Since the passage of The American Taxpayer Relief Act of 2012 and the submission of the President's federal budget proposal for 2014, it is clear that high net worth and high income taxpayers continue to be under attack. Surprised?
Reacting to these "silver bullets" is like a game of grade school Dodgeball You hope that you don't get hit. I might mention in passing that after many years of heavy weightlifting and conventional sports participation, one of my worst sports injuries as a child or adult came through a game of Dodgeball. Clearly, it is not a game for sissies and I can promise you that the tax version of the game is not a game for sissies either.
This article focuses on the high marginal tax brackets that some taxpayers must contend with as a result of federal and state level tax reform. The top federal marginal tax rate is now 39.6 percent for taxpayers filing a joint tax return with adjusted gross income (AGI) in excess of $450,000. The new long term capital gains rate is 20 percent. The tax rate for dividend income is also 20 percent. A new Medicare tax of 3.8 percent is assessed on investment income for joint filers with AGI in excess of $250,000.
The Pease limitation on miscellaneous itemized deductions and the phase out of personal exemptions has the effect of adding an additional two percent to the marginal tax bracket. Additionally, a Medicare surcharge of 0.9 percent applies for earned income in excess of $200,000.
Some states have raised personal income taxes. The top bracket in California is now 13.3 percent of income in excess of $1 million. The top bracket for residents of New York City is 12.7 percent(8.82% State and 3.876% New York City). The top marginal bracket in New Jersey is 8.97 percent. The top bracket in Minnesota is 7.85 percent. A large cluster of states hover in the 5-7 percent range for state tax purposes.
Some states have such a high personal income tax rate that the combination of the new federal long term capital gains tax of 20 percent along with the new Medicare tax on unearned income of 3.8 percent plus the top marginal tax rate in a particular state, approaches the top federal marginal tax rate of 39.6 percent. Consider a top marginal bracket taxpayer from California with a long term capital gains and dividend rate of at least 37.1 percent and a tax rate of at least 58-59 percent on ordinary income!
In this game of Dodgeball, it may not be exceedingly difficult from a legal standpoint to minimize the tax impact on passive investment income and investment real estate located outside of the jurisdiction of residence.
This article is designed to analyze how the "game" is played and what it takes to avoid being "hit" by the Taxman - state or federal, in this game of Dodgeball. The article will analyze PLR 201310002 as the roadmap for how to play the game.
We need to cover a little ground before we jump into an example of the strategy. First, what is a so-called “grantor trust”? The Internal Revenue Code – Sections 671-679 provide the rules for grantor trusts. Grantor trusts have been the mainstay in advanced estate planning techniques largely since Chapter 14 (IRC Sec 2701-2704) largely paralyzed the use of “partnership freezes” and corporate reorganizations as estate freezing techniques.
Under the grantor trust rules, the trust settlor is considered the owner of trust assets for income tax purposes. As a result, all trust income and losses flow through the trust to the settlor. The trustee is able to accumulate assets within the trust without any depletion for income tax purposes. The grantor or settlor’s payment of the income tax liability is not considered an additional gift to the trust. At the same time, the trust assets are outside of the settlor’s taxable estate.
Trusts that are not taxed as grantor trusts are taxed as separate taxable entities. In general, marital trusts and most testamentary trusts are non-grantor trusts (“NGT”). Most asset protection trusts are also non-grantor trusts for income tax purposes. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket- $11, 950. A NGT is a trust that does not fall within any of the provisions of IRC Sec 671-679.
The essential trust provisions necessary to classify a trust as a NGT include retention of a power by the settlor to name new trust beneficiaries, or to change the interest of trust beneficiaries except as limited by a special power of appointment (ascertainable standard). The settlor’s transfer to a trust with this power renders the transfer an incomplete gift for gift tax purposes.
Income Taxation of Trust Income within a Non-Grantor
Believe or not, the legal question of a State’s right to tax trust income has been litigated a lot including the U.S. Supreme Court several times. The constitutional restraint on a State’s ability to tax trust income centers on the 14th Amendment Due Process and the Commerce Clause. Most of the States focus on these five criteria below:
(1 ) Was the trust was created by the Will of a testator who lived in the state at death?;
(2) Did the settlor of an inter vivos trust live in the State?;
(3) Is the trust administered in the State;
(4) Does one or more trustees live or do business in the State?;
(5) Does one or more beneficiaries live in the state?
