Tag Archives: Trust Fundamentals

Charitable Remainder Trusts & IRAs

A Strategy for Taxation of Retirement Assets after Loss of “Stretch”

By Matthew D. Blattmachr, CFP® Jonathan G. Blattmachr, JD, LLM, & Amber Gunn, CTFA

In some cases, it is beneficial for distributions from a qualified (pension) plan or an IRA to be paid over a rela- tively long period of time. One reason is that the longer assets are left inside such a plan or account, the more time they have to grow tax-deferred.

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"After the changes to the Internal Revenue Code made by the SECURE Act, there is a substantially reduced time that the income taxation of assets in a plan or IRA can be postponed once the plan participant or IRA owner dies.”

After the changes to the Internal Revenue Code made by the SECURE Act, there is a substantially reduced time that the income taxation of assets in a plan or IRA can be postponed once the plan participant or IRA owner dies. (Special rules apply to what are called Roth IRAs which are not addressed in this article).

After the SECURE Act, long-term income tax deferral remains unchanged for select beneficiaries such as a surviving spouse, a minor child of the participant or owner, a disabled person, a person who is chronically ill, or someone who is not more than ten years younger than the participant or owner. All others, however, must take out the entire amount in the plan or IRA within ten years (or, in some cases, five years).

The options can be complicated when deciding the best way to continue to postpone taxation of interests in plans or IRAs; however, one strategy is to make use of a charitable remainder trust.

 

An Answer for Some: A Charitable Remainder Trust

A charitable remainder trust (CRT) is a trust where one or more individuals receive benefits for life or a fixed term (of not more than 20 years) and then the remaining property in the trust passes to charity. Both the Internal Revenue Code and regulations have detailed rules about CRTs. Generally, these trusts have been used to postpone taxation. For example, if a taxpayer decides to sell appreciated stock, the shares instead can be contributed to a CRT and the trust can then sell them without any tax because the trust is exempt from income tax.

Distributions from the trust are included in the recipient’s income under somewhat complex rules. Because a CRT is income tax-exempt, proceeds from a qualified plan or IRA can be paid to the trust when the participant or owner dies and no income tax will then be payable. However, as the plan or IRA proceeds are distributed out of the CRT, they will be taxed to the recipient.

 

A Special Kind of CRT: The NIMCRUT

The rules related to CRTs are complicated. One of the complications is choosing what kind of CRT to use. There are three types of CRT. One type, called a charitable remainder annuity trust (CRAT), pays a fixed amount (an annuity) each year to the beneficiary or beneficiaries. Actuarial rules limit how much of an annuity and for how long the CRAT can pay.

The second type, called a charitable remainder unitrust (CRUT), pays an annual amount equal to a fixed percentage of the annual value of the trust. If the trust grows in value, the beneficiaries receive more. If the trust declines in value, they will receive less. Actuarial rules also limit how much of a unitrust amount can be paid and for how long, but there is greater flexibility with a unitrust than with an annuity trust.

The third type is the most complicated but may offer the best results. It pays the lesser of either the unitrust amount or the “fiduciary accounting income” (“FAI” or simply “Trust Income”). This type of CRT is sometimes called a “Net Income” CRT. Trust Income is itself a complicated topic. Generally, it means income (as opposed to principal or corpus) under state law rules relating to trusts. Trust Income usually consists of dividends and interest and normally not capital gains, however, there are exceptions that a taxpayer may use to produce a better result.

With this third type, the law allows for amounts to be “made up” or paid in future years. For example, if Trust In- come is lower than the unitrust payment, the annual payment can be postponed until a year when Trust Income is greater than the unitrust amount. This type of CRT is sometimes called a “Net Income with Make-up Charitable Remainder Unitrust” or “NIMCRUT".

 

Why a NIMCRUT May Help with Plan and IRA Proceeds

Making plan or IRA proceeds payable at death to a CRT means they must be paid out within five years of the death of the participant or owner, however, there is no adverse income tax due to the CRT’s tax exemption. The CRT would invest the proceeds and, even if a NIMCRUT is used, Trust Income (such as a dividend or interest) would be earned and would have to be distributed to and taxed to the trust beneficiary, however, by “sandwiching” an entity, such as a limited liability company or LLC, between the CRT and the assets it invests in, Trust Income can be kept at zero. If and when it is desirable to generate Trust Income, the entity (that is, the LLC) can voluntarily make a distribution to the NIMCRUT which will then make distributions to the beneficiary for the unitrust amount for that year and for shortfalls in prior years.

As long as no Trust Income is generated (because the LLC makes no distributions), the value of the trust can grow entirely free of income tax. In fact, a NIMCRUT can provide for a yearly unitrust payment of 11% for 20 years. It will be noted that if the LLC (and thereby the trust) grows over time, the 11% will apply to ever-increasing amounts meaning more will be accruing for the beneficiary. If the LLC makes no distributions until the 20th year, no income tax will be due regardless of how much the LLC earns. If the beneficiary is under the age of 30, the payments can be made for the life of the beneficiary, but payments will usually be under 11% a year.

A limitation to keep in mind is that to have a valid CRT, the value of the remainder in the trust for charity must be at least 10% of the value of the assets when they are first transferred to the trust. That does not mean that the charity must receive 10% of what is in the trust when it ends. In fact, with the current low interest rates the IRS uses, the amount a charity receives at the end may be a very small percentage of what is in the trust when it ends.

