How can undistributed trust income be taxed at beneficiary tax rate?

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ljb
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How can undistributed trust income be taxed at beneficiary tax rate?

Post by ljb »

My question is about possible tax advantages of putting money in trust for the benefit of my adult son who is in the zero income tax bracket. He has multiple challenges and is likely to be in a zero or low tax bracket all of his life. Is it possible to draft the trust so that in the early years the trust can accumulate income and not make any distributions, but have the income in those years be taxed at the beneficiary's tax rate?

I will be the grantor and make gifts to the trust. I am prepared to make the gifts irrevocable and retain no reversionary or income interest in the trust. I am also prepared to draft the trust so that the trustee must distribute all trust assets to him and him alone during his lifetime, and only to his estate should he die before the trust assets are exhausted.

The trust will hold only mutual funds, so the only trust income will be dividends, capital gain distributions, and realized capital gains. I live in Ohio which allows for the trust instrument to specify that capital gains be allocated to income which would include them in DNI. This means that all trust income actually distributed can be taxed at the beneficiary tax rate. But I want the same tax treatment for trust income NOT distributed.

I know that if I draft the trust to give my son a Subpart E Section 678 power to demand distribution of all of the trust assets at his discretion, and if he doesn't exercise this right and allows the trust assets to remain in trust, then taxation at his tax rate will be allowed. However, I do not want to do this. I don't want him to be able to spend the funds at a young age.

Any ideas? . . . Thanks!
FBN2014
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by FBN2014 »

I am not an attorney or CPA but am a trustee for several trusts. I have been advised that any income that remains in trust is taxed at the trusts tax rates which are pretty steep very quickly as I am sure you are aware. You may want to put the bond portion of the portfolio in a short or intermediate tax free muni bond fund. Vanguard offers both.
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Lastrun
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by Lastrun »

You are on the right track with the grantor trust rules.

Since you are presumably committed to making a taxable gift to him, what if the funds are temporarily gifted to him and then HE transfers the assets to the trust as the grantor. The trust could be structured with a benign grant of a power to him to remove and replace assets of equivalent value, which will cause the trust to be a defective or grantor trust. He will not be likely to exercise this power during his lifetime because he would have to swap out the trust fund with equal value assets. The income will be taxable to him despite any accumulation and not included in his estate. See Rev. Rul. 2008-22. There is a step transaction issue here that needs to be looked at. There is also the power to borrow without adequate security under the grantor trust rules which also can be drafted to cause the defect, but also in a manner to limit possible exercise. The overall point here is for you to look at this differently in terms of making your son the grantor rather than you which provides more opportunity to cause a defect and grantor trust status.

FBN is also on a good track to look at the underlying investments if you remain the grantor. One thought is to use a low cost deferred variable annuity for investment. Earnings would grow tax-free inside the annuity and only be taxable when removed BUT, there are two caveats here. The first is, that last time I checked, the cost of this "tax-free wrapper" at Vanguard was 30 basis points a year. The second is that you convert all the earnings inside the annuity into ordinary income when they come out. You need to compare this to just investing the trust fund in a a tax efficient index fund and pay as you go. Again, last time I checked there was not much difference between the pay as you go and the annual cost of the annuity for US stock funds (even in the top trust bracket) (perhaps 10 basis points). There is a wiki on tax efficiency on this site, and Vanguard has a white paper on this.

Another thought to explore is a LLC or a partnership with a very restricted membership/partnership interest and you or someone else remains the manager and controls the distribution of net profit. Income would be allocated to him on the K-1, but the earnings/return could be retained in the company. Not perfect, but just thinking out loud.
Topic Author
ljb
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by ljb »

Thank you FBN and Lastrun for the ideas.

It's a brand new idea to me, Lastrun, to structure the trust so that son is the grantor to get taxation at his rate. Thank you!

I did have another idea myself after I posted my question. Instead of not distributing the income to allow it to accumulate within the trust, perhaps I could distribute it to him but ask him to gift it back to me. Then I could gift it again back to the trust. I think I could persuade son to do this. But do you think this would stand up to an IRS audit? If we did this several years in a row with the entire trust income, the IRS might determine that the distributions were made in form only and not in substance.

