Trust and Estate Strategies and Solutions

Alyssa Rausch: Great to have you.

Scott Testa: Hopefully we can have some fun with trust today.

Alyssa Rausch: We definitely will. So let's talk about decanting. For wine, decanting is the process, as you know, of transferring wine from a bottle to a container and leaving the sediment at the bottom. Is decanting in the trust world similar, in that you're leaving the bad provisions in the old trusts? And then transferring only the good provisions and the new trusts? And why would someone's decant? What are the income tax consequences, if any? And how does it all work

Scott Testa: Exactly. It's a actually interesting topic to start with because a lot of times we get questions on decanting. People no longer like the terms of the trust, a lot of people do estate planning that involves setting up irrevocable trusts, and it's tough to change the terms of the trust or they no longer like the terms of the trust, they no longer apply. The best example is when you have a trust that's payable to the beneficiaries, their children, their heirs at certain ages and they say age 35, for example. And the kids start reaching adulthood and twenties and early thirties and the granter realizes that the children no longer should probably receive those assets at those ages. So they might want to extend the terms of the trust. Another reason could be to correct some ambiguities in the trust or possibly move situs of the trust.

But decanting is done for another reason. It could also be done to merge trusts. So when you decant, you're moving assets from one trust to another, from an old trust to a new trust. And it's supposed to be continuation of the old trust into the new trust. But many provisions, a lot of decanting is done. The first thing you want to look to is the trust document, to see if decanting is permitted in the trust. In other words, there could be a broad discretion to distribute assets from one trust to the other. So a lot of times the trustee will rely on that, rather than estate trust decanting statute. So we look to the trust document, if in the best interest of the beneficiaries it can be done, you distribute one assets to the other.

So as far as income tax consequences, like I said, it's supposed to be continuation, but a lot of times it's based on a distribution. So that distribution from the old trust to the new trust, will generally carry out income like it would on a normal distribution. But that trust will terminate and any tax attributes in the old trust will move into the new trust. So there really shouldn't be any tax consequences upon a decanting.

Alyssa Rausch: All right. So let's jump into a new topic, grantor versus non-grantor trust. Which one is the best? So with a grantor trust, we know that when the trust generates income, the grantor unfortunately has to pick up the tax bill. However, with a non-grantor trust, it depends on whether or not the trust is simple trust or a complex trust. And I want to know which one is the better one. But with the simple trust, everything that gets distributed to the beneficiary, the beneficiary pays the tax on the income. But the trust itself would pay the capital gain.

However, if it's a complex trust, then only the amount that actually gets distributed to the beneficiary, does the beneficiary have to pay tax on. So why when people grantor or settlers come in to set up their trust, what makes them want to choose a grantor trust versus a non-grantor trust? I always wondered this. And also wanted to understand, why simple versus complex? And how does the trust instrument play into all this?

Scott Testa: You've raised a lot of interesting topics and the first thing you have to do is have to understand, what's the difference between a grantor trust and a non-grantor trust or simple and complex trust. But I have to say, the most frequent question I get a lot of times from colleagues, sometimes from clients is what kind of trust is this? Is it a grantor trust for income tax purposes, where the grantor pays the income tax on it? Is it a simple trust that requires all income to be distributed currently? Is it a complex trust? And they want to possibly do some income tax planning or even estate planning with it.

But with a grantor trust, like you said, the grantor retains certain powers over the trust where he's taxed on the income. That could be if you have a trust where there's a power to revoke or a power to retain income, in the grantor or his spouse, then that trust will be a grantor trust. It will also be essentially an incomplete gift trust and as the grantor can, like I said, retain the power to revoke it, and it's essentially a well substitute. But if you're doing an irrevocable trust that's either grantor or non grantor. If it's grantor, the grantor will pay the tax on it. It's a great estate planning move because the payment of the income tax by the grantor on the income that stays in the trust, is not considered an additional gift. So therefore it's a way of getting more money out of your estate, more assets can stay in the trust for future generations.

