Kansas Estate Planning with Trusts
Tax planning for the use of a trust requires an understanding of individual income taxation, fiduciary income taxation and estate taxation. This guide is not intended to constitute legal advice to any specific circumstance. Every circumstance is different. This is a general summary of the law.
Common Estate Planning TechniquesIrrespective of the design, most clients plan to avoid the burdens associated with administering their estate through the commencement of a probate case. Instead, these clients seek what are known as *will-substitutes* which are instruments and arrangements that transfer their assets automatically upon their death by operation of law without a formal conveyance document or an order from a probate court. Common will-substitutes include joint tenancy bank accounts, qualified retirement plans, life insurance policies and transferable on death accounts.
Likely the most common will-substitute is the inter-vivos revocable trust sometimes called a living trust. A trust is an instrument wherein the grantor transfers legal ownership of property to a trustee. At the same time, the grantor or beneficiaries of the trust are the equitable owners of the trust property. In Kansas, a trust instrument has the following features:
(1) An explicit declaration and intention to create a trust; (2) the transfer of lawful and definite property made by a person capable of making transfer thereof; and (3) a requirement to hold [the property] as trustee for the benefit of a cestui que trust with directions as to the manner in which the trust funds are to be applied.
The trustee owes a fiduciary duty to manage the property held in the trust for the benefit of the trust beneficiaries. Under Kansas Law, a revocable trust can be funded by a formal conveyance instrument such as a deed or assignment; or by grantor making a written declaration that certain property shall be held in trust. Typically, a grantor will serve as trustee of their own revocable trust until a time when based on age and other circumstances, the grantor resigns as trustee and appoints a relative or professional to serve as successor trustee. Even though the grantor is no longer trustee, he or she generally retains the right to revoke the trust. When the grantor dies, the trust becomes irrevocable by operation of law. The successor trustee is then charged with distributing the trust assets to the trust beneficiaries in accord with the terms of the trust. The trustee is authorized to administer and terminate the trust without court supervision. Over the course of the grantor*s life, the grantor can convey some or all of his or her assets to the trust. If the grantor transfers all of his or her assets to the trust so that he or she dies owning only minimal assets, then it will be unnecessary to commence a probate lawsuit in order to transfer the grantor*s assets to the beneficiaries. At the time of drafting a revocable trust, a *pour-over will* is executed which provides that any assets owned by the grantor at death are to be conveyed by the probate court to the trust. If the grantor dies, owning substantial assets, then the grantor*s will catches those assets and pours the assets over to the trust.
Tax ConsequencesExecuting and funding a revocable trust generally will not immediately cause a change in a client*s tax circumstances. This is because a revocable trust constitutes what is known under the Internal Revenue Code (*I.R.C.*) as a grantor trust. 26 CFR 1.671-4(b)(1) provides that if a settlor is trustee of a grantor trust, all trust income can be reported on form 1040 and completing form 1041 is not required. A grantor trust is a trust that is deemed to be owned by an individual grantor or beneficiary under I.R.C. ** 671-679. I.R.C. * 673(a) sets forth the general rule that a *grantor shall be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5 percent of the value of such portion.* I.R.C. 674(a) provides with certain exceptions that the grantor shall be treated as the owner of any portion of a trust for which he may exercise a power of appointment. I.R.C. 675 provides that the grantor shall be treated as the owner of any portion of a trust in which he may exchange or dispose of the corpus or income for less than adequate consideration. I.R.C. 676(a) states that a grantor shall be treated as the owner of any portion of a trust *where at any time the power to re-vest in the grantor title to such portion is exercisable by the grantor or a nonadverse party, or both.* Spouses are treated as a single grantor if they are both U.S. Citizens or residents. Thus, a revocable trust established by a husband and wife as grantors will result in both spouses being treated as the deemed owners of all the income and assets related to the trust for federal income tax purposes.