 

Key Considerations for Drafting a CRT

The IRS has issued sample forms for CRTs which, if used, practically guarantees a valid CRT; however, these IRS forms can be modified to ensure a better result. It will almost always be best to have the value of the remainder when the CRT is created to be the minimum required, which is 10%. As indicated, the best benefit of a CRT is its exemption from income taxation. That exemption is available whether the remainder is 10% or greater. Since the family member of the participant or owner benefits from this exemption and loses the benefit to the extent the trust goes to charity, it usually is best to keep the charitable remainder value at 10% and not more. Those drafting a CRT may consider the included sample provisions to obtain this result.

Sample Language

Unitrust Amount. The Unitrust Amount shall be the lesser of: (i) the trust income for the taxable year (Trust Income), as defined in Internal Revenue Code Sec. 643(b) and the Regulations thereunder, and (ii) the “Unitrust Percentage Amount,” which shall be equal to the largest percentage, paid with the frequency provided below and using the highest rate published by the Internal Revenue Service pursuant to Internal Revenue Code Sec. 7520 that may be used to determine the value of the remainder of this trust under Internal Revenue Code Sec. 664(d)(2)(D), which percentage is not less than five percent (5%) and not greater than fifty percent (50%) of the net fair market value of the assets of the trust valued as of the first business day of each taxable year (the “valuation date”) rounded to the nearest one one-thousandths of one percent, paid for the term and at the manner specified above, such that the value of the remainder within the meaning of Internal Revenue Code Sec. 664(d)(2)(D) of this charitable remainder trust as of the date this trust commences shall be ten percent (10%) or, if it is not mathematically possible for the remainder to equal ten percent (10%), as mathematically close to but greater than ten percent (10%) as possible.


The LLC and Trust Income

In order to provide the greatest flexibility to produce as much or as little Trust Income as possible, the NIMCRUT should be funded with an LLC or similar entity. However, none of the trustees, the grantor of the trust, or any beneficiary of the trust can determine when distributions from the LLC may be made to the trust. However, some independent person, such as legal counsel to the grantor, can be given the power to control distributions from the LLC, by naming that person as a “non-member manager” of the LLC. That means that the person will have no ownership interest in the LLC and the LLC can be a “disregarded entity” for income tax purposes so its income will be attributed to the NIMCRUT, which being tax-exempt will owe no income tax on the income earned by the LLC. The included provision may be considered to obtain this result.

Sample Language

Limitation on Determination of Income.The determination of what is and is not Trust Income of this trust shall be made under Alaska law. In addition, the following rules shall apply: (1) proceeds from the sale or exchange of any assets contributed to the Charitable Remainder Trust herein created must be allocated to the principal and not to Trust Income, at least to the extent of the fair market value of those assets on the date of contribution, (2) proceeds of any sale or exchange of any asset purchased by the Charitable Remainder Trust herein created must be allocated to the principal and not to Trust Income, at least to the extent of the Trust’s purchase price of those assets, and (3) Trust Income may not be determined by reference to a fixed percentage of the annual fair market value of the trust property, notwithstanding any contrary provision and applicable state law.

Notwithstanding the foregoing, the following rules shall apply except to the extent but only to the extent that they depart fundamentally from traditional principles of income and principal within the meaning of Treas. Reg. 1.643(b)-1. The trust will not be deemed to have any Trust Income merely by the imputation of tax income to the trust from an entity, such as a limited liability company or a partnership, whether it is owed in whole or in part by the trust or of which the trust is a partner or member. Any cash distribution from such an entity shall be considered Trust Income except to the extent the entity advises the trust it constitutes a liquidating distribution.


Creating and Funding the Trust

It likely will be best if the NIMCRUT is created and funded with an entity, such as an LLC, prior to the death of the plan participant or IRA owner. The LLC (or other entity) may be named as the beneficiary of the plan or IRA. This way, the proceeds can be paid from the plan or IRA to the entity soon after the death of the participant or owner. The entire plan or IRA must be paid within five years of the death of the owner or participant.

Although the entity will be deemed to receive taxable income from the distributions, this income will be imputed to the NIMCRUT which is income tax exempt. In many cases, this may prove ultimately beneficial. For example, all distributions from a plan or IRA are taxed as ordinary income, but distributions from a CRT follow a more favorable tax regime. If capital gain income is earned in the plan or IRA after the death of the participant or owner, it will be treated and taxed as ordinary income. But, if the entity (LLC) receives qualified dividends, long-term capital gain or other income which is more favorably taxed than ordinary income, this better character or flavor of the income will be retained when and if paid out to the NIMCRUT beneficiary.

 

If you have more questions about Charitable Remainder Trusts & IRAs, get in touch with a trust officer at Peak Trust Company today!

Nevada Trust Decanting: A Solution for Modifying Irrevocable Trusts

By Jay R. Larsen, Esq.

Irrevocable trusts are a common tool in estate planning. They play an important role in protecting assets, reducing taxes, and preserving legacies from one generation to the next. Irrevocable trusts come into existence in a number of ways.

A grantor who created a typical revocable living trust may die, at which point the trust becomes irrevocable. Or perhaps the grantor created an irrevocable trust to protect assets or remove a large life insurance policy from the grantor/insured’s estate for estate tax purposes. The grantors may have grandchildren for whom they wish to establish an irrevocable minor’s trust for future education.

