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George F. Bearup, J.D. Senior Legal Trust Advisor

31-Jan-18

Income Taxation of Trusts and Estates

Take-Away: With the 2017 Tax Act, we can expect that a lot of clients will want to exploit their new $5.0 gift tax exemption by making lifetime gifts into a ‘dynasty’ type trust for the benefit of their spouse (a SLAT) or a conventional ‘dynasty’ trust for the benefit of their children and grandchildren. It is important to keep in mind when creating these trusts the compressed income tax brackets on any accumulated and undistributed trust or estate income that usually results in prohibitive income taxation along with the new rules associated with a 20% deduction against qualified business income and net operating losses. It is also important to make sure that a trust has ‘magic language’ that permits distributions to charities that are income tax deductible.

2017 Tax Act: What follows are the income tax brackets and tax rates faced by trusts and estates that accumulate their income.

Taxable Income: $0.00 to $2,550; The Tax is: 10% of the taxable income

Taxable Income: Over $2,550; to $9,150 The Tax is $255 plus 24% of the excess over $2,500

Taxable Income: Over $9,150; to $12,500 The Tax is $1,830 plus 35% of the excess over $9,150

Taxable Income: Over $12,500; The Tax is $3,011.50 plus 37% of the excess over $12,500

Compressed Income Tax Brackets:  An irrevocable trust or estate that does not distribute its income quickly reaches the highest marginal income tax rate of 37% on its accumulated income in excess of $12,500. If distributions are made from the trust or estate, they normally carry out what is called distributable net income, which means that the beneficiary, rather than the trust or estate, pays the income tax. Consequently there is a high tax ‘cost’ to accumulating income in an irrevocable trust or an estate. Other than make distributions to beneficiaries, sometimes a trustee will want to make distributions to a charity to reduce the accumulated trust income to exposure. However, just making a distribution to a charity by the trustee to obtain an income tax deduction is not as easy as it sounds.

IRC 199A Deduction: A trust or estate may be eligible to claim a deduction under the ‘new’ IRC 199A, which grants a 20% tax deduction against qualified business income, which deduction may mitigate to some extent the confiscatory income taxation faced by an irrevocable trust or an estate that accumulates income. This ‘new’ deduction expires on 12/31/25. What will become  a challenge is how the ‘new’ deduction, if the trust or estate even qualifies to claim it, is allocated between the fiduciaries and the beneficiaries of the trust or estate. The deduction, if available,  cannot be hoarded by the fiduciary and used solely to reduce the accumulated income.

Net Operating Losses: Often a trust or an estate will hold a business that generates losses which can help to reduce current income tax liabilities. Between 2018 and 2026, the excess business losses of a taxpayer other than a corporation cannot be claimed by an estate or trust and are not allowed for the taxable year. These losses are carried forward and treated as part of the taxpayer’s net operating losses (NOL) carryforward in subsequent taxable years. NOL carryovers are generally allowed for a taxable year up to the lesser of the carryover amount or 90% (80% for taxable years beginning after December 31, 2022) of taxable income determined without regard to the deduction for NOLs. Which is a long way of saying that net operating losses will not be as helpful as they have been in the past to reduce a trust or estate’s taxable income.

Charitable Income Tax Deductions By Trusts: As mentioned earlier, one way to avoid the high income tax imposed on accumulated trust income is for the trustee to make distributions which carry out the trust’s distributable net income. Another way is for the trustee to make a distribution of trust income to a charity which results in a charitable income tax deduction claimed by the trust. But not all the Tax Code rules that apply to individuals who make charitable contributions apply to a trust that makes distributions to charities. Some of the difference between individuals who claim charitable deductions and trusts are summarized below:

  • General Rule: A trust is taxed as an individual is taxed, with exceptions which follow; IRC 641(b).
  • Unlimited Contribution: Unlike an individual who has adjusted gross income limits on the amount that can be deducted as charitable gifts ranging from 20% to 60% of AGI, a trust’s annual contributions to charity are unlimited; IRC 642(c)(1).
  • Source of Contribution: An individual can use almost any assets as the source of the gift, e.g. marketable securities, and claim a charitable deduction; a trust can only make charitable contributions using gross income; IRC 642(c)(1).
  • Year of Deduction: An individual can tax the charitable deduction in the year of the gift to the charity, with ‘carry forwards’ of unused deductions that are caused by the AGI limitations; a trust must take the deduction in the year of the charitable gift or in some circumstances, the following year;
  • Trust Instrument Authorization: A trust instrument must specifically authorize a distribution to charity from the trust’s gross income. This power to make charitable gifts is not implied, and if the trust is silent on this power given to the trustee, it will not be inferred. This past calendar year the Tax Court ruled that a court approved trust modification to add a provision empowering the trustee to make charitable gifts from the trust’s gross income was invalid and not binding on the IRS. The Court distinguished a trust modification (i.e. an amendment) from a trust reformation (which has retroactive effect due to a mistake when the trust was initially drafted.)

Key Point: Thus, in order for the trustee to be able to make tax deductible charitable contributions from the trust (which might be an unlimited amount): (i) the trust instrument must expressly contain an authorization or directive to the trustee to make charitable gifts; and (ii) the trust instrument, in order to comply with IRC 642, must expressly state that the source of the tax deductible charitable gift made by the trustee must come from the trust’s gross income.

Tracing Gross Income: This question of the trust’s gross income ‘source’ limitation was recently litigated in the federal courts. In that case an irrevocable trust, which contained the required magic language, used gross income to purchase land. In the following year the land was then donated by the trustee to charity. The trustee initially claimed as a charitable deduction for the trust the price (income tax basis) for the land that it had purchased. Later the trustee filed a claim for an income tax refund, asserting that the fair market value of the land (not just its tax basis-price) should have been used as the amount of the charitable income tax deduction. The federal Court of Appeals held: (i) so long as the land’s purchase could be traced to the trust’s gross income, the land could be the basis for a charitable income tax deduction claimed by the trustee-i.e. property that is acquired using gross income is the equivalent to gross income; (ii) there is no obligation imposed on the trustee to segregate the gross income generated by the trust from other assets held in the trust, but the trustee will still have to trace the purchase price paid for the donated property to the trust’s gross income; and (iii) the trustee is NOT entitled to deduct the fair market value of the land for its charitable income tax deduction, only the property’s adjusted gross basis (purchase price) because the land’s unrealized gain had not be included in the trust’s gross income. Green v. U.S. #16-6371, 2018 Westlaw 386656, 121 AFR 2d 2018-427 (10th Cir. 2018).

Conclusion: If a long term trust is intended, which empowers the trustee to accumulate trust income, that income will be exposed to compressed tax brackets and easily subject to the 37% federal income tax rate, not to mention the net investment income tax of another 3.8%. The trust might get some relief by virtue of the new IRC 199A 20% deduction from business profits. If the trustee feels compelled to make distributions from the trust to charities in order to the amount of income accumulated in the trust, the trust must have specific authority given to the trustee to make those charitable gifts from the trusts gross income. The power to make charitable gifts will not be imputed to the trustee.