A revocable trust becomes irrevocable upon the death of the grantor. As an irrevocable trust, the trust no longer qualifies under the taxation rules proscribed for grantor trusts. Instead, other portions of Subchapter J of the I.R.C. will govern the tax consequences. An irrevocable trust with any taxable income or gross income exceeding $600 is required to file a tax return using IRS Form 1041. Income arising from an irrevocable trust is in most circumstances taxed to the recipient of the taxable income. In other words, if taxable income is retained by a trust rather than distributed to the beneficiaries, the trust will generally pay tax on that income. Generally speaking, if a trust makes a distribution to beneficiaries, some or all of that distribution may be taxable to the beneficiaries depending upon whether the trust had *distributable net income* (*DNI*) for the tax year. When the beneficiaries receive a taxable distribution, the trust is usually allowed a deduction for an equal amount to prevent taxing the same income twice. If a trust has DNI in a tax year and makes a distribution to beneficiaries, the distribution will be taxable to the recipients only to the extent of DNI. The balance of the distribution constitutes a tax free return of trust corpus or income previously taxed.
Tax Consequences Part IIAs explained above, the extent to which a trust has DNI in a tax year will dictate the tax consequences to the beneficiaries of distributions from the trust. DNI in a given year is essentially the taxable income of the trust plus the personal exemption otherwise available to the trust and with adjustments to remove capital gains and losses and tax exempt income from DNI. Income to a trust is generally taxed consistent with how income to an individual is taxed. However, the calculation of DNI incorporates the trust’s fiduciary accounting income which is governed by state law and the terms of the trust. Fiduciary accounting rules may provide for example that capital gains are allocated to the principal portion of the trust property and therefore do not constitute income of the trust in a fiduciary accounting sense even though a capital gain would result in taxable income under federal tax law. Trustees are restricted by state law and the trust instrument when deciding how to distinguish between income and principal for purposes of honoring the trust terms regarding distributions due to beneficiaries. By incorporating fiduciary accounting income into DNI, Subchapter J generally imposes the burden of the income taxes generated by the trust upon an individual beneficiary only to the extent the beneficiary receives a distribution from the trust. DNI is allocated to beneficiaries according to tiers. Beneficiaries holding an enforceable right to income share in the first tier of DNI pro rata. Beneficiaries holding only a discretionary right to income are allocated any remaining DNI that is not absorbed by first tier beneficiaries. In most circumstances, when a trust makes a distribution to its beneficiaries, the trust is afforded a deduction to the extent of the trust DNI for that year.
Issues Presented by Low Basis PropertyIn light of the potential under Subchapter J for a trust or the beneficiary to be taxed on a capital gain when trust corpus is sold, it is important to consider the basis of property transferred to a trust and the potential for basis to change at the grantor’s death. When property is conveyed intervivos to a revocable grantor trust, there is no distinction for tax purposes between the grantor and the trust and therefore if the property is sold prior to the trust becoming irrevocable, gain or loss on the sale will be calculated by reference to the grantor’s adjusted basis. If the revocable trust still owns the property at the time of the grantor’s death, the revocable trust receives a step-up in basis to fair market value of the property at the grantor’s death. If a grantor makes a completed gift to an irrevocable trust during the grantor’s life, the irrevocable trust will take a carryover basis from the grantor under I.R.C. § 1015. The distinction in treatment of basis under I.R.C. §§ 1014 and 1015 is noteworthy. Under the right circumstances , the decision to utilize a revocable trust, as opposed to an irrevocable trust, to transfer low basis property at the grantor’s death may reduce the capital gains taxes imposed on the trust or the beneficiaries because assets held by the revocable trust are eligible for a step-up in basis to fair market value upon the death of the grantor under I.R.C. § 1014(b)(9).
The timing for recognizing gain on appreciated trust property is elective under I.R.C. § 643(e). Under that subsection, a beneficiary taking an in kind distribution of trust property takes the trust’s carryover basis unless the trust elects to recognize gain when the property is distributed by treating the property as being sold for its fair market value. If appreciated property is transferred to satisfy a pecuniary obligation of the trust, the transfer is treated as a sale.
