July 26, 2023
Simple, and Not-So-Simple, Trusts
Take-Away: A trust beneficiary’s power of withdrawal is treated as a general power of appointment for tax purposes. A power of withdrawal can provide flexibility in shifting income to lower marginal income tax brackets, gaining an income tax basis adjustment when the powerholder dies, and avoid generation skipping transfer taxes.
Background: The taxation of trusts is always a ‘big deal’ due to the compressed income tax brackets that an irrevocable trust faces. An irrevocable trust reaches the highest marginal federal income tax bracket (37%) when its accumulated and undistributed income exceeds $14,450. A married couple reaches that federal income tax bracket only after their combined income exceeds $693,750. And it is not just reported income taxes where the income tax disparity arises. For the federal net investment income tax (3.8%), an irrevocable trust must pay this additional tax when its income exceeds $13,450. In contrast, a married couple only has to pay the NIIT when their total income reported on their joint tax return exceeds $250,000. For long-term capital gains and qualified dividends, the more favorable zero-tax rate for a trust stops after only $2,800 in income, while a married couple can enjoy the benefits of the zero-tax rate for up to $109,250 in reported long-term capital gains and qualified dividend income. All of which means that a dynasty-type of discretionary irrevocable trust that fails to distribute its income faces significant tax erosion due to these unfavorable tax compressed brackets, tax rates, and exclusions from tax.
Example: Jack creates a dynasty-type irrevocable trust for his four daughters. The trust generates $200,000 in long-term capital gains and qualified dividends in 2023. If the trust makes no distributions, the trust will owe $45,980 in income taxes. If all of the $200,000 in long-term capital gains and qualified dividends were distributed from the trust to Jack’s four daughters equally, their total federal income tax liability would be $0.00. Or, if the trust’s $200,000 in income came solely from commercial rental income (taxed as ordinary income,) the trust’s tax bill would be $79,311. If all $200,000 rental income was distributed from the trust equally to Jack’s four daughters, their combined income tax bills would be $16,976- a savings of $62,355 when the income is taxed to the individual beneficiaries.
Simple and Complex Trusts: A simple trust is a trust that “requires that the trust distribute all of its income currently for the taxable year and the trust does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for charitable purposes.” [Regulation 1.651(a).] A trust that makes discretionary distributions of income is called a complex trust. [Regulation 1.651(a)-(b).] Thus, any trust that is not a simple trust is a complex trust (talk about an understatement!)
Distributable Net Income Deduction: Under the Tax Code an irrevocable trust will be entitled to claim an income tax deduction for the sum of (i) income required to be distributed; and (ii) other amounts that are properly paid by the trustee during the taxable year to the trust beneficiaries. Trust beneficiaries are then required to report that income, even if the income is not actually distributed to them. [IRC 662(a)(1).] Consequently, the distribution of trust income from a complex trust to a beneficiary will shift the income from the trust’s income tax return to the trust beneficiary’s income tax return. Looking at the example above, the obvious tax benefit from this shift of income from the trust to its beneficiary is to save income taxes overall. However, in order for the discretionary irrevocable trust to actually shift its income to its beneficiaries, it must make a distribution of the trust income to the beneficiaries, sometime an outcome that neither the settlor nor the trustee want for a variety of reasons.
Shifting Trust Income: One way to shift an irrevocable trust’s income to its beneficiary, but without making an actual distribution of income to the trust beneficiary, is through the use of a power of appointment, or more accurately, a power of withdrawal, which is given to the trust beneficiary. A power of withdrawal is treated, and taxed, as a general power of appointment.
Michigan Trust Code: The Michigan Trust Code defines power of withdrawal as follows:
“Power of withdrawal” means a presently exercisable general power of appointment other than a power that is either of the following: (i) exercisable by a trustee and limited by an ascertainable standard; and (ii) exercisable by another person only on consent of the trustee or a person holding an adverse interest.” [MCL 700.7103(f).]
The lapse, waiver, or release of a power of withdrawal does not make the powerholder a settlor under the Michigan Trust Code.[MCL 700.7506.]
