ASNP Practical Tax Considerations of Grantor v. Non-Grantor Trusts Vincent J. Russo Vincent J. Russo & Associates, PC Long Island, New York

What You Need To Know About Grantor Trusts? Grantor is treated as the owner for income tax purposes  If Trust uses Grantor’s TIN, then no trust income tax return  If Trust uses its own TIN, then trust income tax return will have to be filed

What You Need To Know About Non-Grantor Trusts? All Trusts other than “grantor trusts” Trust must file income tax return Tax Consequences to the trust or the beneficiaries of the Trust

Examples of Grantor Trusts All  Revocable Trusts Optional  First Party Special Needs Trust  Irrevocable Life Insurance Trust  Grantor Retained Annuity Trust  Qualified Personal Residence Trust  Third Party Irrevocable Special Needs Trust

Examples of Non-Grantor Trusts All  Testamentary Trusts Optional  Irrevocable Life Insurance Trust  GRATS and QPRTS after the term expires  Third Party Irrevocable Special Needs Trusts

Advantages of a Grantor Trust Income tax consequences stay with the grantor  Beware of the exception Lower income tax brackets than a trust  Single Individual reaches 35% at $357,700 for 2008  Trust reaches 35% bracket at $10,700 for 2008 Simpler tax filings Easier to explain to the client

Advantages of a Non-Grantor Trust Spread out the income tax consequences Grantor does not have to come up with funds to pay tax on “phantom income” Beneficiary who receives the income pays the income tax Qualified Disability Trust

Disadvantages of a Non-Grantor Trust If not careful, higher overall taxes Beneficiary does not understand that they need to come up with income tax payments Need to pay attention to calendar year end distributions

First Party Special Needs Trust Set up by parent, grandparent, legal guardian or a Court To or for the sole benefit of a person who is disabled and under age 65 Funded with the assets of the person who is disabled Payback required to reimburse the State for Medicaid Paid 42 U.S.C. § 1396p (d)(4)(A)

Drafting for a Grantor Trust Tainting the Trust as a Grantor Trust IRC Sections 671 – 678 Favorite Taints  Power to remove Trustee and replace with a non- adverse party who is related to or subservient to Grantor (IRC §672, §674)  Use Trust income to pay premiums of insurance on life of Grantor or grantor’s spouse (IRC §677)  Grantor may exchange property of equivalent value in non-fiduciary capacity (IRC §675)

Drafting for a Grantor Trust Grantor Trust Taints (continued)  Income payable by non-adverse party to the grantor (IRC §677)  Adverse Party - any person who has a substantial beneficial interest in the trust which would be adversely affected (IRC §672) Taints Not To Be Used  Ignore IRC §676 - Power to Revoke

i-GNORE? or eye-GNORE?

What The Grantor Needs To Know Tax Consequences of the Trust Impact on the Grantor and Beneficiaries, if any Filing of Tax Returns  Trust  Grantor  Beneficiary Gift and Estate Tax Consequences

What the Trustee Needs To Know Fiduciary Record Keeping Year End Income Tax Planning Filing of Tax Returns  Due April 15 th (for Tax Years ended 12/31)  Six-Month Extension Available Extension of time to file (not to pay)

Who is Doing What? Determine who is going to do what Be the “quarterback” Who is taking the “tax football”?

Role of Tax Practitioner Offer tax planning strategies Keep client/attorney apprised of need for estimated tax payments Provide list of tax related information needed in a timely manner Prepare tax returns Manage tax deadlines

Working With The Accountant Provide the Accountant with:  Copy of Trust Instrument (or Will)  Attorney Letter Summarizing Tax Treatment of Trust  Necessary Information Names, addresses and SS# of fiduciaries and beneficiaries TIN for Trust, if applicable List of Trust Assets (to know what 1099 forms, etc. to expect)  Copy of the Estate Tax Return If Trust Assets were included in Grantor’s Estate Form 706 will reflect “step-up” in basis of assets

Reviewing the Fiduciary Income Tax Return – Form 1041, Page 1 Trust Name and TIN Tax Year  General Rule: Trusts are calendar year filers  Trap for unwary: In year of Grantor’s death – there may be 2 returns:  Grantor trust through DOD  Complex Trust from DOD through 12/31 Fiduciary Name and Address Date entity created  Ex: Date of trust; DOD if testamentary trust

Reviewing the Fiduciary Income Tax Return – Form 1041, Page 1 Type of Entity – which box was checked?  Ex: Grantor Trust, Complex, Qualified Disability Trust  If Grantor Trust - Page 1 should reference IRC § Number of K-1 Forms  Complex Trust - Attach a K-1 if distribution was made and if there is DNI (Distributable Net Income)  Grantor Trust - Attach a Grantor Information Statement (in lieu of a K-1)

Reviewing the Fiduciary Income Tax Return – Form 1041, Page 1 Checkbox for Initial Return/Final Return Checkbox - “May IRS discuss return with preparer?”  Issues to consider if attorney is not the preparer How well do you and your client know the preparer? What if the tax preparer contacted the IRS about the return without your knowledge?