Now whether you want to go with simple or complex, a simple trust requires that all income be distributed currently. So you have to think about who the beneficiaries are, if you want to make distributions currently, if you want to make them discretionary. A lot of times it's limited to health, education, support and maintenance or the trustee can allow for distributions in complete discretion of ... you have to look to see who your trustee is, as well. Because if you're dealing with a corporate trustee and you want to make sure distributions either go to your spouse or your kids, you might want to put mandatory provisions in there. And again, the more assets you can stay in it in an irrevocable trust, the more assets that will be out of the estate of a spouse or your beneficiaries. So you have to consider all of those things.

Alyssa Rausch: So you really have to think about who the beneficiary is. I mean, who would be getting the money in the first place and how do you want that to work out? What's the timeline? And also it sounds like, with the grantor trust, that's kind of a nice tool because then the grantor pays the tax. And then the trust itself, the assets don't get depleted. So you're able to keep a lot of the value of the assets and the trust out of the estate.

Scott Testa: Exactly. And with the grantor trust, the grantor's going to pay the income tax on it, no matter who receives the distributions. So you have to factor that in, as well. You have to look to see who the trustee is. And as I say, any trust question that you're going to have is going to relate to what does the trust document say. So it's important to examine that and see when distributions are to be made and if it changes from year to year.

Alyssa Rausch: So the next thing I wanted to go into was, I wanted to dive into residency trust. Because I have a client who the only reason why they're considered the trust itself is considered a New Jersey resident for the mere fact that the trustee is located and is a resident of New Jersey. Had they not had a trustee in New Jersey, then they would be able to save at a tax rate of almost 11%, as you know it's pretty high in New Jersey. So is there a way to set up a trust so that it's exempt in a state? Or at least pays at a lower tax rate? How does that all work?

Scott Testa: The residency of a trust is usually determined at the state level. So a lot of states have set up a rule that a trust is resident in that state. If it's set up by the grantor who is resident at the time, he makes a gift to the trust or the time it becomes irrevocable or at the time he dies. It is then a resident and will always be a resident trust of that state.

When you're dealing with a resident trust, you can still have a trust that's resident in the state, but yet exempt for income tax purposes from that state. And New York, New Jersey have the same rule, some states have the same rule that say, if all trustees, all assets and all income is out of that state, that trust will not have enough nexus to be taxed there. It will not be taxed in that resident state and it won't be taxed in any state, as long as there's no income that's specifically sourced to a state.

So if you're dealing strictly within tangibles, and tangibles don't count as assets located in that state. So it is possible, and this is one of my favorite moves, if you could have a trust that's resident exempt and it pays no tax in any state. Now, it has to be a non-grantor trust because a grantor, as we said, will be taxed on all income of the trust. So it has to be a non-grantor trust, and it's only on the undistributed income of that trust. So if the trust can retain the income, the ordinary income, the capital gains, they've all escaped state taxation. And again, every state has different rules. Some states want tax where the trust is administered and each state has their own rules. So you need to consider that if you plan on setting up a trust where you set it up. Or even if you want to decant it and move it to a trust and possibly change the situs.

Alyssa Rausch: So careful consideration should be made to whoever the trustee is when you're forming the trust. Who's the trustee? Where do they reside? Who's the beneficiary? Where do they reside? And looking at all those factors because maybe you could strategize and try to reduce the amount of tax, at least state wise.

Scott Testa: Right. Trust are set up for all different reasons. I mean, it's more than just income and estate tax because you're dealing with asset protection, creditor protection, divorce protection, protection from the beneficiaries. So you need to consider all these things, but there's a number of income tax savings moves, as well, and this is one of my favorites. The example is I had a client that had a trust, it was a grantor trust. He no longer wanted to pay the tax on it, he had private company stock in there, was going to sell the stock about an $8 million gain and wanted to turn off the grantor trust status on it. So he didn't pay the tax on it. And his brother-in-law was the trustee who resided in New Jersey. I'm like, well, if you move the trustee, you change trustees to a non-New Jersey trustee, will completely escape state taxation. So it was a great move and it saved up to 10% of the income tax on the trust at the state level.