“There are many reasons for using irrevocable trusts, but a common
characteristic is that they are typically not amendable.”

There are many reasons for using irrevocable trusts, but a common characteristic is that they are typically not amendable. A carefully drafted irrevocable trust may provide some flexibility, for example through a limited power of appointment. But generally speaking, an irrevocable trust that has “gone wrong” in some way can be difficult to change.

 

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Why Might You Want to Change the Trust?

Rather than things going wrong with the trust, it is more likely that goals or circumstances change such that it is difficult to accomplish the original intent of the trust. Sometimes issues arise with trust assets or beneficiaries, and the trust language is too ambiguous to provide clear direction about what should be done.

Maybe circumstances arise which cause the parties involved to recognize the benefits of extending the trust beyond a fixed term or mandatory payout at a certain age. Changing a trust from one that provides for the health, education, support and maintenance needs of a beneficiary to a discretionary trust can provide superior asset protection. Perhaps it makes sense to combine trusts that otherwise cannot be merged by their terms. Or due to the differing needs of a pool of beneficiaries of a single large pot trust, it might make sense to divide the trust into separate trusts. Perhaps tax laws change.

In addition to the reasons above, there are many others for wanting to modify an otherwise seemingly unchangeable irrevocable trust. So how does one go about accomplishing that objective?

 

How to “Fix” the Irrevocable Trust.

  • Court Order: One possible method of dealing with desired changes is to petition the court. This works well to fix clerical errors, confirm new trustees, or clarify ambiguities. However, certain modifications, such as changing distribution provisions, may be more difficult, especially without the consent of all the beneficiaries affected by the change.
  • Non-Judicial Settlement Agreement: If beneficiary consent is going to be needed anyway, a non-judicial settlement agreement (“NJSA”) should be considered if your state allows it. Nevada statute permits a wide range of changes to an irrevocable trust, including its termination. NRS 164.940.
  • Decanting: A third option for fixing potential problems with irrevocable trusts is for the trustee to transfer assets from the irrevocable trust causing the concern to a new irrevocable trust that does not have the problems. This transferring process is known as “decanting.” Not all trusts are eligible for decanting and not all states allow decanting. Fortunately, Nevada statute allows for decanting as long as the statutory requirements are met. NRS 163.556.

The Decanting Process

First, the irrevocable trust should be domiciled in Nevada and subject to Nevada law. If necessary, jurisdiction of the trust should be transferred to Nevada so that the Nevada decanting statutes apply.

“As you can imagine, in order to prevent a trustee from abusing the decanting power, there are additional restrictions to decanting if the trustee is also a beneficiary of the first irrevocable trust.”

Next, the trustee must satisfactorily answer several questions. Do the terms of the trust prevent decanting? If so, the trust may not be decanted. Does the trustee have discretion or authority to distribute income or principal of the trust either to or for the benefit of a beneficiary? If so, then the property which is subject to the discretion or authority may be transferred to a second irrevocable trust.

It is important to note that new beneficiaries may not be added to the second trust. Also, there are several circumstances under which decanting is not allowed. Such circumstances include the second trust reducing an income interest if the first trust is a marital trust, a charitable trust, or grantor retained annuity trust. Or if property specifically allocated to a particular beneficiary is not allocated to that same beneficiary in the second trust, unless the beneficiary consents. There are also a couple of other prohibited situations.

As you can imagine, in order to prevent a trustee from abusing the decanting power, there are additional restrictions to decanting if the trustee is also a beneficiary of the first irrevocable trust.

Once it is determined that the trustee may decant assets from the first irrevocable trust to the second, the next step is to create the second irrevocable trust, if it is not already established.

Before appointing assets to the second trust, the trustee may give notice to the beneficiaries or may seek court approval. The statute is not clear whether or not the trustee may decant without either notice or court approval, but arguably should be okay. Nevertheless, the recommended course of action is to either obtain beneficiary consent, provide the appropriate notice, or obtain court approval. If court approval is sought, notice of the petition is given to the beneficiaries.

After court approval is obtained, the notice period expires, or beneficiary consent is obtained, the trustee may assign the desired assets from the first trust to the second trust.

Decanting has become an additional tool to remedy “broken” trusts, whether from drafting problems or from changed life circumstances. However, proper decanting is not a do-it-yourself project. Working with an experienced trust company serving as trustee and receiving the advice of experienced legal counsel is important for successful trust decanting.

Special Needs Trusts: Ensuring Financial Security for Individuals with Disabilities

By Mariam Hall, CFMP & Amber Gunn-Holt, CTFA

A special needs trust (SNT) is a privately and professionally managed trust set up by one or more persons, called grantors, for the benefit of a person with disabilities or other impairments. An SNT is administered and managed by a trustee. Ideally, this trustee is an experienced professional fiduciary, such as a trust company. In addition to being created by individual grantors, SNTs can be formed from litigation proceeds payable to a disabled beneficiary, including lump sums and annuity payments. If drafted and administered properly, an SNT can supplement government benefits, such as Supplemental Security Income (SSI) and Medicaid and will not disqualify the beneficiary from receiving means-tested government benefits.

 

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“A Special Needs Trust (“SNT”) is a privately and professionally managed
trust set up by one or more persons, called grantors, for the benefit of a person with disabilities or other impairments.”