Planning for Minimum Required Distributions from Tax Qualified PlansTread carefully when considering whether to convey ownership of a tax qualified retirement plan to a revocable trust or to name such trust as beneficiary of the retirement plan. The genesis of this concern is that improper mixing of a trust and a tax qualified retirement plan has the potential to expedite the deadlines for which a beneficiary of such account must begin taking a Minimum Required Distribution (“MRD”) or else be subject to a 50% tax penalty. Retirement plans with tax deferred features must begin distributing plan funds to the employee or plan owner generally beginning at age 70.5. A tax-deferred retirement plan means a plan that is tax qualified within the meaning of I.R.C. § 401(a) or an individual retirement account (“IRA”) within the meaning of I.R.C. §§ 408 and 408A. The MRD is the distribution required by I.R.C. § 401(a)(9). The MRD is calculated using a life expectancy factor based on the age of the employee or plan owner.
One of the beneficial features of a qualified retirement plan is that the investments therein can grow and accumulate earnings income tax deferred which permits the earnings to grow at a faster rate than if the investments were saddled with Applicable income tax on capital gains, interest and dividends. Thus, prolonging the period wherein the investment can grow tax deferred will generally result in a larger asset value for the beneficiary than if the account becomes subject to income tax shortly after a decedent dies. The regulations governing MRDs provide for longer deferral opportunities if an individual is the beneficiary of a retirement plan as opposed to a legal entity such as a trust.
The consequence of naming a trust as the beneficiary of a retirement plan can, without careful drafting consideration, reduce the size of the asset that a decedent is ultimately able to pass to his or her chosen beneficiary and; potentially result in malpractice for the estate planning attorney. For example, consider a client with a $1,000,000 IRA account who intends to leave the entire account to his only child. The client dies when the child is age 30. The child does not need the account for living expenses and would prefer that the account remain invested and grow as large as possible. If the client had been advised to designate his child as the designated beneficiary of the account then at client’s death, then the child will be subject to lower annual MRDs which are calculated with the aim of distributing the account evenly over the child’s life expectancy. As a result, much of the account can remain in tax deferred status for the rest of the child’s life; meaning the account can grow faster than if the earnings were taxed. If the client had been advised to select a trust as the designated beneficiary of the account, then the account must be fully distributed over five years or else be subject to a 50% penalty. Under this scenario, when the account is fully distributed to the child, no portion of the account can grow tax deferred meaning that the account will grow slower over time.
Planning for Estate TaxI.R.C. § 2001 imposes a 40% tax on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States. However, I.R.C. § 2010(a) provides a tax credit (“Unified Credit”) for individuals dying in 2019 which has the effect of excluding up to $11,400,000 (“the Applicable Exclusion Amount”) from such decedent’s taxable estate. Consequently, there is no estate tax due on a taxable estate valued at less than $11,400,000. Furthermore, a surviving spouse can utilize the unused portion of the deceased spouse’s Applicable Exclusion Amount so that estate tax is not imposed unless the couple’s total estate exceeds $22,800,000. Only a small portion of U.S. citizens will ultimately be subjected to federal estate tax. For this reason, consideration of tax basis in trust assets will often be more relevant to tax planning that consideration of the estate tax. Nonetheless, laws can change and a solid estate plan should be flexible enough to address the potential for estate tax liability.
A B (Credit Shelter Trust ) PlanningA couple with assets exceeding the Applicable Exclusion Amount might consider an estate plan that intentionally includes within the taxable estate of the first spouse to die an amount of assets equal to the Applicable Exclusion Amount and then bequeaths those assets to someone other than the decedent’s spouse such as the decedent’s children in order to prevent triggering a martial deduction which has the consequence of tagging those assets for later inclusion in the surviving spouse’s taxable estate. For reasons apparent in the discussion below, this type of planning is sometimes referred to as “A-B Planning.” When a revocable trust is involved in credit shelter planning, the trust provisions generally provide that upon the grantor’s death, the trust becomes irrevocable and the trust corpus is allocated into two separate trusts. One trust is referred to as the credit shelter trust or bypass trust or B trust. The trustee allocates to this trust a portion of the corpus equal to the Applicable Exclusion Amount. The terms of the credit shelter trust provide that the corpus shall pass to beneficiaries other than the surviving spouse except that the surviving spouse during his or her lifetime can access the corpus for his or her health, education, maintenance and support. The credit trust ensures that the first to die’s Unified Credit is fully utilized but still allows the surviving spouse limited access to the corpus. The balance of the trust assets are allocated into what is referred to as the marital trust or continuing trust or A trust. The assets conveyed to the marital trust qualify for the marital deduction thereby removing those assets from the decedent’s taxable estate. By virtue of the Unified Credit and the martial deduction, no estate tax will be due when the first spouse dies. When the surviving spouse dies, his or her taxable estate will include all of the assets owned at death, which will include those assets received under the marital trust unless consumed prior to death.