Regarding setting up a MLP or some kind of a corporation . . . I don't think I have enough money to put into trust for him to be worth the trouble. Also, the family doesn't own any business currently. Those are good ideas for a family with more wealth I think.
bsteiner
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by bsteiner »

ljb wrote:... I know that if I draft the trust to give my son a Subpart E Section 678 power to demand distribution of all of the trust assets at his discretion, and if he doesn't exercise this right and allows the trust assets to remain in trust, then taxation at his tax rate will be allowed. ...
If you're familiar with Section 678 (which treats a beneficiary as the owner of a trust for income tax purposes where the beneficiary has the power to withdraw the trust assets), you're probably a ringer.

You could give him a withdrawal power over the entire contribution that lapses after 30 days.

Some people think that even after the withdrawal power lapses, Section 678 would still apply. There have been several private letter rulings to that effect in the context of lapsed Crummey withdrawal powers where the taxpayer wanted that result to preserve an S election.

Usually the lapse is limited to the greater of $5,000 or 5% of the value of the trust each year, so as not to have the trust assets included in the beneficiary's estate or to have a taxable gift by the beneficiary. However, you said you wouldn't be concerned if the assets were included in his estate.

As you know, the grantor trust rules in Sections 671-677 trump Section 678. So you would have to make sure that the trust wasn't otherwise a grantor trust.

Of course, as you know, the authority on this is sparse. As a practical matter, many trustees and their accountants ignore 5 and 5 withdrawal powers and lapsed Crummey powers after the death of the grantor in determining how the income is taxed.
Last edited by bsteiner on Sat Oct 01, 2022 10:00 pm, edited 1 time in total.
Topic Author
ljb
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by ljb »

I'm not sure what you meant about me being "a ringer", but I'll take it as a compliment :D . . . I'm really just a mom who wants to save money and has been doing A LOT of reading on the internet. I do have an attorney, who is very nice kindly old man and inexpensive, but I'm afraid that he doesn't do much trust work. I feel like I'm going to have to either direct him or find someone else who will almost certainly be more expensive.

Thank you for your suggestion of giving son only a temporary power to withdrawal the trust assets. I'm very nervous about doing that, because if I did it properly (with no implied understanding him that the power is not to be exercised) I bet he would take the money. It would probably be too much money for him to resist.

Another idea is that son currently lives with me but pays no rent. I could have the trust income distributed to him, and then start charging him rent, and maybe even have him start paying his own health insurance premiums. This would be enough to eat up all the trust income and it would would reduce my monthly expenses by the same amount. Then I could afford to make an equivalent amount of additional gifts to the trust. I kind of like this idea, because my goal is for him to move out on his own eventually and then at that time for the trust to be there to help him.
bsteiner
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by bsteiner »

ljb wrote:I'm not sure what you meant about me being "a ringer", but I'll take it as a compliment ....
From your reference to Section 678, I assumed you were a tax or trusts and estates lawyer or both.
ljb wrote:... Thank you for your suggestion of giving son only a temporary power to withdrawal the trust assets. I'm very nervous about doing that, because if I did it properly (with no implied understanding him that the power is not to be exercised) I bet he would take the money. It would probably be too much money for him to resist. ....
You didn't say how old he was. If he were sufficiently young, he (or his other parent or a guardian on his behalf) would be less likely to exercise the withdrawal power.
Redlee
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by Redlee »

ljb wrote: Fri Jun 23, 2017 5:52 pm My question is about possible tax advantages of putting money in trust for the benefit of my adult son who is in the zero income tax bracket. He has multiple challenges and is likely to be in a zero or low tax bracket all of his life. Is it possible to draft the trust so that in the early years the trust can accumulate income and not make any distributions, but have the income in those years be taxed at the beneficiary's tax rate?

I will be the grantor and make gifts to the trust. I am prepared to make the gifts irrevocable and retain no reversionary or income interest in the trust. I am also prepared to draft the trust so that the trustee must distribute all trust assets to him and him alone during his lifetime, and only to his estate should he die before the trust assets are exhausted.

The trust will hold only mutual funds, so the only trust income will be dividends, capital gain distributions, and realized capital gains. I live in Ohio which allows for the trust instrument to specify that capital gains be allocated to income which would include them in DNI. This means that all trust income actually distributed can be taxed at the beneficiary tax rate. But I want the same tax treatment for trust income NOT distributed.

I know that if I draft the trust to give my son a Subpart E Section 678 power to demand distribution of all of the trust assets at his discretion, and if he doesn't exercise this right and allows the trust assets to remain in trust, then taxation at his tax rate will be allowed. However, I do not want to do this. I don't want him to be able to spend the funds at a young age.

