2017 Tax Act: New Planning With Non-Grantor Trusts

Take-Away: The 2017 Tax Act  forces us to look at planning with a new perspective. The new focus is on saving income taxes, and less on saving estate and GST taxes with each individual now having a $11.2 million transfer tax exemption. In particular, how do we help clients to ‘work around’ the doubled standard deduction and the limitation on state and local tax (SALT) income tax deductions? One way to deal with these changes is to exploit the use of an irrevocable non-grantor trusts which are separate income taxpayers.

Background: The 2017 Tax Act essentially doubled the amount of a taxpayer’s standard deduction ($24,000 for married individuals filing jointly, and $12,000 for single individuals.) Most individuals, especially those with moderate incomes, will claim this larger standard deduction, which means that the charitable income tax deduction or the deduction for real property taxes will no longer be usable by that individual. The ability of an individual to deduct state and local taxes, including state property taxes, is ‘capped’ at $10,000 a year under the Act. Those former income tax deductions will be lost if the taxpayer ends up using the larger standard deduction for income tax reporting purposes.

Non-Grantor Trust: A non-grantor trust is a separate income taxpayer, with its own (small) income tax exemption. A non-grantor trust can help an individual with their income tax obligations under the 2017 Tax Act.  Using a non-grantor trust to report income and claim income tax deductions can provide a couple of tax strategies to at least consider.

Charitable Giving: Some obvious and not-so-obvious strategies should be considered for individuals who are philanthropically inclined, admittedly two not using a non-grantor trust. Consider the individual who regularly gives to charity each year, but who now finds that he/she will only use the larger standard deduction, thus ‘wasting’ their charitable income tax deduction if they continue with their annual charitable giving.

• Obvious: Qualified IRA Distribution: For individuals over the age 70 ½ they can direct that a portion of their required minimum distribution (RMD) for the year from his/her IRA, up to $100,000, be distributed by the IRA custodial directly to a designated charity. While there is no income tax deduction using this Tax Code authorization for a direct payment from their regular IRA, the distribution to the charity from the individual’s IRA will not be included in the individual’s adjusted gross income for the tax year. Indirectly,  the direct charitable distribution from the IRA functions as an income tax deduction (by reducing the individual’s taxable income for the year.)
• Less Obvious: Bunch Gifts to Donor Advised Funds: What if the individual is not yet age 70 ½? The individual can make a large gift to a donor advised fund in one calendar year. The donor then directs gifts from that donor advised fund for the next several years. That ‘bunching’ of the charitable gift to the donor advised fund in one calendar year can overcome the standard deduction limitation for that year, and thus it allows the individual to itemize his or her income deductions for charitable giving for that year. This strategy can also work well when it is timed with some of the few other itemized income tax deductions that remain, such as the medical expense deduction, or the deduction for medical improvements made to a home in the same year that the large gift is made to the donor advised fund. Note, too,  that the IRS recently authorized the use of a donor advised fund to pay the donor’s outstanding charitable pledges [so long as the pledge is not a legally enforceable contract and the gift out of the fund to the charity does not mention that it is in satisfaction of the pledge. (Why the don’t ask, don’t tell condition is needed is a mystery to me!)]
• Not Obvious: Create a Charitable Deductions Trust: What if the donor is uncomfortable with a donor advised fund, since the fund sponsor is only ‘advised’ by the donor, and arguably sponsor does not have to follow the donor’s gift recommendation? As noted, most individuals with moderate income will claim the standard deduction and no longer use the charitable deduction. The individual donor can establish an irrevocable, non-grantor trust and name a family member as trustee. The settlor-donor would transfer enough income producing assets to the trust  to generate enough income to meet the settlor’s annual charitable giving objectives for the year. The trust makes the charitable gifts each year by the trustee using the income generated by the donated income producing assets.  The settlor-donor is thus able to take his/her ‘doubled’ standard deduction each year without wasting any charitable gifts that would otherwise be deductible. The trust will take the charitable income tax deduction against its own taxable income. This retains the full standard deduction for use by the settlor-donor, and salvages the full charitable contribution deduction to offset the investment income earned by the non-grantor trust. In short, the non-grantor trust functions like a donor-advised, with the additional benefit of shifting any appreciation in the trust’s assets out of the settlor-donor’s taxable estate for estate tax purposes.

Multiple SALT Deductions: As noted, many individuals will take the standard deduction now due to it being twice the size of what is was in 2017. Deductions such as the SALT deduction may no longer be useable by the individual taxpayer, particularly those individuals who own a substantial amount of real estate and used to deduct the real property taxes that were assessed on the real property by state and local taxing authorities.

• Use Multiple Trusts:  Assume an individual owns a parcel of real estate besides their home. That individual could create a non-grantor trust to hold title to the real estate (while the transfer would be a gift, the settlor would use part of his/her enlarged gift tax exemption to avoid paying  gift taxes on the transfer of the real property to the non-grantor trust.).This transfer to the trust would enable the $10,000 SALT deduction for the real estate, as the trust would be the new taxpayer that could deduct up to $10,000 in real property taxes, while the individual-settlor could continue to use their own $24,000 standard deduction.  Even if family members are the beneficiaries of the non-grantor trust, there would an ‘uncapping’ of the taxable value on the transfer of the real estate to the trust ( real property is non-residential), but if there is not much of a spread between taxable value and state equalized value for the real property, then there could still be tax savings even if the taxable value increases as a result of the ‘uncapping.’ This strategy might make more sense for real estate held in a state that does not use a ‘hair-trigger’ approach to re-assessing real property values, such as a vacation home in a state that does not play the ‘uncapping game’ like Michigan.
• Fractionalize Real Estate: Assume an individual owns a large parcel of real estate, perhaps commercial real estate with a very large real property tax burden. Assume the individual has three children and four grandchildren. The individual property owner could transfer a 25% tenant in common interest in the real estate to four different non-grantor trusts, one for each child and one for the grandchildren. Again, these would be taxable gifts using the settlor’s larger gift tax exemption to shield the transfers from having to pay a gift tax.  Each of these non-grantor trusts would be able to deduct up to $10,000 in real property taxes. If non-income producing real estate is the subject of this fractionalization of the real estate, then enough other income producing assets will also have to be transferred to each non-grantor trust and in order to pay the real property taxes owed by each trust.
• Cautions: If real estate is to be transferred to non-grantor trusts or fractionalized in order to exploit the $10,000 per trust SALT income tax deduction, a couple of warnings need to be heeded.