Disclaimer PlanningA-B Planning imposes additional administrative complexity that may not be appropriate in every situation. When planning the estate of an elderly couple with less than $1,000,000 in total assets, A-B Planning has the potential to cause more problems than it solves. This is especially true in light of the portability provision now included in I.R.C. 2001. In situations where incurring estate tax is unlikely, A-B Planning will usually be unnecessary. However, a device known as a disclaimer trust can create a safety hatch that is flexible enough to provide A-B Planning in the unexpected event that a couple’s assets grow in excess of the Applicable Exclusion Amount. Under a disclaimer trust, at the death of the first spouse to die, all the corpus passes to a marital trust for the benefit of the surviving spouse which qualifies for the marital deduction meaning that none of these assets will be included in the taxable estate of the decedent. If the couples’ assets are less than the Applicable Exclusion Amount, the end result is that no estate tax is due and the surviving spouse has complete access to the entire corpus of the original trust. As a backup plan, the trust will also include a provision for the establishment of a credit shelter trust which will receive a portion of the trust corpus on the condition that the surviving spouse disclaims her interest in the marital trust. If at the time of the first spouse’s death, the trust corpus exceeds the Applicable Exclusion Amount so that A-B Planning is necessary to reduce estate taxes, the surviving spouse can disclaim a portion of the corpus that would otherwise pass to the marital trust. By exercising the disclaimer, assets exceeding the Applicable Exclusion Amount are transferred to the credit shelter trust.
Relevant Private Letter RulingsWhen considering the tax consequences of an estate plan, if relevant case law is not available, one may find helpful guidance in what is known as a private letter ruling from the IRS. A private letter ruling is not binding precedent. However, private letter rulings do provide an indicator of how the IRS is likely to view a legal issue in the future. As part of the research for this paper, a case law search was performed in order to find guidance on how the step-up in basis provisions of I.R.C. § 1014 have been interpreted in the context of a joint trust. A search of all reported federal court cases, including tax court cases, that contained the search terms “joint trust” and I.R.C. § 1014 produced zero results. However, a search of the private letter ruling database produced two highly relevant private letter rulings which are discussed below. In light of the absence of federal case law addressing the subject, these two private letter rulings represent the latest and most relevant guidance on the subject.
Relevant Private Letter Rulings Part IIIn Priv. Ltr. Rul. 200101021, husband and wife grantors sought a ruling with regard to the tax consequences of a joint trust. The joint trust was funded with property that they owned as tenants by the entireties. During their joint lives, either grantor had the power to terminate the trust and cause the trust property to return to the grantors who would then own such property as tenants in common. Pursuant to the trust terms, at the death of the first spouse to die, the deceased spouse shall hold a testamentary general power of appointment over all of the trust assets. If the general power of appointment is not exercised, then the trust provided as follows:
[A]n amount of Trust property sufficient to equal the largest amount that can pass free of federal estate tax by reason of the unified credit, is to be transferred to an Irrevocable Credit Shelter Trust. Any amount in excess of the amount needed to fully fund the Credit Shelter Trust that has not been appointed by the deceased Grantor will pass outright to the surviving Grantor.