Alyssa Rausch: So the other thing I want to go over was your favorite tax strategies. So as I call the alphabet soup of names, there's the rats, the gluts, the krats, all these different kind of thing. I know you wanted to coin your own trust, what was it going to be? The test trust?

Scott Testa: Yeah, first it depends what your goals are, what the client's goals are. And you need to look at estate planning, income tax planning, like I said, asset protection. But from an estate planning standpoint, if you have a trust and you have a lot of clients that are reluctant to give away assets, so they might set up a trust where the spouse is a beneficiaries. So you have that out, you can take distributions to your spouse indirectly through you. If you want to set up a trust and you want to make sure you retain some assets or some right to that income that's in the trust.

It's a great estate planning move, it is a grantor trust because your spouse is a beneficiary. So it does have the tax burn, it gets assets out of your estate. Like I said, a lot of clients are reluctant to start setting up trust to give money away. So I was at a conference, we talked about setting up a test trust. I'm like, let's give it a name, let's give it an acronym. We call it the test-a-trust. And it's just a mechanism to get clients comfortable with giving away assets and getting used to having a trust, and see if they can do some income tax planning on it. Once they get used to it, they can then continue to make gifts, annual exclusion gifts, use their lifetime exemption to get assets out of their estate.

Alyssa Rausch: Yeah, I find a lot what you were saying in terms of control. A lot of the clients don't want to give up control yet, they're not quite ready. So I see where you come from that.

The other thing that when we discussed was I wanted to go over the most frequently asked questions that our clients asked us in our trust and estates practice. And kind of throw them at you and see what your thoughts are. You kind of addressed this one a little bit earlier, but we'll kind of go in a little more depth. How do I change my trust from a grantor to a non-grantor trust? How do I do that?

Scott Testa: Well, first you have to understand what makes a trust a grantor trust and there's certain powers over the trust. Again, some make the trust incomplete, like the power to revoke, power to retain income. But there's other provisions, call it a loophole, call it what you want, where you have a completed gift for estate tax purposes, but it's considered disregarded for income tax purposes. The grantor could retain certain powers like the power to substitute assets or the power to use income to pay for insurance on the life of the grantor.

That power to reacquire trust assets is a typical trust provision that would make a trust a grantor trust for income tax purposes. And a trust should be flexible enough to allow the grantor to toggle on or off that power. So if you have a trust that's a grantor trust, you no longer want to pay the tax on it. Maybe there's a big gain that's going to be in the trust or you just want the beneficiaries to pay their own tax or the trust to pay its own tax at this point. You could toggle off that grantor power.

Alyssa Rausch: Okay. So a lot of times people talk about, and you kind of addressed this earlier, with kids. What are the tax advantages and disadvantages of making a distribution to a child? I know there's obviously that they could be at a lower tax rate. Well of course you have to factor in the kiddie tax, but maybe sometimes you don't always want to do that and maybe why?

Scott Testa: Trust could be used for income shifting, as well. You could move trust to beneficiaries who might be in a lower tax bracket. Like you've mentioned, there's kiddie tax applied that might be taxed at the parents rate, but adult children could be in a lower bracket. Trusts were set up so that they're taxed at the highest rate, at least at the federal level. At a very low level for 2023, that number's $14,450. Anything above that is taxed at the highest rate. So there's flexibility there to make distributions and distribute assets to beneficiaries who might be in a lower bracket.

The next question we sometimes get is from a client, if there's a big gain in the trust and they want to distribute that gain to the beneficiaries, is that permissible? Because under the typical terms of a trust, capital gains are considered corpus and are taxed to and retained by the trust. But there is a way to allow for distributions of capital gains to a beneficiary. One, the trust document could allow for it, the capital gains to be allocated to distributor net income. Or if the trustee regularly and consistently distributes out the proceeds to the beneficiaries. So you have to think about whether you actually want to do that. You also distribute out proceeds from the sale to a beneficiary to distribute out the gains. Because you actually have to distribute out the money to the beneficiary, so that's one of your considerations, as well.