Thus, a power of withdrawal given to a trust beneficiary will cause that beneficiary to be taxed on the trust’s income, even when no distribution is actually made by the trustee to the trust beneficiary, effectively shifting that income to a lower marginal income tax bracket.
Example: In Brehm v. Commissioner, 33 Tax Court 734, reversed, 285 F.2d 102 (7th Circuit, 1960) parents created an irrevocable trust for their minor children. The terms of that trust authorized the parents, or guardians for the minor trust beneficiaries, to demand their shares under the trust in writing, or to terminate the trust at any time, the equivalent of a power of withdrawal. The Tax Court held that the trust, and not the minor trust beneficiaries, was taxable on the accumulated trust income. The federal Circuit Court reversed the Tax Court decision. It noted that under IRC 671 and IRC 678, a trust beneficiary is taxable on their share of the trust income if the beneficiary “has a power, exercisable solely by himself, to vest the corpus, or the income therefrom, in himself.”
Thus, by giving a trust beneficiary a power of withdrawal over the trust’s income, the trust instrument’s terms will cause the trust beneficiary, not the trust, to pay tax on the trust’s undistributed trust income without the trustee having to make an actual distribution of the trust income to the trust beneficiary, effectively shifting the income from the trust’s high marginal income tax bracket to the individual trust beneficiary’s lower marginal income tax bracket. [Regulation 1.643(a)-3(d); 1.642(h)-1.] This is often referred to as a beneficiary-grantor-trust, since the trust beneficiary pays the trust’s income tax liability, much like the settlor pays the trust’s income tax liability with a conventional grantor trust.
Proactive Planning with a Power of Withdrawal: Other tax benefits can also be derived by giving a trust beneficiary a power of withdrawal besides shifting the trust’s income tax burden from the trust to its beneficiary.
Income Tax Basis Adjustments: The value of property that is subject to a general power of appointment, like a power of withdrawal over trust income, is included on an estate tax return of the powerholder and will thus qualify for an income tax basis adjustment to the fair market value of the trust’s assets that are subject to that power of withdrawal determined as of powerholder’s date-of-death. [IRC 2041(a)(1); IRC 1014(b)(4).] As such, giving a trust beneficiary a power of withdrawal will result in an income tax basis adjustment to trust assets (hopefully a step-up in basis) on the powerholder’s death.
Example – All Income vs. Right of Withdrawal: Rob and Laura are married. Rob dies, leaving a credit shelter trust for Laura’s lifetime benefit, requiring the distribution of all income to Laura, with the trust’s remainder interest passing to their son Richie on Laura’s death. Rob’s intent is to not have the credit shelter trust taxed in Laura’s estate on her death, so it is a conventional credit shelter trust. Rob gives to Laura a special (or limited) testamentary power of appointment over the credit shelter trust corpus on her death, benefiting potentially skipping over Richie if exercised, and leaving credit shelter trust assets to Richie’s children or more remote descendants. Because Laura holds only a testamentary special power of appointment on her death, there will be no income tax basis adjustment to the credit shelter trust assets on her death. Laura has a large applicable exemption amount that goes unused because the value of the credit shelter trust assets are not included in Laura’s gross estate when she dies.
Instead, if the trust instrument gives to Laura a power of withdrawal over all of the credit shelter’s trust’s income, she will be considered to hold a general power of appointment over the credit shelter trust assets, which in turn will cause the value of the credit shelter trust assets to be included in Laura’s taxable estate on her death, and thus those assets will enjoy an income tax basis adjustment to date-of-Laura’s-death values.
Triggering the Delaware Tax Trap: The Tax Code defines a general power of appointment as including a combination of two powers of appointment, the first which is a special power of appointment, which is then treated/deemed to be a general power of appointment. [IRC 2041(a)(3).] That Tax Code section provides that a special power of appointment will be treated as a general power of appointment [i.e. triggering estate inclusion and a basis adjustment] if the special power creates: “another power of appointment which under the applicable local law can be validly exercised so as to postpone the vesting of any estate or interest in such property or suspend the absolute ownership or power of alienation of such property, for a period ascertainable.” In plain English, if one power of appointment is stacked on top of another special power of appointment, the assets subject to the special power of appointment will nonetheless be taxed in the first powerholder’s estate, even though that first powerholder only held a special (or limited) power of appointment.