 

Considerations for Creating Special Needs Trusts

SNTs are powerful tools that enable individuals with disabilities to maintain eligibility for government benefits while also receiving financial support from the trust. When creating an SNT, it is essential to carefully consider various factors to ensure the trust is structured and funded appropriately and that it effectively meets the beneficiary’s unique needs. Critical factors include:

  • Maintaining government benefits eligibility
  • Providing clear guidance in a letter of intent to ensure the best care for the beneficiary
  • Selecting a qualified trustee who can administer the trust without a conflict of interest

Government Benefits Eligibility

When creating an SNT, it is essential to consider whether the beneficiary’s assets and other resources will likely cover the full cost of their lifetime needs or whether government benefits will also be needed to help cover such needs. This assessment will help determine the appropriate structure and funding of the SNT. It is important to note that even if a beneficiary does not financially need to rely on Medicaid for health insurance or on SSI for monthly payments, he or she may still need to be “Medicaid-eligible” to participate in beneficial state or local programs, such as life skills training. Working with an estate or Medicaid planning professional can help estimate the beneficiary’s future expenses and identify programs for which they may be eligible.

Understanding the differences among Medicare, Medicaid, SSI, and Social Security Disability Income (SSDI) is crucial when setting up an SNT. A special needs beneficiary may benefit from all four programs, each with eligibility rules and covered services. SSDI and Medicare are not based on financial need, while SSI and Medicaid have strict financial requirements. Comprehending the eligibility requirements of the particular programs for which the beneficiary qualifies or is likely to qualify for in the future is critical.

When establishing an SNT, reviewing all assets and beneficiary designations is crucial to ensure that no funds or resources pass directly to the beneficiary. All the beneficiary’s inherited property shares should pass directly to the SNT. SSI, Medicaid, and other means-tested government benefits could be lost if assets pass outright to the beneficiary.

This review should include:

  • IRA, 401(k), and other retirement benefits.
  • Life insurance.
  • Employer-provided death benefits.
  • Annuities and savings bonds.

It is worth noting that trusts can be drafted to contain an SNT provision that is activated if a beneficiary’s life circumstances change. This flexibility ensures that the trust can adapt to the beneficiary’s evolving needs and maintain their eligibility for essential government benefits.

 

Letter of Intent

Providing a letter of intent to assist the SNT trustee is highly recommended. This letter provides valuable information concerning the beneficiary’s daily life, health care concerns, likes, dislikes, needs, preferences, and other important details. It is especially helpful when a new caregiver steps in to manage day-to-day activities. Once the SNT has been created, the letter of intent should be regularly updated to document any changes in care requirements, ensuring the best care for the beneficiary.

 

Trustee Selection

Selecting a qualified trustee is a critical consideration when creating an SNT. During the initial stages, a trustee will be chosen to administer and manage the trust assets for the sole and exclusive benefit of the beneficiary. Performing the duties of a trustee is a serious responsibility. The trustee must understand the trust terms, appropriately manage the trust assets, and properly apply the trust funds without disqualifying the beneficiary from government benefits. Most importantly, the trustee must be able to fulfill their fiduciary duties, including maintaining undivided loyalty to the beneficiary.

“As you can imagine, in order to prevent a trustee from abusing the decanting power, there are additional restrictions to decanting if the trustee is also a beneficiary of the first irrevocable trust.”

SNT Trustee Duties

  • Invest the assets of an SNT to reflect the needs, risk tolerances, and projected length of care for the beneficiary; risk tolerance tends to be low. SNT funds should be invested to produce an appropriate mix of current income and capital appreciation.
  • Distribute income and principal “for the sole benefit” of the beneficiary, preferably directly to providers of goods and services to avoid misuse of funds or inadvertent impact on government benefits.
  • Reimburse persons who have expended their own funds for items that are permissible SNT disbursements.
  • Coordinate with healthcare professionals to provide for the current and anticipated needs of the beneficiary.
  • Provide accurate accounting, periodic reporting of receipts and disbursements, and periodic and accurate accounting that reflect trust expenditures and receipts.
  • Verify that SNT distributions do not defray a legal obligation of support owed by another to the beneficiary.

Choosing a Trustee

When selecting a trustee for an SNT, it is highly recommended to choose a professional trustee, such as a trust company, due to the specialized skills required to administer the trust properly. Individual trustees are unlikely to afford the high cost of specialized training necessary to manage an SNT effectively.

The chosen trustee must be capable of recognizing and discharging “regular” fiduciary duties, in addition to undertaking an appropriate ongoing analysis of relevant government programs and the impact of trust distributions on the beneficiary’s eligibility for those programs. This requires a deep understanding of the complex rules and regulations surrounding SNTs and government benefits.

Corporate fiduciaries, such as trust companies, are often more cost-effective than individual, non-professional fiduciaries. An individual trustee must separately retain the paid services of investment advisors, accountants, claims processors, bonding agents, and other professionals to effectively manage the SNT. In contrast, corporate fiduciaries typically have these resources and expertise in-house, which permit streamlining the trust administration process and reducing overall costs.

Some states specifically prohibit parents, guardians, or other family members from serving as trustees of an SNT. This is because these individuals are often named as remainder beneficiaries of the trust or are considered heirs-apparent of the beneficiary. Naming a family member as trustee could create conflicts of interest and potentially jeopardize the beneficiary’s
eligibility for government benefits.

For more information on special needs trusts, contact Peak Trust Company today.

Understanding Directed Trusts: Empowering Advisors and Clients

What is a Directed Trust?