Alyssa Rausch:And it could be very powerful if you do distribute out the capital gains. Because, like you mentioned, if the child, let's say, or the young adult has huge capital loss carry forwards at their individual level and then they transfer the capital gain out to them, they might not have to pay any tax on it because the losses will absorb the gain and the trust won't have to pay tax on it. So that could be a really powerful mechanism. Typically, we're always told that trust pays the capital gains on the tax on it. But you're saying there is a way out of that and we could structure it.

Scott Testa: Right, if you want to regularly and consistently distribute out the gains, it's something you can do. But this should be done essentially from the onset. Again, this only applies to non-grantor trust. The other thing about state income tax that the beneficiary might be in a no tax state, therefore if the trust is in a state where it's paying income tax, it be distributed at the gains to the beneficiary, the beneficiary will pay no state tax.

Alyssa Rausch: Right, right. The other thing is, trust reached the highest tax bracket much faster than individuals, just the way the tax rate schedule is, as you know. So a lot of questions we have from clients are, well, why should I set up a trust then?

Scott Testa:Good question. Let me think about that for a second.

Alyssa Rausch: Well sometimes it's not always for non-tax ... sometimes it's for non-tax reasons to get it out of your well estate. It is more for non-income tax reasons, but it is for estate tax reasons, to get your assets out of your estate.

Scott Testa:  There's several non-tax reasons for setting up a trust. As I mentioned, it could be for asset protection and creditor protection. And then, you could set up a dynasty trust that is out of the estate for your children's and future generations. So it's a powerful tool for estate planning purpose.

Alyssa Rausch: If you keep assets in a dynasty trust, basically you're able to keep it out of the estate, and you don't make any distributions out of it for years and years to the beneficiaries. You can keep it out of beneficiaries going for generations. So-

Scott Testa:Correct.

Alyssa Rausch:It could be really powerful.

Scott Testa: Right. And if the trust only allows for discretionary distributions, again, if the money is needed, you could distribute out the assets to the beneficiary for whatever purpose, if they're buying a house or for whatever reason. Or you can keep the assets in the trust if needed.

Alyssa Rausch: The other question that comes up is, let's say the trust makes a donation to charity. It seems like it would be an obvious thing, but can the trust claim a charitable deduction?

Scott Testa: Well, the first thing you have to look at, like I said, the answer to any trust questions was what does the trust document say? The trust has to allow for charitable contributions, it's got to be written in the trust. That's number one. Number two, it's got to be out of trust income. So trusts don't have the same rules that individuals do, whereas there's a limit to certain percentage of gross income. As long as the payment to the charity is allowed under the trust document and is out of trust income, then the trust can take a charitable contribution deduction. So distributions to charity of appreciated securities don't count because that's considered principle, that's not out of income. But gains do count for income for that purposes.

And the other thing to consider is that other than not being limited to a percentage of gross income, trust can make distributions to foreign charities where individuals can. So if somebody wants to set up a trust and be able to take distribution deductions to charity, you could set up a trust for this purpose, to allow for charitable contributions to a foreign charity.

Alyssa Rausch: So what are some trust income tax strategies that you could apply or implement?

Scott Testa: When dealing with non-grantor trust, there are certain ways to possibly save some income taxes. Like I said, there's the resident exempt trust, that could be exempt from any state taxation. But also trusts are allowed to take additional deductions that individuals might not be able to take. In other words, if you have a non-grantor trust, you get an additional tax deduction. Right now there's the state and local tax limit of $10,000, you can get additional $10,000 income tax or property tax deduction. Tax prep fees are deductible by trust.

