Income Tax Planning for Trust Beneficiaries

In a recent column I discussed the benefits of embedding continuing testamentary trusts for your children and grandchildren into your revocable living trust. After your passing, rather than having your estate distribute all the assets outright to your loved ones, I suggested protecting them from divorce, creditors and predators.

Your adult children don’t have to lose control of these trusts and the assets. My clients fear a situation where their adult child will have to beg a bank or trust company to enjoy the benefits of her inheritance. You can name your adult children as their own trustee, putting them in control of investment and distribution decisions. This is where the income tax planning comes into play.

When creating testamentary trusts for loved ones, many attorneys will draft provisions that read something like this, “all of the income shall be paid to my child…” This type of provision makes the income tax planning relatively easy in the sense that the trust earns the income (usually interest and dividends) and pays that income to the child/beneficiary. The child/beneficiary is the taxpayer. This type of wording, however, doesn’t help with estate tax planning (as the amounts will likely be included in the child’s estate when he or she dies) or with protecting the assets from divorcing spouses, business lawsuits or creditors.

In order to both minimize tax and offer protection; the trust must be discretionary to the trustee/ beneficiary. Most attorneys do this by limiting the distributions to an ascertainable standard as defined in the tax law. You’ve probably seen this phrase: “My trustee may distribute the income to the beneficiary for her health, education, maintenance and support.” Those are magic words in the Internal Revenue Code that satisfy various legal requirements.

But that generic language isn’t enough to thwart an adverse income tax outcome. Let’s suppose, for example, that Lisa is an adult child beneficiary of her mother’s trust. Mother recently died. The testamentary beneficiary trust for Lisa’s benefit was discretionary, and included the health, education maintenance and support language. Suppose further that Lisa is subject to a lawsuit, so she doesn’t want to distribute the income from the trust, she’d rather accumulate that income inside of the trust until the legal danger subsides.

When income is accumulated, it usually means that the trust is the taxpayer. The income tax rates for trusts are compressed, such that accumulating $13,000 of income results in the trust paying the highest marginal federal rate! Lisa won’t pay that rate unless she earns several hundred thousand dollars of income.

Is there a workaround? Yes, there is. It requires using an advanced planning strategy, that if not used properly, could strip away the asset protection features of Lisa’s testamentary trust. I won’t go deeper than that as an explanation because the strategy should be tailored to each individual situation, but the result is the income can be accumulated, thereby shielding it from the lawsuit, yet treated for tax purposes as if it was distributed to Lisa, so it’s taxed at a lower marginal rate than what the trust would pay.

This strategy is especially effective when you leave Traditional IRA or 401(k) distributions in trust. Using my prior example, let’s assume that Lisa has a daughter, Kaylee, who’s a minor. Lisa’s mother can’t name Kaylee directly as an IRA beneficiary or the financial institution where the account is held (Vanguard, Schwab, UBS, etc.) can’t make a distribution to a minor. Therefore, Mother created a trust and named Lisa as the trustee with Kaylee as the beneficiary.

When Mother died the Traditional IRA account became an inherited IRA account. Lisa has ten years from her mother’s death to withdraw the entire balance. She doesn’t want to wait until the tenth year to withdraw, since the tax burden would be higher as the amount would be the entire amount plus all the growth over the ten years.

Say Lisa chooses to withdraw $50,000 but wants to accumulate it in the trust for Kaylee, and would rather wait until Kaylee is in college before she uses the money. Here again, we have a $50,000 taxable distribution from the IRA, and the trust will be the taxpayer, paying taxes at the highest marginal rate.

Can we use the same strategy mentioned above for a minor beneficiary to tax the income at Kaylee’s lower rate? Yes and no. I say “yes” because we can use workarounds to treat the income as distributed when it really isn’t. The “no” is because Kaylee is a minor, so the “kiddie tax” rules apply. Her tax rate will likely be Lisa’s marginal tax rate.

As you can see, there’s a lot more to estate planning than estate tax. Asset protection and income tax consequences are important factors to consider. The rules are complicated, but it pays to consider all your options.

©2021 Craig R. Hersch. Learn more at floridaestateplanning.com

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