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

27-Jan-22

Mitigating the Income Taxes of Non-Grantor Trusts

Take-Away: The high federal income taxation of discretionary non-grantor trust’s accumulated income can be mitigated, to some extent, by directing discretionary distributions from the trust to a charity, a charitable remainder trust or to a qualified subchapter S trust where the trust beneficiary is also the beneficiary of that ‘other’ trust.

Background: As has been repeatedly covered in the past several months, non-grantor discretionary trusts are subjected to an extraordinarily heavy federal  income tax burden. Non-grantor discretionary trusts reach the highest marginal federal income tax bracket with accumulated income at $13,450, while also subjecting that trust to the 3.8% net investment income tax. At the same time, a non-grantor trust is denied any standard deduction, thus making the income taxation of a non-grantor discretionary trust fairly punitive.

Example: If a non-grantor trust has accumulated income of $25,000, it will pay a federal income tax of $7,500 (compared to the income tax a single individual would pay on that same amount of $1,350, or a married couple with that  same amount income, of $60.00.) If the non-grantor trust had accumulated income of $200,000, it will pay a federal income tax of $72,000 (compared to the income tax that a single individual would pay on that same amount of income of $41,500, or a married couple with reported income of $200,000 will pay $30,500.)

Distribution Deductions: Of course, this income tax liability faced by a non-grantor discretionary trust can be mitigated by distributions made by the trustee from the trust, which in turn will reduce the amount of accumulated income held in the trust that is subject to federal income taxation. Distributable net income (DNI) is the trust’s income for the year determined without regard to the deduction for the distribution of DNI to beneficiaries. By distributing DNI [defined in IRC 643(a)] to a trust beneficiary [who is described in IRC 651 and IRC 661] the trustee can reduce the taxable income held in the non-grantor trust and thus shift to an extent the trust’s federal income tax liability. In some cases, capital gain income of a trust (or an estate) does not form part of DNI. The result of the DNI distribution deduction is to shift taxable income away from the non-grantor trust and to the trust beneficiary who is presumably in a much lower marginal federal income tax bracket. Although this shift in taxable income is limited to DNI for the year (and all trusts are required to use a calendar year for income tax purposes) the trustee is allowed to elect to treat any distribution made within 65 days of the close of its calendar year to be treated as made during the prior calendar year up to the extent of the greater of the trust’s fiduciary accounting income (FAI), or its distributable net income (DNI) for the year to the extent it is not already distributed. [IRC 663(b).]

Challenge: One major problem associated with the heavy income taxation of discretionary non-grantor trusts and the use of the trust’s DNI distribution deduction is that many settlors deliberately use a discretionary trust to avoid making large distributions to their trust beneficiaries. Several reasons may exist for using a non-grantor discretionary trust. Maybe the settlor is worried that the trust beneficiary will dissipate the distribution, or lose the distribution through the undue influence of others, or the trust beneficiary faces multiple creditor claims. Then again, the trust beneficiary may currently be entitled to receive governmental benefits, like Medicaid, and a substantial distribution of DNI from the non-grantor trust to that disabled beneficiary will jeopardize that beneficiary’s continued entitlement to governmental benefits. Or, maybe the non-grantor discretionary trust is intended to accumulate wealth in order to prevent that wealth from being subject to federal estate taxation on a trust beneficiary’s death. Whatever the reason for using a non-grantor discretionary trust, if trustee’s decision to make a distribution to the trust beneficiary to carrying out taxable DNI to that beneficiary, that decision may be contrary to one of the settlor’s material purposes for establishing the non-grantor discretionary trust.

Practical Solutions: As such, the trustee is faced with a balancing act to consider trust distributions, to carry out taxable DNI to trust beneficiary who is in a lower marginal income tax bracket ( income tax efficiency) with the settlor’s material purposes which may be to use the discretionary trust as a device to prevent excessive wealth from falling into the hands to trust beneficiaries for a variety of logical reasons. A couple of common trust provisions are used to help the trustee deal with this ‘balancing act’ include:

  • Income Spray Provisions: If a non-grantor discretionary trust has several beneficiaries, the trustee could decide which trust beneficiary to whom to shift DNI for the calendar year by making distributions only to that low-income beneficiary, or beneficiaries,  who is in a marginally lower federal income tax bracket than the trust. That decision to spray trust income to select trust beneficiaries could reduce the overall income tax burden on the DNI earned by the trust. However, that decision could also be challenged by other trust beneficiaries when the trustee appears to ‘favor’ one beneficiary (who is at a lower marginal income tax bracket) over other trust beneficiaries. By mentioning a material purpose of the trust to be the avoidance of income taxes by the trust and the trust’s beneficiaries might help to insulate the trustee from claims of breach of the fiduciary duty of impartiality if DNI is distributed only to those trust beneficiaries who are in lower federal income tax brackets.
  • Distributions to Charity: Another option is to give the trustee under the trust instrument the authority to make discretionary distributions of DNI to a charity, e.g. the settlor’s family donor advised fund. A trust is allowed an income tax charitable deduction for contributions of gross income made for a charitable purpose regardless of the level of the trust’s adjusted gross income (unlike an individual), except when that gross income includes unrelated business taxable income [defined in IRC 512.] However, the authority to distribute trust income in the trustee’s discretion to charities must be expressly authorized in the trust instrument, and such a provision to make distributions to charities cannot be added by decanting the trust assets to a ‘new’ trust where a charitable distributee is authorized. The authority to make a distribution to a charity must be contained in the original trust instrument to be respected by the IRS.