In its simplest form, a directed trust is a trust arrangement that effectively relieves the trustee of specific duties, such as investments or distributions, and requires the trustee to act upon the direction of an advisor named in the trust agreement. Directed trusts are often directed as to investments and/or directed as to distributions. For example, with a directed trust that is directed for investments, the trust's terms specify an appointed investment advisor who holds the authority to direct the trustee in all matters related to investments within the trust. The trustee, in this scenario, takes direction for all investment-related actions guided by explicit guidance from the authorized party designated by the trust's terms. This division of responsibilities results in a partnership where the trust company or trustee manages the administrative aspects of the trust, while the client's chosen financial advisor or family advisor maintains control over investment decisions and asset management.

The Rise of Directed Trusts: A Win-Win for Advisors and Clients

The transformation of many trust companies into comprehensive wealth management firms has presented a predicament for financial advisors serving high-net-worth clients. They often find themselves in the awkward position of surrendering control over a portion or the entirety of their clients' assets to a competing entity when recommending the creation of a trust.

Directed trusts offer a solution, allowing the grantor to instruct the trust company to follow the investment directives of an external advisor. In such arrangements, the control over assets, along with the associated investment fees, remains with the advisor, while the trustee assumes the responsibility for trust administration.

In essence, directed trusts align the interests of all parties involved, including grantors and beneficiaries, while minimizing potential conflicts. It's important to note that in directed trusts, someone other than the trustee is responsible for managing the underlying assets. This marks a departure from traditional common law trusts, where the trustee holds responsibility for both property administration and investment decisions.

With a directed trust, control over the assets (and the investment fees they generate) remains with the advisor, while the trustee administers the trust itself.

Directed trusts, as a practice, originated with the Uniform Prudent Investor Act of 1994. Early beneficiaries of these arrangements utilized them to consolidate control over family-held business entities. Since these families possessed a profound understanding of their business operations, directed trusts allowed them to create family LLPs or LLCs and transfer ownership units into the trust. A trust company would act as trustee, while the partnership manager retained control over the enterprise, resulting in a beneficial outcome for all parties involved.

Over the past few decades, the concept of directed trusts has expanded to include more conventional asset classes such as stocks, bonds, cash, and other marketable securities. As before, the legacy advisor, who is most familiar with managing the wealth, continues to oversee investments, while a trust company serves as the trustee, leading to a mutually advantageous setup.

The Directed Trust Company

In the last two decades, a dynamic industry of independent trust companies, such as Peak Trust Company, has emerged as specialized directed trust providers. The best-directed trust companies support open architecture custody platforms, enabling them to manage trust clients' portfolios across a broad range of asset classes, including cash, stocks, individual bonds, mutual funds, exchange-traded funds, and exotic instruments—all in line with the client's directives.

Typically, fees for administration and custody at directed trust companies are approximately half of what comprehensive firms charge for bundled wealth management and trust administration services. Fees in the financial sector can vary significantly, so advisors should explore options on behalf of their clients.

Additionally, the investment manager directing the trust assets retains the authority to set their own management fees and, when appropriate, performance fees. Directed trust companies are often able to avoid additional charges that full-service trust companies may impose for handling complex or illiquid assets since they assume the responsibility and liability for managing such assets.

In conclusion, directed trusts have emerged as a beneficial solution for high-net-worth clients, financial advisors, and trust companies. By separating administrative and investment responsibilities, these trusts create a harmonious environment where all parties can focus on what they do best while ensuring the best interests of the grantors and beneficiaries are upheld. The growth of directed trust companies has further expanded the reach and versatility of this financial strategy, offering more options and cost-effective solutions for clients seeking tailored trust management.

If you have more questions about directed trusts, get in touch with a trust officer at Peak Trust Company today!

Nevada Asset Protection Trust – Just Prudent Planning

Geri Tomich, Esq., discusses Nevada Asset Protection Trust.

 

Nevada is one of the few states, that has a statute that allows the creation of a self-settled spendthrift trust to protect one’s assets from creditors. As a practitioner in this state, I may be biased in saying that Nevada law is superior in the creditor protection arena but many will agree that this bias is not baseless.

In October of 1999, the Nevada State Legislature revised the “Spendthrift Trust Act of Nevada” allowing a person to create a spendthrift trust for the protection of his own assets – hence the term self-settled spendthrift trust. If created and managed correctly, a person can create a trust to which he transfers his personal assets and avail of creditor protection, even when the person is also a beneficiary of the trust. Nevada law also does not prohibit the person from serving as a trustee of the trust but it is very important that the power to make distributions to the person is at the discretion of someone else. This is where the use of professional trustees is highly beneficial.

Nevada has one, if not, the friendliest of the self-settled spendthrift trust laws out there. Mainly because it has the shortest time frame for a creditor to file an action at two years compared to the common four-year window that other states impose. What window?! Under Nevada law, creditors may still file an action against assets transferred into self-settled spendthrift trusts for the first two years of the transfer or six months after a creditor discovers the transfer, whichever is later. In other states, the common time frame is four years.