Here is a brief summary for how trust income taxation works out for our key states:
(1) New York (NY) -NY will not tax a trust’s income if it has no NY trustees, no NY assets, and no NY source of income. Intangible property such as investment portfolio assets should be exempt from NY state and local income taxation in a Nevada Trust.
(2) New Jersey (NJ)- NJ will not tax a trust’s income if it has no NJ trustees, no NJ assets, and no NJ source of income.
(3) Connecticut (CT) – CT will not tax a trust’s income if it has no CT trustees, no CT assets, and no CT source of income.
(4) California (CA) – CA taxes trust income if the trust has at least one trustee resident and one non-contingent beneficiary in CA.
(5) Massachusetts (MA) – MA will not tax a trust’s income if it has no MA trustees, no MA assets, and no MA source of income.
A. The Facts
The facts of PLR 201310002 involved the creation of a Nevada irrevocable trust. Under the provisions of the trust, the grantor established the trust for the benefit of himself and his issue. The trust had a single trustee, a corporate trustee. The terms of the trust provided that the trustee had to distribute the net income and principal as directed by the Distribution Committee of the trust. During the grantor's lifetime, the trust had three major provisions.
(1) Grantor's Consent Power - At any time, the Trustee, pursuant to the direction of a majority of the Distribution Committee members, and with the written consent of Grantor, could distribute to Grantor or Grantor’s issue such amounts of the net income or principal as directed by the Distribution Committee
(2) Unanimous Member Power- At any time, the Trustee, pursuant to the direction of all of the Distribution Committee members, other than Grantor, could distribute to Grantor or Grantor’s issue such amounts of the net income or principal as directed by the Distribution Committee
(3) Grantor's Sole Power At any time, the Grantor, in a non-fiduciary capacity, was able but not required to, distribute to one or more of the Grantor’s issue, such amounts of the principal as the Grantor deemed advisable to provide for the health, maintenance, support and education of Grantor’s issue. The Distribution Committee could direct that distributions be made equally or unequally among the trust beneficiaries.
The terms of the Trust provided that at all times at least two “Eligible Individuals” had to be members of the Distribution Committee. Under the terms of the trust, an “Eligible Individual” was a member of the class consisting of the adult issue of Grantor, the parent of a minor issue of Grantor, and the legal guardian of a minor issue of Grantor.
The trust terms provided that a vacancy on the Distribution Committee had to be filled by the eldest of Grantor’s adult issue other than any issue already serving as a member of the Distribution Committee, or if none of Grantor’s issue not already serving as a member of the Distribution Committee is an adult, then the legal guardian of the eldest minor issue shall serve, or if such minor issue does not have a legal guardian, then the parent of such minor issue. At all times, the Distribution committee required at least two eligible members.
Upon the Grantor’s death, the remaining balance of the Trust had to be distributed under the grantor's testamentary special power of appointment to or for the benefit of any person or persons or entity or entities, other than Grantor’s estate, Grantor’s creditors, or the creditors of Grantor’s estate, as Grantor could appoint under his last will and testament.
In default of the exercise of the special power of appointment, the balance of Trust had to be distributed, per stirpes, to Grantor’s then living issue in further trust. If none of Grantor’s issue is then living, such balance had to be distributed, per stirpes, to the then living issue of Grantor’s deceased father
B. Key Rulings within PLR 201310002
The taxpayer essentially wanted three outcomes in the ruling. First, he wanted to make sure that the trust was not a grantor trust for tax purposes and that he would not be taxed on the trust's income. Secondly, the grantor wanted to ensure that the funding of the trust would not be a completed gift for gift tax purposes and lastly, that trust distributions from the trust were not taxable gifts to the either the grantor or the trust beneficiaries. The Service ruled favorably on all three matters.
(1) Non-Grantor Trust Status
Based on the facts the ruling request, the Service concluded that none of the circumstances in the trust caused the grantor to be treated as the owner of any portion of Trust under the grantor trust rules. Additionally, none of the members of the Distribution Committee members had a power exercisable solely by himself to vest trust income or principal to himself, resulting in the Distribution Committee being treated as the owner for income tax purposes of any portion of the Trust under § 678(a).
Additionally, under the facts of the ruling, the Service did not see anything that would cause administrative controls to be considered exercisable primarily for the benefit of Grantor under § 675. The Service stated that this aspect was a question of fact dependent upon the operation of the trust and could only be evaluated at the time the tax return was reviewed.