Novel Solutions?: A recent article by Doug and Jonathan Blatmachr and Marty Shenkman suggests naming a charitable remainder trust (CRT) or a qualified subchapter S trust (QSST) as a potential beneficiary of a non-grantor discretionary trust so as to avoid the onerous federal income taxation of the non-grantor trust’s income. Such a distribution to another trust shifts taxable income away from the distributing trust while at the same time preventing the distribution from falling into the hands of the trust beneficiary. While these suggestions may be a bit counter-intuitive for most conventional non-grantor discretionary trusts, they should be kept in mind when structuring a dynasty-type of non-grantor discretionary trust, which will become even more important if Congress gets around to adding the recently proposed federal surtaxes on a non-grantor trust’s accumulated income [a proposed 5% surtax on trust income above $200,000 and an 8% surtax on trust income in excess of $500,000.]

  • CRTs: A distribution to a charitable remainder trust (CRT) [IRC 664] by a non-grantor discretionary trust can be used to shift taxable income away from the distributing trust by using the distribution deduction to carry out DNI to the CRT. The CRT is exempt from income tax. Distributions from the CRT to the CRT beneficiary may be included in the beneficiary’s gross income, but not by following the traditional DNI rules the discretionary trust otherwise faces. [IRC 664(c).] By authorizing the trustee of the non-grantor discretionary trust to make distributions to a CRT established for the discretionary trust’s beneficiary, such a distribution will postpone the taxation of the trust’s DNI. CRT’s, as noted earlier, are tax exempt. CRT’s are also subject to a 100% excise tax on unrelated business taxable income. However, the character of income as unrelated business taxable income (UBTI) is lost when it is distributed from a trust to the CRT. Consequently, for example, a distribution from a non-grantor trust to a ‘net income with makeup remainder unitrust’, or NIMCRUT, could provide significant opportunities to defer income taxation distributed from the discretionary trust, and if the growth in assets not taxed is sufficient, the non-charitable beneficiaries of the NIMCRUT may ultimately receive more wealth than if distributions to them had been made earlier in time from the discretionary trust. Accordingly, a non-grantor discretionary trust might authorize the trustee to make distributions of DNI to CRTs or NIMCRUTs if one or more of the named trust beneficiaries is also a beneficiary of the CRT or NIMCRUT.
  • QSST: In order to be a qualified subchapter S trust (QSST), the trust’s sole beneficiary must be a U.S. individual taxpayer and that beneficiary must be taxed as though the trust were described in IRC 678 to the extent of the income of the S corporation. The trustee of a QSST can be authorized to and may make payments on behalf of a QSST beneficiary, such as paying the income taxes on the income that is imputed to the QSST beneficiary. This imputed income should not cause a disabled beneficiary to be treated as having resources for purposes of governmental benefit eligibility,  nor should the income accumulated in the QSST be subject to the claims of creditors of the QSST beneficiary. In addition, even though S corporation income may be imputed to the trust beneficiary for income tax purposes, that income, if not distributed, will not become part of the beneficiary’s wealth for estate tax computation purposes. Accordingly, a QSST is required to currently distribute it’s fiduciary accounting income (FAI) to its beneficiary. [IRC 1361(d)(3) and IRC 643(b).] However, all taxable income of the S corporation, to the extent the QSST is a shareholder, is attributed to the trust beneficiary regardless of whether the income would constitute DNI. Thus, a distribution of DNI from a non-grantor discretionary trust to a QSST will mean that the income will be taxed to the beneficiary of the QSST level, even if no distribution is actually made to that QSST beneficiary, i.e. phantom income. To the extent the trust distribution constitutes FAI of the QSST it must be distributed, almost immediately, to the QSST beneficiary. Instead of, or in addition to the trust instrument authorizing distributions to one or more QSSTs, of which one of the individual beneficiaries of the discretionary trust are beneficiaries, the trustee could also be authorized under the discretionary trust instrument to make distributions to any S corporation of which one or more of the beneficiaries of the discretionary trust are the shareholders, or one or more QSSTs are the shareholders and each beneficiary of any such QSST is also an individual beneficiary of the discretionary trust. The S corporation income will be attributed to the QSST beneficiary  which QSST is a shareholder of the corporation. Again, giving the trustee the discretion to make distributions to a QSST established for a beneficiary of the non-grantor discretionary trust might enable the trustee to take advantage of the distribution deduction while at the same time satisfy one of the material purposes of the discretionary trust.

Conclusion: If a non-grantor discretionary trust, like a dynasty-type of trust established to continue for multiple generations, is considered as part of a comprehensive estate plan designed to avoid federal estate taxes, then considerable thought should also be given to structuring that trust to avoid the punitive federal income taxes imposed on the trust’s accumulated (not distributed) trust income. Authorizing trust distributions to save federal income taxes should be mentioned as one of the trust’s material purposes to address the trustee’s duty to treat trust beneficiaries impartially. The trust instrument might also include authorization to give the trustee the discretion to make distributions of income to charities. In addition, the trust instrument might also authorize discretionary distributions by the trustee to CRTs or QSSTs that are established for the discretionary trust’s beneficiaries in order to provide additional opportunities to reduce the discretionary trust’s income exposure to federal income taxes, while at the same time preventing the distribution from falling into the hands to the trust beneficiary, contrary to the settlor’s material purpose for his or her discretionary trust..