Any ideas? . . . Thanks!
Did you find any good solution to this?

We are in a similar situation with regard to one our children and are trying to accomplish the same result. And we're getting conflicting guidance from the attorneys we have consulted.

The first attorney said it couldn't be done. The attorney we went to for a second opinion said that if the income was made available for withdrawal to the beneficiary for a limited time to each year, the income would be taxable to the beneficiary (even if the money was kept in the trust) under Section 678. And also said that the amount of income made available to the beneficiary should be limited to $5,000 or 5% of the trust.

When we reported this back to the first attorney (the one who has been preparing out estate plan) he said that the second attorney must be "of a certain age" with outdated information--that nobody has been using Section 678 and/or "the 5 and 5" since the 90's because of all the "problems they caused."

I'm not sure who to believe.

So I'm wondering what guidance you got--If you don't mind me asking, what did you end up doing?
bsteiner
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by bsteiner »

ljb wrote: Sun Jun 25, 2017 8:35 pm I'm not sure what you meant about me being "a ringer", but I'll take it as a compliment :D . . . I'm really just a mom who wants to save money and has been doing A LOT of reading on the internet. I do have an attorney, who is very nice kindly old man and inexpensive, but I'm afraid that he doesn't do much trust work. I feel like I'm going to have to either direct him or find someone else who will almost certainly be more expensive.
...
I assume you have an estate large enough that you expect to pay estate tax, since if you didn't, you wouldn't do this during your lifetime, so as to get a basis step-up for the assets at your death.

If you expect to have a taxable estate, the cost of a more appropriate level of legal advice shouldn't be an obstacle.
Redlee wrote: Sat Oct 01, 2022 9:09 pm ...
We are in a similar situation with regard to one our children and are trying to accomplish the same result. And we're getting conflicting guidance from the attorneys we have consulted.

The first attorney said it couldn't be done. The attorney we went to for a second opinion said that if the income was made available for withdrawal to the beneficiary for a limited time to each year, the income would be taxable to the beneficiary (even if the money was kept in the trust) under Section 678. And also said that the amount of income made available to the beneficiary should be limited to $5,000 or 5% of the trust.

When we reported this back to the first attorney (the one who has been preparing out estate plan) he said that the second attorney must be "of a certain age" with outdated information--that nobody has been using Section 678 and/or "the 5 and 5" since the 90's because of all the "problems they caused."

I'm not sure who to believe.
...
Withdrawal powers over annual exclusion gifts

In the 1990s the estate and gift tax exclusion amount ranged from $600,000 to $650,000, so almost all of our clients had taxable estates. Many made annual exclusion gifts each year to take advantage of some or all of their $10,000 per donee annual exclusion. Gifts in trust qualified for the annual exclusion if the beneficiary had a withdrawal power (often referred to as a Crummey power, named after the taxpayer in the case that allowed this). As long as the withdrawal rights didn't lapse by more than the greater of $5,000 or 5% of the value of the trust each year, the lapsed amount wouldn't be a gift by the powerholder or be incluible in the powerholder's estate. Given the current level of the estate and gift tax exclusion amount, very few people have taxable estates. However, taxpayers who expect to have taxable estates still do this.

5 and 5 powers generally

My guess is that the lawyer was referring to 5 and 5 withdrawal powers not related to annual contributions, such as marital trusts, credit shelter trusts, and trusts for children. From 1979 to 1995, the IRS took the position that if a grantor reserved the right to change the trustee, the trust would be included in the grantor's estate. Most lawyers believed that this also applied to beneficiaries. To give the spouse or child some degree of control, we often gave the beneficiary a 5 and 5 withdrawal power, which allowed the beneficary the right to withdraw up to 5% of the trust assets each year. We did this when a client proposed giving the beneficiary the income. We said that this effectively gave the beneficiary the option to take or not take the income each year. But in 1995, the IRS changed its position, and agreed if a grantor had the power to change the trustees, the trust wouldn't be included in the grantor's estate as long as the replacement trustee couldn't be a close relative or subordinate employee. Most lawyers assume that the same would apply to a beneficiary. By giving the spouse or child the power to remove and replace trustees (provided the replacement isn't a close relative or subordinate employee), the beneficiary will effectively control the trust. So there's no longer any need to give the beneficary a 5 and 5 power.

