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, FEBRUARY 10, 2016 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: James G. Blase, Principal, Blase & Associates , Des Peres, Mo. 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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The Minimum Income Tax (“M.I.T.”) Trust Drafting techniques to help unburden estate planners James G. Blase, CPA, JD, LLM jimblase@blaselaw.com
The M.I.T. Trust Overview T he federal income tax law contains many unfair, if not punitive, clauses applicable to the estate planning area. While most of the unfairness can be eliminated by simply removing all trusts from the client’s estate plan or having the trust distribute all income (including, where possible, all capital gains) to the trust beneficiaries currently, doing so also means eliminating or seriously undermining all the benefits the trusts were designed to achieve. 6
The M.I.T. Trust Overview The MIT Trust isn’t a separate trust document in and of itself, but rather represents several techniques for drafting revocable and irrevocable trusts intended to sidestep the federal income tax law’s aforementioned unfairness. The goal of the MIT Trust is to minimize overall income taxes for clients and their families without disrupting the clients’ non -tax estate-planning objectives. 7
The M.I.T. Trust Unfair Laws Here’s a sampling of some of the unfair income tax laws applicable to estate planning: A maximum federal income tax rate of 39.6 percent on trusts applicable to levels of trust taxable income in excess of only $12,400, whereas single individuals don’t reach the 39.6 percent bracket until their taxable incomes exceed $413,200; 8
Unfair Laws A 5 percent surtax on capital gains and qualified dividends of trusts applicable when trust taxable income is in excess of only $12,400, whereas single individuals don’t pay the same surtax until their taxable incomes exceed $413,200; A 3.8 percent surtax on items of net investment income of trusts when adjusted gross income (AGI) exceeds only $12,400, whereas single individuals don’t pay the same surtax until their AGIs exceed $200,000; 9
Unfair Laws At the first spouse’s death, a new income tax basis for the surviving spouse for all community property owned by a married couple which isn’t income in respect of a decedent (IRD), however titled, but for residents of non-community property states, a new income tax basis only for non-IRD assets includible in the first spouse to die’s gross estate for federal estate tax purposes; and A loss of a new income tax basis on non-IRD assets when most trusts terminate as a result of the death of the life beneficiary, whereas non-IRD assets owned outright by an individual generally receive a new income tax basis at the individual’s death. 10
Minimizing Taxes on Trusts Minimizing the effect of the current high income tax rates on trusts, without undermining the purpose of the trusts through unnecessary outright distributions of trust income and capital gains, involves using Internal Revenue Code Section 678. The aim is to cause the trust beneficiary, rather than the trust, to be taxed on the trust’s taxable income, including capital gains, by vesting the beneficiary with a sole power of withdrawal over the trust income. 11
Utilizing IRC Section 678 If desired, an estate planner can limit the beneficiary’s withdrawal power to the types of trust income that are taxed at the highest federal income tax rates only, for example, by excluding qualified dividends and capital gains taxed at still favorable (though, as discussed above, not as much for most trusts) income tax rates, as well as items of federally tax-exempt income. The so- called “portion rules,” under IRC Section 671 and the related regulations, are what allow for this “tax tracing” treatment. 12
Utilizing IRC Section 678 Estate planners should ensure that no provision of the trust document will infringe on the power holder’s Section 678 “sole power to vest” the trust income for the current tax year (including, if desired, capital gains) in himself. For example, a disinterested trustee may possess the power to suspend the beneficiary’s withdrawal power (if, perhaps, the beneficiary is exercising his withdrawal power unwisely or if the beneficiary gets divorced or is the subject of a lawsuit), but only if the suspension power is exercised prior to the beginning of the trust’s applicable tax year. 13
Utilizing IRC Section 678 Note that attaching an IRC Section 678 income withdrawal power to a bypass or otherwise estate tax or GST tax exempt trust can also provide transfer tax benefits in high net worth situations, i.e., by intentionally causing the trust beneficiary to be taxed on the income of the estate tax or GST tax exempt trust, thus reducing the size of the beneficiary’s independent taxable estate while preserving the full value of the tax exempt trust. 14
Combining with IRC Section 2514(e) To avoid an annual taxable transfer by the beneficiary, the beneficiary’s withdrawal power over trust income should be limited to 5 percent of the value of the trust, per year. The scope of the 5 percent limitation should normally be broadened to its fullest extent possible, by making it clear in the trust document that the trustee may satisfy the beneficiary’s withdrawal right by liquidating any asset of the trust, including those payable to the trust over time, such as benefits payable under individual retirement accounts, qualified plans and nonqualified annuities. 15
Distributions Over 5 Percent If distributions in excess of 5 percent of the trust value are determined to be desirable in any given year (for example, because the trust has a significant amount of capital gains or IRA/qualified plan receipts during the year), a disinterested trustee may be given the authority to make such excess distributions to the beneficiary. Capital gains, however, must first be properly allocated to the distributable net income (DNI) of the trust; otherwise, they won’t “carry out” to the beneficiary. 16
Allocating Capital Gains to DNI The IRS regulations establish alternatives for recognizing capital gains as part of DNI by providing that an allocation to income of all or a part of the gains from the sale or exchange of trust assets will, generally, be respected if it’s made pursuant to either: the terms of the governing instrument and applicable local law, or a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law. 17
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