What to Look For When Reviewing Fiduciary Income Tax Returns Request the Diagnostic Reports generated by the Accountant’s tax preparation software  Ensure there were no “Overrides” If found, ask preparer why the override was necessary What other areas of the return may have been affected Was a state/local fiduciary return also prepared (if necessary)  Be aware there are some differences between Federal and State tax treatment of certain income/expense items

What to Look For When Reviewing Fiduciary Income Tax Returns Reminder – Trust is a Cash Method Taxpayer Were all income items reported?  Any missing Bank or Brokerage accounts?  Compare 1099 forms to income summary Were all expenses taken on the return?  Legal Fees  Trustee Commissions  Investment Advisory Fees Knight v. Commissioner of Internal Revenue, US Supreme Court (decided 1/16/08), USTC ¶50,132  Real Estate Taxes if real property

What to Look For When Reviewing Fiduciary Income Tax Returns Page 2, Schedule B – Distributions  Do the distributions listed on the return coincide with the distribution made by the Trustee?  Page 2, Other Information – Questions Make sure the questions are answered  Note: IRC §663(b) election (“65 day election”) Allows distributions to be made in the prior tax year Check the box to make the election, if desired

Tax Traps (Issue Awareness) Income Tax Brackets Kiddie Tax Estimated Tax Payments Distributable Net Income End of Tax Year Distributions State Income Tax Return Requirements Support Obligations

Tax Traps: 2008 Income Tax Brackets TaxEstate or RateSingleMarriedTrust 10% < $8,025< $16,050N/A 15% $ 8,026 -$16,051 -< $2,200 32,55065,100 25% $32,551 -$65,101 -$2, ,850131,4505,150 28% $ 78,851 -$131,451 -$5, ,550200,3007,850 33% $164,551 -$200,301 -$7, ,700 10,700 35% over $357,700 over $10,700

Tax Traps: Kiddie Tax Starting in 2008, the Kiddie Tax has been expanded to include dependents under 19 and dependent full-time students under 24. Children who provide more than half of their own support are not affected by the Kiddie Tax change. The Kiddie Tax can only apply if the child has unearned income that exceeds the threshold ($1,800 for 2008). If the unearned income doesn't exceed the threshold, then it will be reported on the child's income tax return, if required.

Tax Traps: Kiddie Tax Parent can make special election to include income on their own return if:  The child’s income consists entirely of interest and dividends;  The child's income does not exceed $9,000 for 2008 (Rev. Proc );  No estimated tax payments have been made in the name of the child; and  The child is not subject to backup withholding.

Tax Traps: Trust Estimated Tax Payments If Non-Grantor Trust  Be aware of the underpayment of estimated tax penalties Safe harbor rules  100% of prior year’s tax  110% if AGI is more than $150K If Grantor Trust  Estimates may be needed for the Grantor’s personal income tax liability No Estimates Needed at Trust Level

Tax Traps: Distributable Net Income Distributable Net Income  Used to compute a trust’s income tax deduction for amounts distributed  Distributions to beneficiaries push the income out to beneficiaries (via the K-1)  Capital Gains do not flow through to beneficiary (via K-1) unless:  Final Year of Trust; or  If State Law and the Trust Instrument permit

Tax Traps: End of Year Distributions 65 Day Election under IRC §663(b)  Trustee can treat distributions made within 65 days after the close of the tax year as if they had been made within the tax year  Trustee has an opportunity to review the year- end/December statements to determine if more distributions are needed to pass out DNI and reduce/eliminate tax at the trust level

Tax Traps: Final Grantor Tax Returns If Decedent is Grantor - include income from January 1 st to DOD  Flows through to decedent’s Final 1040 Income from DOD forward reportable on Trust’s separate 1041 IRC §645 election – can elect to treat assets held by Revocable Trust established by decedent as if they are estate’s assets – combined 1041 (for the 1 st 2 years of an estate)

