Trust and Estates

Are income taxes taking a bite out of your trusts?

If your estate plan includes one or more trusts, review them in light of income taxes. For trusts, the income threshold is very low for triggering the:

  • Top income tax rate of 39.6%,
  • Top long-term capital gains rate of 20%, and
  •  Net investment income tax (NIIT) of 3.8%.

The threshold is only $12,500 for 2017.

3 ways to soften the blow

Three strategies can help you soften the blow of higher taxes on trust income:

1. Use grantor trusts. An intentionally defective grantor trust (IDGT) is designed so that you, the grantor, are treated as the trust’s owner for income tax purposes — even though your contributions to the trust are considered “completed gifts” for estate- and gift-tax purposes.

IDGTs offer significant advantages. The trust’s income is taxed to you, so the trust itself avoids taxation. This allows trust assets to grow tax-free, leaving more for your beneficiaries. And it reduces the size of your estate. Further, as the owner, you can sell assets to the trust or engage in other transactions without tax consequences.

Keep in mind that, if your personal income exceeds the applicable thresholds for your filing status, using an IDGT won’t avoid the tax rates described above. Still, the other benefits of these trusts make them attractive.

2. Change your investment strategy. Despite the advantages of grantor trusts, nongrantor trusts are sometimes desirable or necessary. At some point, for example, you may decide to convert a grantor trust to a nongrantor trust to relieve yourself of the burden of paying the trust’s taxes. Also, grantor trusts become nongrantor trusts after the grantor’s death.

One strategy for easing the tax burden on nongrantor trusts is for the trustee to shift investments into tax-exempt or tax-deferred investments.

3. Distribute income. Generally, nongrantor trusts are subject to tax only to the extent they accumulate taxable income. When a trust makes distributions to a beneficiary, it passes along ordinary income (and, in some cases, capital gains), which are taxed at the beneficiary’s marginal rate.

Thus, one strategy for minimizing taxes on trust income is to distribute the income to beneficiaries in lower tax brackets. The trustee might also consider distributing appreciated assets, rather than cash, to take advantage of a beneficiary’s lower capital gains rate.

Of course, this strategy may conflict with a trust’s purposes, such as providing incentives to beneficiaries, preserving assets for future generations and shielding assets from beneficiaries’ creditors.

If you’re concerned about income taxes on your trusts, contact us. We can review your estate plan to uncover opportunities to reduce your family’s tax burden.

© 2017

Follow all rules when transferring assets to an irrevocable trust

Irrevocable trusts can provide a variety of benefits, including gift and estate tax savings, creditor protection, and the ability to control how assets are distributed. To preserve these benefits, however, it’s critical to respect all trust formalities.

Case in point

Here’s an example of just how critical this can be: In U.S. v. Tingey, a taxpayer set up an irrevocable trust for the benefit of his wife and children, naming someone else as trustee. Around the same time, the taxpayer and his wife purchased a ski cabin, the title to which was transferred to the trust. Later, the couple got into financial trouble and ended up owing more than $2 million in federal taxes. The government successfully foreclosed several tax liens on the ski cabin.

The couple argued that the government couldn’t enforce the liens against the ski cabin, because title was held by the trust. But the 10th U.S. Circuit Court of Appeals disagreed. The court explained that a tax lien may be satisfied by property if it’s held by the taxpayer’s “nominee” — in other words, “the taxpayer has engaged in a legal fiction by placing legal title . . . in the hands of a third party while actually retaining some or all of the benefits of true ownership.”

Several factors indicated that the couple had done just that. Among other things, they maintained the ski cabin, paid the utility bills and insurance premiums (on a policy issued in the taxpayer’s name), used the cabin without the trustee’s permission or supervision, and rented the cabin to friends without the trustee’s knowledge.

Tread carefully when transferring assets

As this case illustrates, if you continue to treat assets as your own after transferring them to an irrevocable trust, they may be at risk. If you have questions regarding asset transfers, contact us.

© 2016

Properly fund your living trust to shield assets from probate

Many people set up a revocable, or “living,” trust to shield assets from probate and take advantage of other benefits. For the trust to work, you must transfer assets to it that would otherwise go through probate — a process known as “funding” the trust. Most people fund their trusts around the time they sign the trust documents.

Once your estate plan is complete, however, it’s easy to overlook the need to transfer later-acquired assets to your trust. If you don’t transfer them, those assets may be subject to probate and will be outside the trust’s control.

How to transfer assets

Procedures for transferring assets to a trust vary depending on the asset type:

To transfer real estate, you must execute and record a deed conveying title to the trust.
Transferring bank and brokerage accounts typically involves providing forms or letters of instruction to the institution holding the accounts.
Interests in closely held businesses usually require a simple assignment.
Tangible personal property may require an assignment or bill of sale.

Assets that shouldn’t be transferred

Be aware that certain assets shouldn’t be transferred to a living trust, such as IRAs and qualified retirement plan accounts. These are “nonprobate” assets, so avoiding probate isn’t an issue, and transferring them to a trust is considered a taxable withdrawal.
Instead, you can name an individual as beneficiary. Or, if you don’t want an individual to have complete control over the account, you can name a trust as beneficiary.