Another reason why Nevada laws are far more superior than other states is that Nevada self-settled spendthrift trusts are also protected against child and spousal support. Just this year, 2017, the Nevada Supreme Court upheld the validity of Nevada self-settled spendthrift trusts as asset protection against child and spousal support obligations. The lower court first ruled that funds from a Nevada self-settled spendthrift trust can be used to pay for the settlor’s child- and spousal-support obligations because, despite the validity of the Nevada self-settled spendthrift trust, there is a strong public policy argument which favors subjecting the interest of the trust beneficiary to claims for child support and alimony. However, the Nevada Supreme Court reversed the lower court and ruled that, despite such a strong public policy rationale, Nevada law is clear and explicitly protects Nevada self-settled spendthrift trust assets from the personal obligation of the beneficiary. The Nevada Supreme Court even discussed the legislative history that supports this conclusion. Specifically, the Nevada legislature enacted these laws to make Nevada an attractive place for wealthy individuals to invest their assets. So, despite public policy arguments that are allowed in other states to pierce the protection of a self-settled spendthrift trust, Nevada laws acknowledge that the protection is meant to apply to despite such public policy arguments.

The protective outcome of this case does not, however, apply to child-support or alimony obligations if they are already known at the time the trust was created. Again, advanced planning is key! Create a Nevada self-settled spendthrift trust before threats of financial obligations exist.

To create a Nevada self-settled spendthrift trust, certain requirements must be met:

 

What are the General Requirements?

  • The Trust must be in writing and irrevocable;
  • The Trust must not require the Trust’s income or principal be distributed to the Settlor; and
  • The Trust must not be intended to hinder, delay or defraud known creditors. If you are already being sued, it’s too late.

Who Can Create The Trust?

Anyone can create an asset protection trust under Nevada law so long as there is a Nevada connection. Nevada connection is established if the creator of the trust (“Settlor or Grantor”) is domiciled in the state of Nevada, some of the assets transferred into the trust are located in Nevada, and/or one of the trustees is a Nevada resident of Nevada trust company.

While anyone can utilize the benefits of this trust, persons who are exposed to risk and liability through their profession (e.g. doctors, home builders, attorneys) should seriously consider creating an asset protection trust as soon as possible to have a vehicle to protect their assets from potential personal claims – this is simply part of prudent planning. Remember, when a lawsuit is pending, it is too late.

 

How Are Assets Protected?

As to creditor claims and actions, Nevada statute clearly states that “a person may not bring an action with respect to a transfer of property to a spendthrift trust if the person is a creditor when the transfer is made, unless the action is commenced within: (i) two years after the transfer is made; or (ii) six months after the person discovers or reasonably should have discovered the transfer, whichever is later.” If a person becomes a creditor after the transfer of property is made, that creditor must commence its action within two years after the transfer of property is made into the trust. Thus, any creditor whose claim arises two (2) years after the transfer of property to the Trust is forever excluded from bringing an action to recover assets from the Trust.

Because of the simplicity and ease of creating self-settled spendthrift trusts under Nevada law, creating, and of course funding, said trusts have become a part of any prudent planning used to protect a person’s assets from frivolous lawsuits and potential judgment creditors without the expense and complications of “shipping your money away” off-shore.

 

* Geraldine Tomich, Esq. is a shareholder at Marquis Aurbach Coffing with offices in Reno and Las Vegas, Nevada. She practices in the areas of asset protection, estate planning, probate, guardianships, estate & gift taxation, and business entity formation. Ms. Tomich obtained her masters of law (LL.M.) degree from Thomas Jefferson School of Law from which she graduated magna cum laude. She obtained her juris doctor degree from Gonzaga University School of Law. Ms. Tomich is involved in various community outreach organizations where she volunteers her time. She is a founding director of the Gift Planning Advisors, a Las Vegas group of professionals who provide educational opportunities for planned giving professionals and heighten awareness of donor opportunities. She also sits on the board of Nevada Community Foundation, an officer of the Southern Nevada Estate Planning Council, and a member of the Planned Giving Council of Vegas PBS.

i In Matt Klebacka, Distribution Trustee of the Eric L. Nelson Nevada Trust dated May 30, 2001 v. Eric L. Nelson, et. al., 133 Nev. Adv. Op. 24 (Nev. 2017).

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What Is a Life Insurance Trust?

By Amber Gunn, CTFA and Mariam Hall

As the name suggests, a life insurance trust is a trust designed to own life insurance. This type of trust will most often be irrevocable. An irrevocable life insurance trust, or “ILIT” is a trust created to own and control a life insurance policy while the insured is alive, and then to manage and distribute the proceeds paid out after the insured’s passing according to the terms of the trust and the grantor’s intent. If a couple sets up a life insurance trust jointly, the insurance policy purchased inside the trust is often a “survivorship” or “second to die” policy, which pays the death benefit on the passing of the last surviving spouse.

How Are Life Insurance Trusts Used?

Life insurance trusts are used for many reasons, including minimizing estate taxes, avoiding gift taxes, protecting assets, retaining control over the distribution of insurance proceeds, protecting government benefits, and many more estate- and tax-planning considerations. Learn more here about how life insurance trusts are used.

Funded vs Unfunded Life Insurance Trusts

Life insurance trusts can be either “funded,” where the trust owns both a policy and income earning assets that provide for the payment of insurance premiums, or “unfunded,” where the trust owns the policy and the grantor makes an annual contribution to the trust that is used to pay the insurance premiums.

Funded and unfunded life insurance trusts are effective tools. However, keep in mind that with a funded life insurance trust, the transfers to fund the trust may be subject to the gift tax (when transferring income-producing assets to the trust) and income tax for a grantor trust. Unfunded insurance trusts make use of the grantor’s annual gift tax allowance to maximize tax savings and pay the annual insurance premiums.

