, Other Information – Questions
Make sure the questions are answered Note: IRC §663(b) election (“65 day election”)
Allows distributions to be made in the prior tax year Check the box to make the election, if desired
Tax Traps (Issue Awareness)
Income Tax Brackets Kiddie Tax Estimated Tax Payments Distributable Net Income End of Tax Year Distributions State Income Tax Return Requirements Support Obligations
Tax Traps: 2008 Income Tax Brackets
Tax Estate orRate Single Married Trust10% < $8,025 < $16,050 N/A
15% $ 8,026 - $16,051 - < $2,200
32,550 65,100
25% $32,551 - $65,101 - $2,201 -
78,850 131,450 5,150
28% $ 78,851 - $131,451 - $5,151 -
164,550 200,300 7,850
33% $164,551 - $200,301 - $7,851 -
357,700 357,700 10,700
35% over $357,700 over $357,700 over $10,700
Tax Traps: Kiddie Tax
Starting in 2008, the Kiddie Tax has been expanded to include dependents under 19 and dependent full-time students under 24.
Children who provide more than half of their own support are not affected by the Kiddie Tax change.
The Kiddie Tax can only apply if the child has unearned income that exceeds the threshold ($1,800 for 2008).
If the unearned income doesn't exceed the threshold, then it will be reported on the child's income tax return, if required.
Tax Traps: Kiddie Tax
Parent can make special election to include income on their own return if: The child’s income consists entirely of interest and
dividends; The child's income does not exceed $9,000 for 2008
(Rev. Proc. 2007-66); No estimated tax payments have been made in the
name of the child; and The child is not subject to backup withholding.
Tax Traps:Trust Estimated Tax Payments
If Non-Grantor Trust Be aware of the underpayment of estimated tax
penalties Safe harbor rules
100% of prior year’s tax 110% if AGI is more than $150K
If Grantor Trust Estimates may be needed for the Grantor’s personal
income tax liability No Estimates Needed at Trust Level
Tax Traps: Distributable Net Income
Distributable Net Income Used to compute a trust’s income tax
deduction for amounts distributedDistributions to beneficiaries push the income
out to beneficiaries (via the K-1)Capital Gains do not flow through to
beneficiary (via K-1) unless: Final Year of Trust; or If State Law and the Trust Instrument permit
Tax Traps:End of Year Distributions
65 Day Election under IRC §663(b)Trustee can treat distributions made within 65
days after the close of the tax year as if they had been made within the tax year
Trustee has an opportunity to review the year-end/December statements to determine if more distributions are needed to pass out DNI and reduce/eliminate tax at the trust level
Tax Traps: Final Grantor Tax Returns
If Decedent is Grantor - include income from January 1st to DOD Flows through to decedent’s Final 1040
Income from DOD forward reportable on Trust’s separate 1041
IRC §645 election – can elect to treat assets held by Revocable Trust established by decedent as if they are estate’s assets – combined 1041 (for the 1st 2 years of an estate)
Tax Traps:State Income Taxes
State Income Tax Return requirements Be alert as to different tax treatment of items on State
returns Examples:
Interest on U.S. Obligations not taxed at state level Out-of-state municipal bond interest (which is not taxable
on the federal return) may be taxable on the state return There may be a tax exclusion for some pension/annuity
income/IRA distributions
Tax Traps:Support Obligations
Any amount that is used in full or in partial discharge of a legal support obligation of Child is includible in the gross income of the Parent.
The legal obligation of a parent for support is determined under local law (Reg. §1.662(a)-4).
For Example, Joan has a daughter, Annie, age 11 Joan has a legal obligation to provide support to
Annie Grandma sets up a 3rd party SNT allowing the Trustee
to access principal and/or income for the benefit of Annie.
Summary
Attorney has the power to control the tax consequences of Trusts
Determine the best tax plan for the client and his/her family
Draft Carefully Make sure that the Client’s objectives are
not derailed due to the tax drafting
ASNPPractical Tax Considerations of Grantor v. Non-Grantor Trusts
Vincent J. Russo Vincent J. Russo & Associates, PC
Long Island, New York
2008 Income Tax Brackets
Married Individuals If Taxable Income is:
Not over $16,050 $ 16,051 to $ 65,100 $ 65,101 to $131,450 $131,451 to $200,300 $200,301 to $357,700 Over $357,700
The Tax is: 10% of the taxable income $1,605 plus 15% of excess $8,962.50 plus 25% of excess $25,550 plus 28% of excess $44,828 plus 33% of excess $96,770 plus 35% of excess
2008 Income Tax Brackets
Single Individuals If Taxable Income is:
Not over $8,025 $ 8,026 to $ 32,550 $32,551 to $ 78,850 $78,851 to $164,550 $164,551 to $357,700 Over $357,700
The Tax is: 10% of the taxable income $ 802.50 plus 15% of excess $4,481.25 plus 25% of excess $16,056.25 plus 28% of excess $40,052.25 plus 33% of excess $103,791.75 plus 35% of excess
2008 Income Tax Brackets
Estates & Trusts If Taxable Income is:
Not over $ 2,200 $2,201 to $ 5,150 $5,151 to $ 7,850 $7,851 to $10,700 Over $10,700
The Tax is: 15% of the taxable income $ 330 plus 25% of excess $1,067.50 plus 28% of excess $1,823.50 plus 33% of excess $2,764 plus 35% of excess
Tax Traps: Final Income Tax Returnsof the Decedent
Can deduct Medical expenses paid within one year of death
Opportunity to elect to include accrued US Savings Bond Interest on Final 1040
RMD for IRAs must be taken by 12/31 by named beneficiary if decedent hadn’t yet taken it prior to death Affects clients who schedule “auto-withdrawals” in December or
on a monthly basis
Investment Advisory Fees
Knight v. Commissioner of Internal Revenue
US Supreme Court (decided 1/16/08)2008-1 USTC ¶50,132
Unanimous decision in favor of the Internal Revenue (written by Chief Justice Roberts). The Trustee managing the Pepperidge Farm fortune filed a tax return deducting fees paid for investment advice.
Investment Advisory Fees
Knight v. Commissioner of Internal Revenue
(continued)The Trustee had deducted 100% of investment advisory
fees (without subjecting the fees to the 2% AGI
limitation) on the theory that the expenses “would not
have been incurred if the property were not held in such
estate or trust.”
Investment Advisory Fees
Knight v. Commissioner of Internal Revenue (continued) There had been a split among the Federal Circuit Courts
of Appeals Pro-Taxpayer: 6th Circuit (O’Neill v. Commissioner) Pro-IRS: 2nd Circuit, 4th Circuit, Federal Circuit
Held: Investment Advisory fees are generally subject to 2% floor when incurred by an estate or trust. An exception may be available if the trust had:
an unusual investment objective; or required specialized balancing of interests of various parties; or A special additional charge applicable only to fiduciary accounts
In such case, the incremental cost of expert advice beyond what normally would be required for the ordinary taxpayer would not be subject to the 2% floor.
List of Attachments
Letter to Accountant re: Special Needs Trust Grantor Trust Informational Tax Return Non-Grantor Trust Income Tax Return Knight v. Commissioner of Internal Revenue, US
Supreme Court (decided 1/16/08), 2008-1 USTC
¶50,132 US Supreme Court Decision