IRC 121(i): Assume that a Florida condo is held in the non-grantor trust in order to be able to deduct the real property taxes paid by the trustee on the condo. If the condo (home) is to be sold, the $125,000 capital gain exclusion on the sale of a principal residence under IRC 121 per taxpayer is unavailable to the trust. In order to be able to claim the IRC 121 gain exclusion, the title to the condo must be returned to the individual-settlor at least two years before the condo is sold by the individual owners in order to fall under IRC 121.

IRC 632(f): Assume multiple irrevocable non-grantor trusts are created to hold fractional (tenant in common) real estate interests in order for each trust to claim a SALT deduction for its share of the real property taxes paid. IRC 643(f) is an aggregation rule, which collapses such trusts when they are established  for the same beneficiaries with same purpose and only established to avoid income taxes if it were held in a single trust. Interestingly this code section specifically references Treasury Regulations, but none have ever been promulgated. How does an individual know if he/she is subject to IRC 643(f) when there are no Regulations? Does this mean that IRC 643(f) has no teeth? The obvious point would be to name different beneficiaries for different trusts, perhaps with different trust terms, e.g. powers of appointment given to one child, right to income given to another child, power of withdrawal given to yet another child, and a ‘pot trust’ for the grandchildren,  to avoid imposition of any aggregation rule onto these multiple trusts.

SALT the SLAT: As I have suggested in previous ‘missives’, there should be renewed interest with the 2017 Tax Act in the creation of spousal lifetime access trusts (SLATs.) This is an irrevocable trust that is created by one spouse for the other spouse’s lifetime benefit. However, the donor-settlor does not claim the federal gift tax marital deduction for the transfer of assets to the SLAT established for their spouse, i.e. no QTIP election is made. The result is to use the grantor-spouse’s lifetime exemption amount (now $11.2 million +/-) to shelter the transfer of the gifted assets to the SLAT. That transfer removes $11.2 million from the one spouse’s taxable estate for federal estate tax purposes; nor will the SLAT’s assets be taxed in the beneficiary-spouse’s taxable estate. If the other spouse creates a second SLAT, then between the two SLATs,  $22.4 million of marital estate assets are removed from the couple’s combined taxable estates.

The perceived beauty of a SLAT, beyond avoiding estate taxes on the transferred assets, is that each spouse is the lifetime beneficiary of the SLAT that is created for his/her benefit, thus providing to the married couple almost all of the income that is generated by the $22.4 million of assets which will no longer be subject to federal estate taxation. In short, the couple’s lifestyle continues unabated with the continued flow of income from the $22.4 million in assets, but all of the assets that generate the income are no longer subject to federal estate taxation. The Tax Code is clear though, that normally a SLAT is a grantor trust, as it is a trust that is established for the benefit of a spouse. [IRC 672.] Thus, the SLAT’s income, as well as any deductions and credits generated by its assets,  are passed through to the grantor spouse and reported on the grantor-spouse’s 1040 income tax return. If real property was transferred to the SLAT, and property taxes were paid, the property taxes so paid on the SLAT’s real property would be attributable to the spouse who created the SLAT. Thus we encounter the same problem with an individual who will be taking the standard deduction on his/her own 1040 income tax return, and the SALT deduction for the real estate held in the SLAT may no longer be useable by the individual.

One way to exploit the SLAT as a separate taxpayer is to make the SLAT a non-grantor trust for tax reporting purposes, thus enabling it to claim its own SALT deduction for real property taxes paid. The easiest way for the SLAT to be a non-grantor trust is to give someone who has an adverse interest in the SLAT (adverse to the spouse for whose benefit the SLAT is established) the power to veto any proposed distribution to the spouse. IRC 2514 provides guidance as to who holds an adverse interest to the spouse lifetime beneficiary. An example would be a child who holds the remainder interest in the SLAT; thus a beneficiary whose interest would be harmed through the allowance of a distribution to the spouse-beneficiary holds an adverse interest.

One caveat to the non-grantor SLAT strategy is that each time the adverse interest holder agrees to a distribution to the lifetime SLAT beneficiary, the adverse interest holder may be viewed as making a gift to the SLAT (but the adverse interest holder will also hold another $5.0 million in gift tax exemption that they can apply against that deemed gift each time the deemed gift is made.)

Admittedly this non-grantor SLAT technique is not for everyone, especially with the additional hoops that have to be jumped before a distribution can be made to the lifetime SLAT spouse beneficiary, but it is something to think about if the SLAT strategy makes sense simply to exploit the $5.0 million federal gift tax exemption that just came available to each individual.

Conclusion: The 2017 Tax Act forces us to look at estate planning differently than we have in the past. Using a non-grantor trust as a separate taxpayer, with its own SALT deduction, is something to keep in mind as individuals re-examine their estate planning documents in light of the new tax law.