Section 678

Section 678 taxes trust income to a beneficiary who has the power to withdraw it: https://www.law.cornell.edu/uscode/text/26/678.

Some people think that you can shift the income to a beneficiary by giving the beneficiary a withdrawal power that lapses.

As I said on June 25, 2017:

"You could give him a withdrawal power over the entire contribution that lapses after 30 days.

Some people think that even after the withdrawal power lapses, Section 678 would still apply. There have been several private letter rulings to that effect in the context of lapsed Crummey withdrawal powers where the taxpayer wanted that result to preserve an S election.

Usually the lapse is limited to the greater of $5,000 or 5% of the value of the trust each year, so as not to have the trust assets included in the beneficiary's estate or to have a taxable gift by the beneficiary. However, you said you wouldn't be concerned if the assets were included in his estate.
...
Of course, as you know, the authority on this is sparse. As a practical matter, many trustees and their accountants ignore 5 and 5 withdrawal powers and lapsed Crummey powers after the death of the grantor in determining how the income is taxed."
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Lee_WSP
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by Lee_WSP »

Redlee wrote: Sat Oct 01, 2022 9:09 pm
You and OP must know someone who read Ed Morrow's BDOT article, heard him speak, or talked to someone who has.

https://www.cfsarasota.org/files/galler ... T-2021.pdf

It's a relatively new and/or not widely used technique.
bsteiner
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by bsteiner »

Lee_WSP wrote: Sat Oct 01, 2022 10:24 pm
Redlee wrote: Sat Oct 01, 2022 9:09 pm
You and OP must know someone who read Ed Morrow's BDOT article, heard him speak, or talked to someone who has.

https://www.cfsarasota.org/files/galler ... T-2021.pdf

It's a relatively new and/or not widely used technique.
It's been around for a while. I think Steve Oshins has also written about it.

You are correct that it isn't widely used. It's complicated, it's uncertain, it can throw assets into the beneficiary's estate, and most accountants aren't familiar with it. You can mitigate the estate tax issue over time by having the withdrawal power lapse as to 5% of the trust assets each year.

We did it twice where there were large capital gains on which the beneficiary wouldn't be taxable. One case involved a qualified domestic trust (QDOT) with a nonresident alien spouse that was selling foreign real estate. The other involved a beneficiary who had a large loss carryover.

Before this, there was some discussion about a simpler form -- giving a beneficiary a 5 and 5 power and taking the position that it's a Section 678 trust as to 5% of the income and gains in year 1, 9.75% of the income and gains in year 2, etc.
Redlee
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by Redlee »

bsteiner wrote: Sun Oct 02, 2022 8:28 am
Before this, there was some discussion about a simpler form -- giving a beneficiary a 5 and 5 power and taking the position that it's a Section 678 trust as to 5% of the income and gains in year 1, 9.75% of the income and gains in year 2, etc.

Yes, and following this progression (5% in year one, 9.75% in year two, etc.), you exceed 50% in year 14. (Specifically for year 14, 51.2325% would be attributed to the beneficiary.

However, since the $5,000 or 5% is the *maximum* -- lower numbers could be used.

If the power were just for 2.5%, then it would change the numbers as follows: 2.5% for year one and 4.9375% for year 2. For year 14, it would be 29.8840%. In fact, the 50% mark wouldn't be crossed until year 28.

So using 2.5% instead of 5% would dramatically decrease how much of the trust would be deemed to be part of the beneficiary's estate, which is useful if having the estate tax kick in is a concern. Also there is concern, that any amount the beneficiary has the power to withdraw will end up in the hands of creditors, which is another reason to limit it. However, having a portion be part of the estate would be a good thing to the extent that it is not subject to the estate tax, but gets a bump-up on basis on death.

And if using 2.5%, if the portfolio is tax efficient, then 2.5% should cover a good portion of the income in most years. It probably wouldn't cover all the income--but it looks like it would cover enough of the income to make a difference if the beneficiary is in a lower tax bracket than the trust (which is likely unless the beneficiary has very high income).

But while this seems to me like it should be a viable strategy--with it making a real difference in some situations--it doesn't seem like this is something that is actually being used very much...
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Lee_WSP
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Re: How can undistributed trust income be taxed at beneficiary tax rate?

Post by Lee_WSP »

The power lapses. At any given point in time, the beneficiary only has control over five percent. Crummey trust estate inclusion is fairly settled amongst planners.
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