Example- Delaware Tax Trap: Rob’s intent was to avoid estate inclusion of the credit shelter trust assets on Laura’s death, so he did not give to her a power of withdrawal over the credit shelter trust’s income- Laura just has the right to receive all trust income. But Laura has plenty of her applicable exemption amount available to her (and her estate) to not have to worry about paying federal estate taxes. Laura, who holds only a special or limited testamentary power of appointment over the credit shelter trust’s remainder interest, can intentionally exploit the Tax Code’s Delaware Tax Trap to force estate inclusion of trust assets on her death. If Laura on her death exercises the special power of appointment on her death and leaves the credit shelter trust assets in a continuing trust, giving Richie a power of withdrawal over that trust’s income(instead of leaving the trust assets outright to Richie), the continuing trust assets that are subject to Richie’s power of withdrawal will be treated for tax purposes as being subject to the general power of appointment held by the powerholder [Laura] who created the power of withdrawal in the beneficiary [Richie.] [IRC 2041(a)(3).] Consequently, if a special power of appointment is exercised to give to another beneficiary a power of withdrawal, then the Delaware Tax Trap is triggered, thus exposing trust assets to an income tax basis adjustment under IRC 1014(b)(9).
Generation Skipping Transfer Tax: A power of withdrawal can sometimes be used as a tool to avoid incurring the generation skipping transfer (GST) tax. By including the value of the trust assets in the power of withdrawal holder’s taxable estate, that will cause the powerholder to be treated as the ‘transferor’ for GST tax purposes.
Example- GST Avoidance: Steve creates an irrevocable trust for his three sons, Robbie, Ernie, and Mike. The trust provides for the sons’ lifetime benefit, giving each a testamentary limited power of appointment over their share of the trust. On the death of one of the sons their interest in the trust passes to the other sons, or to their surviving descendants, if the deceased son dies without descendants. Assume that Mike dies first, leaving two daughters. Later, Robbie dies, but without any children. Robbie’s interest in the trust will now pass to Ernie (50%) and to Mike’s two daughters, Robbie’s nieces, (50%). Distributions from the trust created by Steve (grandfather) to Robbie’s nieces (granddaughters) will cause a 40% GST tax to be incurred. [IRC 2612(b).] If Robbie has more than enough applicable exemption amount available to his estate at the time of his death, Robbie could give to his nieces powers of withdrawal over specific trust assets. Then, Robbie will be treated as the ‘transferor’ of the distributions to his nieces for GST tax purposes, thus causing estate inclusion in Robbie’s estate, but also avoiding the GST tax on distributions from the trust to his two nieces, since Robbie, not his father Steve, is treated as the ‘transferor.’
Conclusion: A power of withdrawal, instead of a ‘right to all income’ can help to expose trust assets to an income tax basis adjustment on the death of the trust beneficiary if that is an important consideration. Should a trust director be given the power to convert a ‘right to all income’ to a ‘power of withdrawal over all trust income?’ Similarly, powers of withdrawal can also be used by a trust beneficiary to intentionally trigger the Delaware Tax Trap, again exposing trust assets to an income tax basis adjustment on the powerholder’s death. And a thoughtful use of a power of withdrawal can avoid a second, GST, tax, when a trust beneficiary dies, by becoming the ‘transferor’ for GST tax purposes. Like all powers of appointment, the power of withdrawal conferred on a trust beneficiary can be expressed by a formula, thus limiting the beneficiary’s estate’s exposure to federal estate taxes, and also targeting those trust assets that will benefit the most from an income tax basis adjustment when the power of withdrawal is conferred. Admittedly, a power of withdraw is not frequently used in most estate planning trusts, but it is something to at least consider in some circumstances.