Tax and Asset Protection Planning with Non-grantor Trusts

Take-Away: Estate planning with the use of grantor trusts receives a lot of attention these days. The benefit of using a non-grantor trust are often overshadowed by grantor trusts for moderately wealthy individuals, yet in many cases taxes can be saved with the use of a non-grantor trust.

Background: A non-grantor trust is taxed as a separate legal entity, unlike a grantor trust where the trust’s income is taxed, usually, to the trust’s settlor. [In some situations, a beneficiary can be taxed as the grantor of the grantor trust, usually referred to as a BDIT-beneficiary defective grantor irrevocable trust.] Like a grantor trust. a non-grantor trust can provide asset protection for a family. However, other income tax attributes can also arise through the use of a non-grantor trust, which may be helpful after the 2017 Tax Act.

Example: Phyllis, a physician, and her husband, Harry, have a net worth of $12 million. Prior to the 2017 Tax Act, Phyllis and Harry were interested in adopting spousal lifetime access trusts (SLATs) to avoid federal estate taxes on their deaths. As a physician, Phyllis and Harry were also focused on the asset protection features of a SLAT in addition to removing $12 million in their assets from their taxable estates. As the SLAT estates grow in value, the estate tax savings would also grow from the use of the SLATs. Now, post-2107 Tax Act, Phyllis and Harry will achieve no federal estate tax savings by creating and funding the two, non-reciprocal, SLATs. However, there are still plenty of income tax advantages to Phyllis and Harry, beyond asset protection, from the creation of a non-grantor trust(s). Some of the advantages from creating non-grantor trusts follow.

Asset Protection: Assets held in an irrevocable trust cannot be seized by creditors to satisfy claims against the trust beneficiary if there is a spendthrift limitation/prohibition in the trust. [MCL 700.7502; 700.7504.]If the trust is a support trust, a limited number of exception creditors can attach the beneficial interest in the trust, but only when distributions are made from the trust to the beneficiary. [MCL 700.7503.] The beneficiary of the non-grantor discretionary does not hold a property interest in the trust for creditor purposes, so there is no property interest that a judgment creditor can attach and sell. [MCL 700.7505; 700.7815(1).] The settlor can also now be a beneficiary of the non-grantor trust that he/she creates with creditor protection if the non-grantor trust is established as a Michigan Qualified Dispositions in Trust, aka asset protection trust. [MCL 700.1041 et. seq.] Consequently, if Harry creates a discretionary SLAT for Phyllis’ benefit, any judgment creditors that she might have will not be able to access Phyllis’ beneficial interest in the SLAT.

Preserve Charitable Income Tax Deductions: Many individuals will not exceed the new standard deduction threshold for federal income taxes. As a result, they will lose the income tax benefits that result from their charitable giving. [It has been estimated that the income tax standard deduction of $24,000 for a married couple will cause charitable giving to drop by about $13 billion per year. Similarly, with the 2017 Tax Act’s doubling the federal estate tax exemption, it is estimated that charitable bequests will drop another $4 billion per year.] However, the use of a non-grantor trust can salvage much of the federal income tax charitable deduction. While some strategies have been identified to address the loss of any income tax deduction benefit through charitable giving, like bunching several years’ charitable gifts into a single calendar year in order to exceed the annual standard deduction amount for one year, e.g. a large gift in one year to a donor advised fund, it is questionable just how effective those alternative charitable giving strategies will ultimately prove to be. Funding a non-grantor trust with income producing investments and authorizing the trustee of that non-grantor trust to make distributions to charities from the trust’s gross income will enable the trust to make income tax deductible charitable contributions to off-set the trust’s taxable income. [IRC 642(c).] Phyllis’ SLAT created for Harry could authorize income distributions to charities in addition to income distributions to Harry. The Phyllis’ heirs can also benefit from the same non-grantor trust by giving the trustee the authority to allocate income distributions among charitable and non-charitable beneficiaries, while naming the Phyllis’ heirs as the remainder beneficiaries of the trust.

Avoid the Net Investment Income Tax (NIIT): A non-grantor trust can be used to avoid the 3.8% net investment income tax, aka Medicare Surtax, if the trustee is actively involved in a business that is held in the non-grantor trust. [IRC 1411.] If an individual’s modified adjusted gross income (MAGI) exceeds $200,000 that individual will be exposed to the NIIT tax on all of their reported investment income. However, the NIIT tax may not apply if the no-grantor trust does not exceed its MAGI amount. This is still something of a gray area as the IRS believes that a trustee must actively participate in the day-to-day affairs of the business to avoid the 3.8% tax [TAM 201317010], yet federal courts have taken a more lenient view of the trustee’s participation in the business held in the trust to be characterized as an active participant in the business, i.e. the income received from the business is business income not investment income. [Frank Aragona Trust, v. Commissioner, 142 Tax Court No. 9, 2014).] Therefore, while Phyllis and Harry might be exposed to the 3.8% NIIT, a non-grantor trust created by either of them might keep their MAGI low enough to avoid the NIIT.