(2) Incomplete Gift for Gift Tax Purposes.
The Service ruled that the gift was not a completed gift for gift tax purposes and that distributions by the Distribution Committee to the grantor were not completed gifts. The Grantor was considered as possessing the power to distribute income and principal to any beneficiary himself because he retained the Grantor’s Consent Power.
The retention of this power caused the transfer of property to Trust to be wholly incomplete for federal gift tax purposes. Under the consent power, the grantor retained the Grantor’s Consent Power over the income and principal of Trust.
Under § 25.2511-2(e), a donor is considered as himself having a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property. The Distribution Committee members were not takers in default for purposes of § 25.2514-3(b)(2). They were merely co-holders of the power.
The Distribution Committee ceased to exist upon the death of Grantor. Under § 25.2514-3(b)(2), a co-holder of a power is only considered as having an adverse interest where he may possess the power after the possessor’s death and may exercise it at that time in favor of himself, his estate, his creditors, or the creditors of his estate. In this case, the Distribution Committee ceased to exist upon Grantor’s death. The Service ruled that the Distribution Committee members did not have interests adverse to Grantor under § 25.2514-3(b)(2) and for purposes of § 25.2511-2(e).
The Grantor also retained the Grantor’s Sole Power over the principal of Trust. Under § 25.2511-2(c), a gift is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries. In this case, the Grantor’s Sole Power gave the grantor the power to change the interests of the beneficiaries. The retention of the Grantor’s Sole Power causes the transfer of property to Trust to be wholly incomplete for federal gift tax purposes.
The grantor also retained a testamentary special power of appointment over the property in trust allowing the grantor to appoint to any person or persons or entity or entities, other than Grantor’s estate, Grantor’s creditors, or the creditors of Grantor’s estate.
Under § 25.2511-2(b) the retention of a testamentary power to appoint the remainder of a trust is considered a retention of dominion and control over the remainder. The retention of this power causes the transfer of property to Trust to be incomplete with respect to the remainder in Trust for federal gift tax purposes.
The Distribution Committee possessed the Unanimous Member Power over income and principal. This power was not a condition precedent to Grantor’s powers. The grantor’s powers over the income and principal were presently exercisable and not subject to a condition precedent. The Grantor retained dominion and control over the income and principal of Trust until the Distribution Committee members exercised their Unanimous Member Power. Accordingly, that type of power did not cause the transfer of property to be complete for federal gift tax purposes. Goldstein v. Commissioner, 37 T.C. 897 (1962); Estate of Goelet v. Commissioner, 51 T.C. 352 (1968)
Any distribution from the Trust to the Grantor was merely a return of Grantor’s property. The Service concluded that any distribution of property by the Distribution Committee from the Trust to the Grantor was not a completed gift subject to federal gift tax by any member of the Distribution Committee.
(3) No Gift Taxation for a Distribution to a Trust Beneficiary
The powers held by the Distribution Committee members under the Grantor’s Consent Power were powers that were exercisable only in conjunction with the grantor. Under § 2514(c)(3)(A), the Distribution Committee members did not possess general powers of appointment by virtue of possessing this power.
The powers held by the Distribution Committee members under the Unanimous Member Powers were not general powers of appointment. As in the example in § 25.2514-3(b)(2), the Distribution Committee members had substantial adverse interests in the property subject to this power. Accordingly, a distribution made from the trust to a beneficiary, other than Grantor, pursuant to the exercise of these powers, the Grantor’s Consent Power and the Unanimous Member Powers, were not gifts by the Distribution Committee members. Those distributions were considered gifts by Grantor.
The income tax planning possibilities under the framework of PLR 20131002 for taxpayers in high tax states is substantial. While this article did not focus on asset protection, the asset protection for the type of trust outlined in this article are substantial representing a significant additional planning benefit. The tax savings on passive investment income and real estate outside the jurisdiction of residence is readily attainable if following the roadmap outlined in this article.
The contribution of property to Trust by Grantor is not a completed gift subject.
Any distribution of property by the Distribution Committee from Trust to Grantor will not be a completed gift subject to federal gift tax, by any member of the Distribution Committee.
Any distribution of property by the Distribution Committee from Trust to any beneficiary of Trust, other than Grantor, will not be a completed gift subject to federal gift tax, by any member of the Distribution Committee.