The big one here, and we've been seeing a lot of this recently, is a 1202, qualified small business stock, which allows you to exempt up to $10 million of gain from federal taxation. By setting up a non-grant or trust, this gives you an additional $10 million exclusion. So it's a way to stack and pack that $10 million exclusion from gain. So it's a powerful move if you have qualified small business stock. Also, we're currently dealing under the tax cuts and job act, with the qualified business income deduction. Trust get that additional deduction if you have a specified service, that if the grantor is over the limit on the deduction that's allowed, if your income is below a certain threshold. But the trust gives you an additional threshold to take the qualified business income deduction.

Alyssa Rausch: So if I'm a lawyer, let's say, and I decide I have an interest in my part in my law firm, can I transfer some of my interest into a trust? And then, even though it's a specified SSTB, you could potentially, as long as you transfer the right amount of shares, a right amount, exclude or have the 20% QBI deduction? Is that what we're saying?

Scott Testa: Yes, kind of. Although I don't know if a law firm will let you transfer your partnership income into a trust. Again, it's got to be a non-grantor trust. A better example could be an active trader business or passive investment.

Alyssa Rausch: And also, are there any aggregation rules with regard to the section 1202 qualified small business stock within the trusts? How many trusts can you set up to get the $10 million limitation?

Scott Testa:  There is a rule, and it has been in existence for a while about having multiple trusts. But this came into light with the QBI deduction. The IRS feared that people would set up too many trusts just to take advantage of this additional deduction. So you can't have similar trusts. You can have trusts that have different beneficiaries, but you can't have multiple trusts for the same purpose. So I call this, the don't be a hazard rule. You can set up a few trusts for your beneficiaries, one for each child. But if you are using this trust to take advantage of certain tax attributes like the QBI deduction, the 1202 stock, it should be limited to dissimilar trusts.

Alyssa Rausch:  So I also wanted to ask you, Scott, about the Kastner case. Can you describe to us what that case was about and what the key takeaways are?

Scott Testa:Sure. This was a case that involved the state's ability to tax trust. And what was interesting about it is it's a Supreme Court case, the US Supreme Court case. So they rarely ever get to deal with trust issues, but this dealt with a state's ability to tax a trust. And this was a New York Trust created by New York settler under New York law. And it had a beneficiary that had moved to North Carolina. And North Carolina wanted to tax this trust based solely on the residency of the beneficiary in North Carolina.

So this went all the way up to the Supreme Court and basically this case said that this was not enough nexus, that North Carolina could not tax that trust in North Carolina on the basis of one resident beneficiary. And again, the beneficiary was not entitled to receive distributions, they were completely the discretionary. So we can use that to determine what is a state's reach and the ability to tax a trust. Now some states, like I mentioned, have their own rules that don't run afoul of any constitutional issues. New York, New Jersey won't tax a trust if there's no nexus there, no assets, no trustees or no income in that state. So we need to look at this case to determine state's ability. I don't know if any other states are going to run afoul of any constitutional issues or might be challenged. But it's just something to keep in mind.

Alyssa Rausch:Yeah, it really is a reminder of making sure that you look at all the state tax rules, each state has their own unique set of rules to determine whether or not it's a resident trust or not in that state or it's taxable. So that's a great summary. Thank you so much, Scott.

So Scott, if you had one thing that you wanted our audience to take away from our conversation, what would it be?

Scott Testa:  The key takeaway is to always refer to the trust document. The answer to any trust question will be, what does the trust document say? This will determine who pays tax on the trust income, who's entitled to receive distributions? Are distributions mandatory or are they discretionary? Did anything change? Did a grantor toggle off the grantor trust power? Did a beneficiary reach a certain age which requires a distribution? And are you able to decant the trust and make a distribution of assets to another trust in the discretion of the trustee? These are a lot of things that are answered within the trust document itself.

Alyssa Rausch:Thank you for joining in the conversation and sharing such valuable insights. It's such a pleasure working with you every day. And just thank you for being here. And thank you for joining in.