Tax Traps: State Income Taxes State Income Tax Return requirements  Be alert as to different tax treatment of items on State returns  Examples: Interest on U.S. Obligations not taxed at state level Out-of-state municipal bond interest (which is not taxable on the federal return) may be taxable on the state return There may be a tax exclusion for some pension/annuity income/IRA distributions

Tax Traps: Support Obligations Any amount that is used in full or in partial discharge of a legal support obligation of Child is includible in the gross income of the Parent. The legal obligation of a parent for support is determined under local law (Reg. §1.662(a)-4). For Example,  Joan has a daughter, Annie, age 11  Joan has a legal obligation to provide support to Annie  Grandma sets up a 3 rd party SNT allowing the Trustee to access principal and/or income for the benefit of Annie.

Summary Attorney has the power to control the tax consequences of Trusts Determine the best tax plan for the client and his/her family Draft Carefully Make sure that the Client’s objectives are not derailed due to the tax drafting

ASNP Practical Tax Considerations of Grantor v. Non-Grantor Trusts Vincent J. Russo Vincent J. Russo & Associates, PC Long Island, New York

ASNP Practical Tax Consequences Of Grantor v. Non-Grantor Trusts Additional Information

2008 Income Tax Brackets Married Individuals If Taxable Income is :  Not over $16,050  $ 16,051 to $ 65,100  $ 65,101 to $131,450  $131,451 to $200,300  $200,301 to $357,700  Over $357,700 The Tax is:  10% of the taxable income  $1,605 plus 15% of excess  $8, plus 25% of excess  $25,550 plus 28% of excess  $44,828 plus 33% of excess  $96,770 plus 35% of excess

2008 Income Tax Brackets Single Individuals If Taxable Income is :  Not over $8,025  $ 8,026 to $ 32,550  $32,551 to $ 78,850  $78,851 to $164,550  $164,551 to $357,700  Over $357,700 The Tax is:  10% of the taxable income  $ plus 15% of excess  $4, plus 25% of excess  $16, plus 28% of excess  $40, plus 33% of excess  $103, plus 35% of excess

2008 Income Tax Brackets Estates & Trusts If Taxable Income is :  Not over $ 2,200  $2,201 to $ 5,150  $5,151 to $ 7,850  $7,851 to $10,700  Over $10,700 The Tax is:  15% of the taxable income  $ 330 plus 25% of excess  $1, plus 28% of excess  $1, plus 33% of excess  $2,764 plus 35% of excess

Tax Traps: Final Income Tax Returns of the Decedent Can deduct Medical expenses paid within one year of death Opportunity to elect to include accrued US Savings Bond Interest on Final 1040 RMD for IRAs must be taken by 12/31 by named beneficiary if decedent hadn’t yet taken it prior to death  Affects clients who schedule “auto-withdrawals” in December or on a monthly basis

Investment Advisory Fees Knight v. Commissioner of Internal Revenue US Supreme Court (decided 1/16/08) USTC ¶50,132 Unanimous decision in favor of the Internal Revenue (written by Chief Justice Roberts). The Trustee managing the Pepperidge Farm fortune filed a tax return deducting fees paid for investment advice.

Investment Advisory Fees Knight v. Commissioner of Internal Revenue (continued) The Trustee had deducted 100% of investment advisory fees (without subjecting the fees to the 2% AGI limitation) on the theory that the expenses “would not have been incurred if the property were not held in such estate or trust.”

Investment Advisory Fees Knight v. Commissioner of Internal Revenue (continued) There had been a split among the Federal Circuit Courts of Appeals  Pro-Taxpayer: 6 th Circuit (O’Neill v. Commissioner)  Pro-IRS: 2 nd Circuit, 4 th Circuit, Federal Circuit Held: Investment Advisory fees are generally subject to 2% floor when incurred by an estate or trust.  An exception may be available if the trust had: an unusual investment objective; or required specialized balancing of interests of various parties; or A special additional charge applicable only to fiduciary accounts  In such case, the incremental cost of expert advice beyond what normally would be required for the ordinary taxpayer would not be subject to the 2% floor.

List of Attachments Letter to Accountant re: Special Needs Trust Grantor Trust Informational Tax Return Non-Grantor Trust Income Tax Return Knight v. Commissioner of Internal Revenue, US Supreme Court (decided 1/16/08), USTC ¶50,132 US Supreme Court Decision

ASNP Practical Tax Considerations of Grantor v. Non-Grantor Trusts Vincent J. Russo Vincent J. Russo & Associates, PC Long Island, New York