Insurance Premium Tax

When establishing a life insurance trust, one of the several factors in deciding where the trust will be domiciled is the insurance premium tax rate in the state where the trust will be located. All states charge some form of tax on insurance premiums, including life insurance premiums. While this tax is rarely noticeable on most insurance products, for large life insurance policies with high annual premium amounts, it can make a big difference. This consideration becomes particularly relevant for annual premium amounts in excess of $100,000 a year, which is usually the case with private placement life insurance.

Insurance premium tax rates vary significantly among states. Alaska and Delaware are two states with particularly competitive insurance premium tax rates for large premium amounts. Alaska’s insurance premium tax rate is 2.7% on the first $100,000 of the premium, and then 0.08% on premium amounts in excess of $100,000. Delaware’s insurance premium tax rate is 2.0% on the first $100,000 of the premium, and premium amounts in excess of $100,000 are tax free. In contrast, most other states average between 1.75% to 2.5% on the entire premium amount, for example, California 2.35%, Nevada 3.5%, Florida 1.75%, New Jersey 2.0%, and New York 2.0%.

Important Considerations for Making ILITs Work

There are several important factors to keep in mind when setting up an irrevocable life insurance trust such as how the trust will be structured to avoid unnecessary gift tax, where the trust will have “situs” or be located, and who will be appointed as the trustee to make sure that the plan is carried out as the grantor intended. Read more here to learn about the important considerations for making irrevocable life insurance trusts work.

If you have more questions about life insurance trusts, get in touch with a trust officer at Peak Trust Company today!

Nevada Incomplete Gift Non-Grantor Trusts (NINGs)

A Nevada Incomplete Gift Non-Grantor Trust (NING) is an irrevocable trust designed to limit state income tax liability, preserve wealth, and protect trust assets using Nevada’s laws. Clients who are high-income earners, have significant unrealized capital gains on the sale of an asset, such as a business, and live in a high-income tax state may benefit from using a NING.

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What Exactly is a NING Trust?

A NING is a Nevada Trust where gifts are considered “incomplete" for gift and estate tax purposes. Incomplete gifts are so named because the grantor may retain control over or access to the contributed asset. NING trusts are non-grantor trusts, which means that the trust is the taxpayer for income tax purposes. This allows the income from trust assets to be taxed based on the residence of the trustee rather than that of the grantor. For grantors living in a high-income state, like California, this can offer significant tax savings. If, for example, the sale of a highly appreciated asset is anticipated, doing so through a NING could limit the capital gains tax which might be higher if done under the laws of the grantor’s state of residence.

"Clients who are high-income earners, have significant unrealized capital
gains on the sale of an asset, such as a business, and live in a high-income
tax state may benefit from using a NING.”

How do NINGs Work?

A NING works exceptionally well if a client lives in a high-income tax jurisdiction and is either looking to eliminate state income taxes or is selling an asset with a significant capital gain.

Here’s how a Nevada Incomplete Gift Non-Grantor Trust strategy works:
1. The grantor transfers an asset or brokerage account with income tax liability to a NING trust. This is often a portfolio of marketable securities or shares in a family business.

2. Once the transfer is complete, the grantor is no longer responsible for the income tax liability because a NING is a non-grantor trust. As a non-grantor trust, the NING will be a separate entity for federal income tax purposes and will file a Form 1041 return.

3. The trust is responsible for the income tax, and since the trust is set up in Nevada, where there is no state income tax, the income earned on the assets in the Nevada Incomplete Gift Non-Grantor Trust trust is not subject to state income tax.

An experienced attorney should draft a NING trust to ensure it is a non-grantor trust per IRS regulations. Having a properly drafted NING Trust is crucial to shift the income tax liability away from the grantor and to the trust.

"Having a properly drafted NING is crucial to shift the income tax liability
away from the grantor and to the trust.”

One of the key characteristics of a NING is the “Distribution Committee.” A “Distribution Committee” is comprised of three adverse parties. To qualify as a non-grantor trust, these adverse parties must have discretion regarding distributions from the trust, and they must also be beneficiaries. In addition, the grantor must give up enough control to make the trust a non-grantor trust but not so much control that the trust becomes a completed gift.

Example NING Trust Scenario

Let’s say you have a client who is a successful business owner in California and is looking to sell their business for a significant profit. The client has a basis of $500,000 in the business which is now worth $10 million. If the business owner were to sell the business, they would incur a capital gain of approximately $9.5 million.

Given that California has a state income tax rate of 13.3%, in this scenario, your client would be responsible for paying approximately $1.3 million in California state income taxes, not considering any other facts and circumstances. However, if you set up a NING trust for your client and transfer ownership to the trust, the trustee in Nevada could then sell the business, potentially avoiding the $1.3 million in state income taxes. Of course, federal income tax would be applicable whether the grantor or the trust sold the asset. However, significant state income tax savings are possible using an appropriately structured Nevada Incomplete Gift Non-Grantor Trust.

After the sale, the proceeds could be invested by your client’s preferred financial advisor, and as long as the funds remain in the NING trust, there would be no state income tax liability. Additionally, if your client were to move to a state without state income taxes, they could avoid paying any state taxes on the trust distributions. Many clients set up a NING Trust with the intent of moving to a state without state income taxes before they start taking distributions from the trust. Others simply use the NING Trust as a legacy preservation vehicle for their children.