The IRS ruled that the contribution of jointly owned assets to the trust did not constitute a completed gift by either grantor because each grantor retained a unilateral right to revoke the transfer causing title to revest in themselves. Each grantor was permitted to terminate the trust and receive 50% of the entire trust corpus. Based on that fact, the IRS found that a distribution of property from the trust to one spouse alone during the existence of the trust would be considered a gift to that spouse from the other spouse equal to 50% of the value of the distribution. This gift would qualify for the marital deduction pursuant to I.R.C. § 2523. At the death of the first spouse to die, the retained control by that spouse over 50% of the trust property caused 50% of the trust property to be included in the deceased spouse’s gross estate under I.R.C. § 2038. Keep in mind, the trust terms also provided that the deceased spouse held a testamentary general power of appointment over 100% of the trust assets. As a result, 100% of the trust assets were included in the deceased spouse’s gross estate for estate tax purposes under I.R.C. § 2041. When the first spouse dies, the surviving spouse is deemed to have lost dominion and control over Trust corpus and therefore is treated as having made a completed gift to the deceased spouse for an amount equal to 50% of the value of the trust corpus. This gift also qualifies for the marital deduction but is also subject to I.R.C. § 1014(e) which prevents a step-up to fair market value basis for appreciated property acquired by a decedent within one year of death that passes to the donor at the death of the decedent. Consequently, only one-half of the trust corpus was eligible for a step-up in basis at the death of the first deceasing spouse under I.R.C. § 1014(b)(9).
Relevant Private Letter Rulings Part IIIIn Priv. Ltr. Rul. 200210051, husband and wife grantors contributed property to a trust that they held as joint tenants with rights of survivorship. During their joint lives, either spouse had the power to revoke the trust causing all property to returned to the spouses. Upon the death of the first spouse to die, the trust divided as follows:
[A]n amount of Trust property equal to the maximum marital deduction allowable to the deceased spouse’s gross estate reduced by the amount necessary to create the largest taxable estate, which after utilizing the unified credit, will result in no tax due is to be transferred to a Marital Trust. During the life of the surviving spouse, the trustee(s) shall pay the net income to the surviving spouse at least quarter-Applicablely, and such amounts of principal as the surviving spouse may direct. Upon the death of the surviving spouse, the trustee(s) shall pay over any remaining principal to such persons that the surviving spouse shall appoint by his or her Last Will. . . . [T]he remaining balance of Trust property is to be placed in a Family Trust. During the life of the surviving spouse, the trustee(s) is to pay all the net income to the surviving spouse. The trustee(s) may also pay so much principal allocated to the Family Trust to or for the benefit of surviving spouse and the issue of both Donors, as the trustee(s) shall deem advisable for their health, support, maintenance, or education. Upon the death of the surviving spouse, the remaining income and principal in the Family Trust shall be distributed to the Donor's living issue per stirpes.
In evaluating the tax consequences of the trust, the IRS found, consistent with the ruling from PLR 200210051, that the portion of the trust corpus transferred to the trust by the first spouse to die would be includible in his or her estate by virtue of I.R.C. § 2038 and the portion of trust corpus transferred to the trust by the surviving spouse would be includible in the estate of the first spouse to die by virtue I.R.C. § 2041 because that spouse held a general power of appointment over all of the trust corpus. The IRS also found, consistent with PLR 200210051, that the property contributed to the trust by the surviving spouse constituted a completed gift to the decedent spouse at the date of the first spouse’s death and was not eligible for a basis step-up under I.R.C. § 1014(e).
Planning OpportunitiesFrom a planning standpoint, consider how the results of PLR 200210051 and PLR 200101021 could be changed if during his or her life, the deceased spouse had the ability to reacquire title to 90% of the trust assets rather than 10%. The analysis from both of the PLRs discussed above would suggest that only 10% of the trust assets constituted a completed gift from the surviving spouse at the time of death of the deceased spouse. As a result, only 10% of the trust assets would be subject to I.R.C. § 1014(e) and 90% of the trust assets would be eligible for a step-up in basis under I.R.C. § 1014(b)(9). In a situation where clients have low basis assets and where one spouse is significantly older than the other, it might be appropriate to draft a trust that provides the older spouse with the ability to withdraw most or all of the trust assets during his or her lifetime. This planning strategy could allow 90% of the assets to experience a step-up in basis at the time of the death of the first spouse and therefore minimize capital gains taxes.
Alternatively, instead of drafting the trust to give one spouse the ability to withdraw most of the assets, the trust terms could provide that each spouse could withdraw from the trust all of the property that was owned by such spouse separately before it was contributed to the trust. Spouses could make tax free gifts between themselves prior to funding the trust so that one spouse ultimately contributes most of the assets to the trust. If that spouse is ultimately the first to die, those assets will receive a step-up in basis to fair market value under I.R.C. § 1014(b)(9).
