Now is the time for high-income individuals and Trustees of irrevocable, non-grantor trusts (such as Bypass Trusts or Dynasty Trusts) to begin looking at ways to minimize their 2018 income tax bill by dealing with income the trust generated this past year.
A higher-net worth client is an obvious focus, but do not neglect widowed spouses. I often find widowed spouses need the most help with administering the trusts after their spouse passes. Many do not realize that a Bypass Trust may be required or that it needs to file a tax return. This misunderstanding or lack of knowledge will only create many more tax problems down the road for their beneficiaries.
In this “extra-credit” article, I outline multiple trust-focused, income-reducing strategies that your individual and Trustee clients should consider before the end of the year. Here are my suggestions:
Using Charitable Remainder Trusts-To Reduce Income Tax for Individuals
While you may be familiar with Charitable Remainder Trusts (CRTs) as an estate tax reduction technique, the CRT is also effective in reducing income taxes under the right circumstances.
The rules for calculating the income tax deduction for a CRT are complex and have limitations based on several factors, including a taxpayer’s adjusted gross income, other charitable giving, and the type of assets being used to fund the CRT. Aside from being able to take a limited income tax deduction over five years for the value of the property transferred into a CRT, a CRT can be used to reduce a client’s income tax bill as follows:
- Avoiding a Large Capital Gain. For clients who anticipate recognizing a large capital gain on an appreciated asset, such as the sale of their business or founder’s stock, the asset can be transferred into a CRT before sale. The client will not recognize any capital gain on the sale. Payment of the annual distribution is only taxed when the client receives it, which spreads the income over a number of years.
- Shifting Income to the Next Generation. If you have clients who will not need the income, they can provide an income stream for their children by transferring income-producing property into a CRT. This shifts the taxable income down to the next generation who are likely in a lower tax bracket.
- Planning for Retirement Income. A Net Income With Makeup Charitable Remainder Trust (NIMCRUT) can be used to invest for tax-deferred growth while the client is still working and will not need investment income. After the client retires, the CRT assets can be invested to replace the lost income.
Strategies for Reducing the Taxable Income of Irrevocable Trusts
Under federal income tax laws, irrevocable, non-grantor trusts (such as Bypass Trusts and Dynasty Trusts) are subject to highly compressed income tax brackets for income retained and accumulated in the trust. In 2018, the top 37% tax rate kicks in at only $12,500 of trust income. In addition, trusts in the top tax bracket are subject to the 20% long-term capital gains rate and the 3.8% surtax.
As part of their fiduciary responsibilities, Trustees of this type of trust must evaluate ways to minimize the impact of income taxes on the trust’s income. After taking into consideration the terms of the trust agreement, the ongoing needs and tax status of the trust beneficiaries, and applicable state law, income-reducing strategies Trustees should consider include:
- Distributing trust income to beneficiaries so that income is taxed on the beneficiaries’ tax returns (usually at a lower effective rate).
- Making in-kind distributions of low basis trust assets to beneficiaries.
- Invoking the 65-day rule and distributing trust income to beneficiaries by March 6, 2019, which will allow the trustee to take a 2018 deduction.
- Exploring options to permit capital gains to pass to beneficiaries instead of being taxed inside of the trust, such as reforming or decanting the trust to broaden the Trustee’s discretion to allocate between trust income and principal.
- Shifting trust investments to focus on long-term appreciation rather than current, taxable returns.
- Terminating small, uneconomic trusts.
Planning to minimize income taxes is a delicate balancing act. The needs of the individual taxpayer or trust beneficiary must be carefully weighed against the overall tax savings. In addition, income, gains, losses, and tax brackets must be reviewed annually since the expenses of the individual or trust beneficiary will change from year to year.
Please feel free to call me with any of your questions or concerns. I’m happy to provide information, guidance, and collaboration.
Kevin Snyder is a husband, father, and an estate and elder law attorney at Snyder Law, PC. He is passionate about family, educating his community, and helping parents, seniors, and veterans protect what matters most.