Reap the full benefits

Avoiding probate is an important estate planning objective for many taxpayers because probate can be costly and time consuming, and its public nature raises privacy concerns. A living trust can also be used to manage your assets if you become incapacitated.

To ensure that your living trust is properly funded so you can reap the full benefits, contact us any time you acquire a major asset.

© 2016

Transfer Assets through Grantor Retained Annuity Trusts (GRATS)


 GRATWhat is a GRAT?

There are several estate planning tools designed to assist in the transfer of assets to a trust for beneficiaries while also retaining the grantor’s right to income or use of the asset. Grantor Retained Annuity Trusts, or GRATs, have become a popular transfer technique with regards to appreciating assets or minority interest in a family business that is subject to valuation discounts. In 2000, GRATs became more useful for estate planning after tax courts held in favor Audrey Walton’s position in Walton v. US. This case both opened the door for the “zeroed out” or “near zero” GRAT and brought the concept of “rolling GRATs” to the public’s attention.

To create a GRAT, a grantor transfers assets to a trust, the gift value of which is determined using Code Section 7520.  Code Section 2702 values the retained interest at zero unless it meets exemptions as a “qualified interest”.  A qualified interest is:

  • any interest which consists of the right to receive fixed amounts payable not less frequently than annually,
  • any interest which consists of the right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually), and,
  • any noncontingent remainder interest if all of the other interests in the trust consist of interests described in 1) and 2).

These “qualified interests” may be deducted from the gift value of the assets placed in the trust, reducing your gift tax and removing property from your estate.  The ultimate goal of a well planned and executed GRAT is to “zero out”.  To “zero-out” the annuity amount, expressed as a percentage of the initial fair market value of the property transferred to the GRAT, is set so that the present value of the amount to be paid to the grantor over the annuity term equals the amount transferred to the GRAT plus Section 7520 assumed rates of return.  While a complete “zeroing out” usually does not happen, most clients will want to create a “near zero GRAT”.  It should be noted, however, that for the GRAT to be “successful” the assets placed in the GRAT need to appreciate faster than the Section 7520 rate.  Otherwise a “zeroed out” GRAT’s assets would be depleted by the annuity payments.

Here is an example of a successful near zeroed out GRAT.  This example assumes a $1,000,000.00 initial contribution of assets, with a 10% rate of return, and an annuity payment based on the Code Section 7520 rate of 2.2% for January 2015.

Beginning Balance 10% growth Annuity End Balance
Year 1 $1,000,000 $100,000 $516,560 $583,350
Year 2 $583,350 $58,335 $516,560 $125,035
Distributions to Grantor $1,033,120
Distributions to family $125,035


As you can see in this example, the grantor’s annuity payment present value is almost equal to the value of the initial assets transferred to the trust.  In this case, the present value of the annuity payments would be $999,884.16.  If you subtract this amount from the value of the initial gift of $1,000,000 you will end up with $115.84 subject to gift tax on a transfer of $125,035.00 to your beneficiaries.

Strategizing your GRAT

One of the most important considerations in creating a GRAT is to be realistic about the life expectancy of the grantor.  If the grantor dies before the GRAT’s term expires, the amount of trust corpus required to complete the annuity payments as calculated by Section 7520 will be included in the decedent’s estate.   This can be mitigated by creating short term “Rolling GRATs,” in which nine 2-year GRATs that feed into one another are created in lieu of a single 10 year GRAT.  The annuity from the first GRAT would be used to establish the second GRAT.  This will continue until you get to the second year of GRAT 8. Thereafter, payments flow to the grantor instead of a subsequent GRAT.

Another consideration when establishing a GRAT is the Code Section 7520 rates that determine the appreciation of the assets.  If the assets fail to grow at 7520 rate, the assets in the GRAT will be depleted by the annuity payments and the GRAT will have failed in transferring assets at reduced gift value.  One of the benefits of a GRAT is that even in the event of a “failure”, the grantor’s only losses beyond opportunity cost are the legal and administrative fees required to establish and administer the trust.

In the current environment, longer term GRAT’s have become particularly attractive as low interest rates have resulted in a very low 7520 hurdle rate.  At the same time, market volatility has depressed certain assets and created a situation in which there is a large potential upside in combining this low IRS return assumption with depressed assets that could potentially appreciate at many times the IRS rate.  By setting up a longer term GRAT, the grantor can “lock in” at today’s historically low Section 7520 rates.  This could potentially result in substantial asset appreciation transferred to beneficiaries while minimizing gift tax liability.

If you are looking for guidance in transferring assets or handling your estate, call 214-696-1922 and ask for Mark Patten.

McKinnon Patten is a CPA Firm with over 40 years of experience dealing with trusts and estates. We specialize in asset transfers as well as family office and fiduciary accounting services.