When making planning decisions, it is important to note that the joint trusts at issue in both PLRs discussed above became irrevocable with regard to all trust assets when the first spouse died. Such a trust provision assures that at least some of the assets in the trust will not receive a basis step up in light of I.R.C. § 1014(e). Perhaps the better planning decision is for each spouse to have his or her own separate revocable trust that is funded with his or her separate property. Under that strategy, none of the marital estate would lose its basis step-up to I.R.C. § 1014(e) because each spouse would retain control over his or her revocable trust until death.
Spendthrift BeneficiariesWhen a trust is a component of the estate plan, it is worthwhile to consider the nature of the rights of the beneficiaries to access the trust property. Kansas law makes a distinction between vested rights and a mere expectancy. Will-substitutes such as a beneficiary designation in a retirement plan, a beneficiary of a TOD account or a beneficiary under a revocable trust constitute only a mere expectancy as opposed to a vested right. This distinction is warranted because the interest can be divested by depletion, revocation or by changing the beneficiary. On the other hand, a beneficiary’s interest in an irrevocable trust would be considered a vested right.
This concept was highlighted in the Kansas bankruptcy case of In re Hall. In that case, the beneficiary’s father died 18 days after Linda Hall filed a Chapter 7 bankruptcy case. Her father’s death entitled her to receive certificates of deposit, real estate, bonds, life insurance proceeds, and an IRA by virtue of her status as a payable on death beneficiary. If Hall’s interest in these assets was a vested right, then the assets would be available to pay her creditors in bankruptcy as property of the bankruptcy estate. The court in Hall expressly held that an expectancy interest is not property of the bankruptcy estate even the right becomes vested during the 180 day period following the filing date. The Court stated:
POD accounts, TOD accounts, and TOD deeds, as well as revocable inter vivos trusts, are all devices frequently utilized in estate planning as “will substitutes”. Further, interpretation of the terms “bequest, device, and inheritance” to include only property passing pursuant to will or intestate succession, but not other more modern methods of transferring property on death, may appear to exalt form over substance. However, we are required to presume congress intended for the courts to apply the plain language of the statute unless such interpretation would lead to an absurd result.
There is also case law in Kansas providing that a beneficiary’s rights under an irrevocable trust could be excluded from property of the bankruptcy estate if the trust contains a valid spendthrift clause.
Gifts to Irrevocable TrustsA lifetime gift to an irrevocable trust might be an appropriate strategy for someone that wishes to make an immediate gift of property that is appreciating in value, rather than at his or her death, so that the gift taxes on the transfer are based upon the present value and the recipient of the lifetime gift can benefit from the appreciation in the property free of gift or estate tax. This strategy is sometimes known as a “value freeze” and can be accomplished through the use of an irrevocable trust. Under this strategy, presume that a 40 year-old unmarried grantor with two children wants to transfer assets to the children and is contemplating whether to make the transfer currently to an irrevocable trust or to retain control of the assets using a revocable trust that will not become irrevocable until the grantor dies.
Gifts to Irrevocable Trusts Part IIThe critical distinction between a lifetime transfer to an irrevocable trust and a revocable trust is that a transfer to an irrevocable trust will generally constitute a completed gift for gift tax purposes at the time of the transfer whereas a transfer to a revocable trust does not constitute a completed gift because the grantor retains the power until his or her death to revoke the trust. A lifetime gift to an irrevocable trust over which the grantor lacks dominion and control is subject to gift tax pursuant to I.R.C. § 2501(a). Gifts that are worth less than the Applicable Exclusion Amount will not result in the imposition of gift tax as a result of I.R.C. § 2505(a) which provides for a tax credit in an amount equal to the tax on the Applicable Exclusion Amount. In most situations, property transferred by a completed lifetime gift will not be included in a decedent’s taxable estate for gift tax purposes because the decedent no longer owns or retains control over the property. On the other hand, property that is held in a revocable trust over which the grantor has the ability to exercise dominion and control (i.e. by revoking the trust) is included in the gross estate for estate tax purposes. The effect of I.R.C. §§ 2501, 2033 and 2001 is to impose a single transfer tax at the time when property is irrevocably transferred whether by lifetime gift or testamentary bequest.