General income tax rules. The typical revocable trust is not a separate entity for income tax purposes, and the grantor is taxed on trust income at individual tax rates. Subject to certain exceptions, the typical irrevocable trust is a separate entity for income tax purposes, and the trust pays income tax on undistributed income and on its capital gains at trust income tax rates. Another way to say this is that the trust receives a deduction for amounts distributed to trust beneficiaries.
Trust income tax rates are compressed. In fact, whereas an individual must earn in excess of $523,600 before the 37% tax rate kicks in, a trust must pay that rate on income in excess of just $13,050. Obviously, there is often an incentive for a trust to distribute income to beneficiaries.
Grantor trusts. All trusts, including irrevocable trusts, classified as grantor trusts are not separate entities and therefore pay no tax. Instead, the grantor pays the tax. Grantor trusts are trusts in which the grantor retains one or more specific powers or interests in a trust such as the power to revoke or amend the trust or the so-called swap power or power to substitute assets of equal value. When the grantor dies, these retained powers die with her. Thus, the trust becomes a taxable entity with its own tax ID.
Simple and Complex trusts. Simple trusts are trusts that distribute all income and do not distribute principal or make charitable contributions. All other trusts are complex trusts.
Estate tax planning. The terms to keep in mind here are “unlimited marital deduction,” “basic exclusion amount,” “bypass trust,”[1] and “qualified terminable interest trust” or “QTIP.” The unlimited marital deduction is the IRS’s gift to married couples because it allows couples to defer estate taxes until the death of the surviving spouse, unless 1. the surviving spouse is not a citizen of the U.S. or 2. the property interest that passed to the survivor is a terminable interest; that is, an interest that passes upon the survivor’s death.
The reason for the 2nd exception should be clear: the IRS wants to collect its pound of flesh sometime. Without the exception, there would be nothing left to tax when the spouse dies. The first exception is justified due to the worry the foreign spouse will die outside the U.S. and possibly pay not pay the estate tax bill. Non U.S. spouses do have an annual exemption of $159,000 on transfers and can defer estate taxes via a qualified domestic trust or QDOT, which is structured such that the estate tax will be paid on the 2nd death.
In addition to the marital deduction trust, the bypass trust is the other go-to tool for estate planners helping their wealthy clients avoid the estate tax. Simply put the bypass trust works like this: 1. Fund the trust with the basic exclusion amount of (currently) $11,700,000. This money/property can avoid the taxman—possibly forever. The remaining property goes into the marital trust, taking advantage of the decedent’s basic exclusion amount and ensuring the property will be taxed at the 2nd spouse’s death. This trust is often a QTIP or terminable interest trust that will qualify for the marital deduction and which will allow the grantor to take care of the surviving spouse until he dies. The trust will contain directions where the property will go after the spouse dies—typically to the children.
Disclaimer Trusts
There are disclaimers and then there are qualified disclaimers, disclaimers that don’t result in gift of estates taxes on the transfer. We’re interested in IRS qualified disclaimers.[2] To be qualified, a disclaimer must
- Be irrevocable and unqualified,
- Be in writing,
- Be received by the transferor, his legal representative, or holder of legal title no later than a date that is 9 months after the later of
- The day on which transfer is made or
- The day on which the transferee turns 21,
- Be given before the person disclaiming has accepted any interest or benefits, and
- Pass without any directions from the person disclaiming and pass either
- To the spouse of the decedent, or
- To a person other than the disclaimer.
Disclaimers are tool sto allow grantors and spouses to defer decision making where things are uncertain—and aren’t they almost always? For example, what if when planning was originally done, the estate was well below the threshold for application of the estate tax, where there might not have been a reason for funding a credit shelter trust. Instead, all the property either went into the marital trust or was distributed outright. Years later, the estate has grown substantially. When the grantor dies, the surviving spouse or some other beneficiary could disclaim, resulting in the disclaimed amount funding the credit shelter trust and thus saving estate taxes.
Of course, this approach has its drawbacks, chief among them being the reluctant beneficiary. Money talks after all.
Crummey Powers and the IRS
Crummey v. Commissioner[3] is the reason we have Crummey powers in our legal lexicon. The case involved a trust into which the Crummeys made annual gifts of $3,000 to each of their children (you can give %15,00 per child per year in 2021). The children, in turn, had the right to withdraw $3,000 each year from the trust. The Crummeys claimed that the withdrawal right qualified the yearly gifts as present interests and therefore eligible for the annual exclusion. Ultimately, the 9th Circuit agreed with them, even their argument that the gifts in trust to the two minor children were also present gifts, arguing that “We interpret that [that “the demand couldn’t be resisted”] to mean legally resisted and, going on that basis, we do not think the trustee would have any choice but to have a guardian appointed to take the property demanded.[4] In 1973, the IRS issued Rev. Rul. 73-405, which said
[A] gift in trust for the benefit of a minor should not be classified as a future interest merely because no guardian was in fact appointed. Accordingly, if there is no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution, the transfer is a gift of a present interest that qualifies for the annual exclusion allowable under section 2503(b) of the Code.
Why is this important? Because using Crummey powers, people can remove assets from their estate via trusts. Because using Crummey powers, people can pay premiums on a life insurance policy in an ILIT (irrevocable life insurance trust). But remember, the Crummey power works because the donee of the power has the right to withdraw. Best practice dictates that donees receive a letter each time a gift to the trust is made, alerting them to the fact that they do have that right.
I Can Help
If you would like to explore these or other ideas further, schedule a virtual meeting with me by clicking on the red button in the lower right-hand corner of this webpage for a free consultation.
[1] Also referred to as the credit shelter trust or family trust or B trust.
[2] IRS Code §2518
[3] 397 F.2d 82 (9th Cir. 1968)
[4] Id 88
My dad was a life insurance salesman. I remember rummaging around in his sales materials and finding a service he subscribed to that reported on the estate tax problems of the rich and famous and even the not-so-famous. He used the reports to make the point that his prospective clients needed to do some estate and insurance planning, so their families wouldn’t face similar fates.
People do rollovers for a variety of reasons. They retire. They change jobs. They become dissatisfied with their current IRA provider. In those cases and others, there’s a need to change move your retirement money from one plan to another. And typically the move goes smoothly–without a hitch.