Family Limited Partnerships: The Power to Move and Protect Your Wealth for Future Generations

Family limited partnerships (“FLPs”) give senior family members a tax efficient way to shift wealth to future family-clip-art-jTxpLpabcgenerations while still exercising control over their assets. As an added benefit, by forming a FLP, senior family members remove assets out of their estate—generally at a reduced transfer tax value.

The FLP structure consists of a general partner and limited partners who typically hold a 1% and 99% interest, respectively, of the total FLP equity. For illustration, senior family members—“the parents”—initially hold both the general partner[1] and limited partner interests. Over time, the parents transfer their limited partnership interests to their children and/or grandchildren as gifts. Even considering the transfer of their LP interests, the general partner parents maintain complete control of the FLP, a role similar to a CEO of a corporation. Meanwhile, the limited partners are considered passive participants and have no control over the FLP. Moreover, transferring their LP interests reduces the parents’ taxable estates and they can avoid the gift tax (and use of the application exclusion amount) as long as the value of each unit transferred to each child does not exceed the annual gift tax exclusion amount ($14,000 per donee in 2015).

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Here’s an example: David and Lisa Smith transfer assets valued at $12 million to a FLP, and collectively become the general partners through an LLC with a 1% interest. Simultaneously, the Smiths—as individuals—also become limited partners with a collective 99% interest. Eventually, the Smiths want to share their 99% LP interest evenly among their four children. To accomplish that, the Smiths annually transfer the maximum allowable gift to each of their four children. That’s a total of $14,000 from each parent to each child each year for an annual total of $112,000 ($14,000 X 2 parents X 4 children). In a decade (assuming no change in the annual gift tax exclusion amount), the Smiths can transfer $1,120,000 to their heirs while that amount is correspondingly removed from the Smith’s taxable estate.

If the Smiths wish to accelerate those transfers, possibly to move highly appreciating assets out of their estate sooner, they can use any portion of their applicable exclusion amount ($5.43 million per donor in 2015) for a total tax free transfer of $10.86 million. Recall that even as the parents transfer their limited partnership interests, they remain in control of the FLP and its assets.

Adding up the Benefits

One of the many benefits of the FLP structure is that valuation discounts are typically applied to limited partnership interests. That is because the limited partners have only a passive interest in the FLP. Specifically, because the limited partners have no management authority or control over the FLP or its underlying assets, they cannot authorize dividends, nor can they sell or transfer their LP interests without consent from the general partner. Because of this lack of control and lack of marketability, the LP interests are typically valued at a discount of as much as 30 – 50% to the FLP underlying assets. This means senior family members can use these valuation discounts to transfer larger amounts of assets each year without violating the annual gift tax exclusion parameters. This translates to additional tax savings.

Let’s go back to the Smiths: If the limited partner interests have an associated 30% valuation discount to the underlying assets, then each parent could actually gift $40,000 worth of FLP assets annually to each child ($28,000 / 70%). That brings the total to $160,000 worth of gifted assets per year, and $1,600,000 in 10 years. The same concept applies to the applicable exclusion amount (“AEA”). Valuation discounts of 30% increase the parents’ collective AEA to $15.51 million ($10.86 million / 70%).

Other substantial FLP benefits include the following:

– A FLP has the ability to protect the family’s assets from creditors. For example, a creditor can latch onto a child or            parent’s limited partner interest with only a “charging order.” Meaning, if a charging order is obtained, creditors              only have the right to receive limited partner distributions which the general partner can decide to withhold. That            leaves the creditor with no money to gain. Moreover, creditors with a charging order have no power to force the                FLP to liquidate assets.

– FLPs enable families to pool their assets, to simplify their estate administration, to create a joint system of family              assets management, and in turn teach children how to manage assets.

– An FLP can ensure the extension of a business even after the senior family member dies, can limit the liability of                individual owners, and consolidate the management of the family business into a sole entity.

– FLPs facilitate the process of gifting, protect assets from otherwise irresponsible family members, and minimize               the expenses of assets management.

Care should be used

FLPs can, however, present a potential challenge from the Internal Revenue Service. Particularly, the IRS may challenge valuation discounts on transfers of FLP assets to family members. In the past, the IRS has used various strategies to disallow and/or reduce discounts. Namely, the IRS may declare that the FLP lacks economic substance and should be ignored. The IRS may also proclaim that the FLP formation is itself a gift, i.e. a transfer of the underlying assets, instead of a transfer of discounted partnership units. The IRS may also use its in-house valuation experts to contest the amount of discounts claimed by the taxpayer’s appraiser.

That means the FLP must be specifically structured and designed to fulfill a valid investment or business purpose. For instance, the FLP can be used to conduct a family business, gather and manage family wealth smoothly and coherently, combine family wealth to maximize growth and investment, and devise a succession plan for transferring business management through generations. Also, valuation discounts should be well supported and documented and determined by a valuation expert.

As always, anyone wishing to create a Family Limited Partnership for themselves and their heirs should consult with an experienced advisory team that can assist them in constructing the FLP. Please contact Mckinnon Patten if you have any questions or wish to confer with our skilled team of accountants.

[1] As an added layer of liability protection, the parents typically form and operate an LLC to serve as the general partner.