Avoid the State and Local Tax Annual Deduction Limitation: The 2017 Tax Act limits the income tax deduction for state and local taxes paid (SALT) to $10,000 per taxpayer. If title to real estate is transferred to a non-grantor trust, then that trust will have its own SALT deduction limit with regard to the real property taxes that the trust pays with regard to its real estate. Obviously other income producing assets would have to be transferred to the trust to generate the income required to pay the real property taxes, but from that taxable income will be deducted the real property taxes (up to $10,000) that are paid by the trustee. If Phyllis and Harry own a cottage and they pay state income taxes due to Phyllis’s profession, segregating their cottage in a non-grantor trust would enable the real property taxes associated with the cottage to be deducted (by the trust), which would not be the case if Harry and Phyllis’ home and cottage real property taxes are added to the state income taxes they paid all of which aggregate in an amount above $10,000. Note that even if their cottage were owned in a non-grantor trust it would not benefit from the personal residence exemption (PRE) since that is only available for their home.

Claim the IRC 199A Deduction: It may still be possible to move business assets into multiple trusts to enable each trust then to claim the IRC 199A 20% qualified business income tax deduction against its share of the qualified business income. Admittedly, it will require a fair amount of courage for Phyllis and Harry to do so.

–        The Final IRC 199A Regulations emphasize that using non-grantor trusts for the purpose of tax avoidance will not work. Those Regulations provide: “Section 643(f) grants the Secretary authority to treat two or more trusts as a single trust for purposes of subchapter J if (i) the trusts have substantially the same grantors and substantially the same primary beneficiaries, and (ii) a principal purpose of such trusts is the avoidance of the tax imposed by chapter 1 of the Code. Section 643(f) further provides that, for these purposes, spouses are treated as a single person. The final regulations clarify that the anti-abuse rule is designed to thwart the creations of even one single trust with a principal purpose of avoiding, or using more than one, threshold amount. If such trust creation violates the rule, the trust will be aggregated with the grantor or other trusts from which it was funded for purposes of determining the threshold amount for calculation the deduction under section 199A.”

–        Unfortunately, many of the more favorable examples that were provided in the Temporary IRC 199A Regulations were removed from the Final IRC 199A Regulations. No examples were provided in their place. Moreover, no effort was made in the Final Regulations to provide definitions for the terms used such as principal purpose or substantially identical grantors and beneficiaries. Consequently, there is little guidance how irrevocable non-grantor trusts might be used to escape IRC 643(f), even when there is no tax avoidance purpose for using several trusts.

–        Consider a non-grantor trust that was established years ago for the Phyllis’ children, which holds a part of a closely held business, such as membership units in the LLC that owns Phyllis’ office building, which it leases to her medical practice. This non-grantor trust operates as a pot trust for the children’s benefit, but the trustee is also given authority under the trust instrument to divide that pot trust into multiple trusts, one share for each child when the youngest child attains the age of 25 years. If the trustee follows the division directive when the youngest child attains age 25 years, arguably that division will activate IRC 643(f), even though that non-grantor trust and its terms were established years before the 2017 Tax Act. However, it should be hard for the IRS to argue that the division of the children’s pot trust was motivated by Phyllis’ tax avoidance. Alternatively, consider an existing pot trust where the trustee is given the discretion, at any time and for any reason, to divide the non-grantor pot trust into multiple trusts, and that discretion is now exercised by the trustee. Can it be argued that the discretion given to the trustee under the non-grantor trust years, created years ago, to divide the trust is now suspect because the separate non-grantor trusts might now each qualify for the IRC 199A deduction. This later example (the trustee exercising discretion to create multiple non-grantor trusts) might be a closer call than an existing non-grantor trust that requires separate trusts to be created upon an event outside of the trustee’s control.

–        As has been reported previously in discussing IRC 643(f), it may be possible to avoid its application if Phyllis and Harry create different trusts for each of their children, arguably with different trust terms for each non-grantor trust. While Phyllis and Harry, the settlors of each trust, will be identical, the Final Regulation’s conjunctive, and beneficiaries, will not, which could make a difference when multiple non-grantor trusts are created for estate planning purposes (and not simply tax avoidance purposes.)

Conclusion: Irrevocable non-grantor trusts will continue to be used for lifetime gifting purposes, especially in this period where large gift tax exemptions can be exploited to reduce the settlor’s exposure to future federal estate taxes. Not to be overlooked are some of the income tax savings that can be achieved with a non-grantor irrevocable trust. Some of the income tax savings can be relatively easily obtained, dependent upon the nature of the asset that is transferred to the non-grantor trust, e.g. real estate, and the beneficiaries of the non-grantor trust, e.g. charities eligible to receive gross income. Less clear is whether other income tax benefits, like the IRC 199A income tax deduction will be available in light of the broad scope, but without any guidance, of IRC 643(f)’s anti-abuse purposes where trusts will be consolidated or attributable to the settlor.

George Bearup
Senior Trust Advisor