Ideal Candidate for a NING

The ideal candidate for a NING trust is someone who is looking to sell an asset with a significant capital gain and wants to eliminate or reduce state income taxes. This person may also be looking for asset protection and privacy and may be open to establishing a trust in Nevada to take advantage of the other benefits of Nevada’s favorable trust laws, such as asset protection, perpetual trusts, and privacy. Additionally, the ideal candidate may be open to relocating to a state without a state income tax or is interested in using the trust as a legacy preservation vehicle for their heirs.

"The ideal candidate for a NING trust is someone who is looking
to sell an asset with a significant capital gain and wants to eliminate
or reduce state income taxes.”

Ultimately, the suitability of a Nevada Incomplete Gift Non-Grantor Trust will depend on the individual’s unique financial and personal circumstances and should be evaluated with the help of legal, tax, and financial advisors familiar with this advanced planning technique.

Here are some questions you may want to ask your client to see if a NING strategy makes sense for their situation:

  • Are you a high-income earner in the top tax brackets and live in a state with a high-income tax environment like California, Massachusetts, or New Jersey?
  • Do you have intangible assets with an embedded large capital gain that you would want to sell?
  • Do you plan on moving to a state with no state income tax? Do your beneficiaries reside in a state with no state income tax?
  • Have you done any estate tax planning? (Assets transferred to a NING trust are still includible in the grantor’s estate at death because the gift is “incomplete” for estate and gift tax purposes.)

Considerations for Establishing a NING

A NING works well if it owns intangible assets, such as shares in a business or a brokerage account. However, a Nevada Incomplete Gift Non-Grantor Trust cannot own tangible assets or assets sourced to the state in which the taxpayer resides. For example, if the asset is physically located in a high-income tax state (source income), the strategy will not work. Sometimes, tangible assets can be converted to intangible assets, but this requires additional careful planning with the help of specialized legal and tax advice.

A NING trust may not work for your client, depending on the state in which your client resides and how that state views the taxation of a trust. New York, for example, has enacted a law to negate the use of the NING trust strategy. Other states automatically impose a state income tax if the grantor is a state resident when the trust is established. Therefore, consulting knowledgeable tax and legal advisors is critical to determine whether the Nevada Incomplete Gift Non-Grantor Trust strategy will work for your client.

NINGs are complex trust structures that must be drafted according to specific rules to achieve the planning benefits. Therefore, working with a qualified attorney with experience creating such complex trusts is critical.

If you have more questions about Nevada Incomplete Gift Non-Grantor Trusts, get in touch with a trust officer at Peak Trust Company today!

Nevada Directed Trusts

Directed trusts are a relatively modern estate planning tool that allow for the separation of investment management and trustee duties. With a directed trust, the trustee has limited responsibilities, and the grantor can appoint outside advisors to manage investments or direct distributions to beneficiaries. Directed trusts have gained popularity in recent years in estate planning. Nevada has become a go-to state for many individuals and families seeking to establish directed trusts due to its excellent directed trust statutes and other favorable trust laws.

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What is a Directed Trust?

A directed trust is a trust structure in which the trustee is directed by one or more designated individuals or entities in making certain decisions related to the trust administration. The person or entity that directs the trustee is called the directing party or directing advisor. Some examples of directing parties include an investment advisor, a distribution committee, or a trust protector. The responsibilities of a directed trustee generally involve the following:

  • Carrying out the instructions given by the directing party.
  • Maintaining legal ownership of the trust’s assets.
  • Providing for the preparation of tax returns.
  • Maintaining trust records.
  • Accounting to the beneficiaries.

The trust document outlines the specific duties and responsibilities of the directed trustee and other trust participants.

"In a directed trust, there are typically at least three distinct roles: the
directed trustee, the trust advisor, and the trust beneficiaries.”

In a directed trust, there are typically at least three distinct roles: the directed trustee, the trust advisor, and the trust beneficiaries. There is also sometimes a trust protector. The trustee administers the trust assets, the trust advisor directs the trustee on certain decisions, and the trust beneficiaries receive the benefits of the trust according to the terms of the trust document.

Choosing the Right State: Why Nevada

Nevada has become a popular state for directed trusts due to its favorable trust laws, including its directed trust statutes. Nevada statutes permit directed trusts and provide certain protections for directed trustees. One of these protections is that a directed trustee is not held responsible for the actions of the advisor with discretion under the trust agreement, as long as the trustee acts in good faith and does not engage in willful misconduct or gross negligence.

"Nevada law offers numerous other benefits for modern trust planning,
such as no state income tax, asset protection, and the ability to create
perpetual trusts.”

Additionally, the law in Nevada considers a trust advisor to be a fiduciary by default unless the trust instrument specifies otherwise. This means that the trust advisor is legally obligated to act in the best interests of the beneficiaries and to exercise reasonable care, skill, and caution in carrying out his or her duties.

In addition to its directed trust statutes, Nevada law offers numerous other benefits for modern trust planning, such as no state income tax, asset protection, and the ability to create perpetual trusts.

Directed Trust Structures: Different Responsibilities for Different Roles

In a directed trust, various roles can be defined in the trust instrument. One of the key roles is the investment advisor, who is responsible for directing the trustee on investment decisions. The investment advisor can be a financial advisor, a family member, or even the grantor of the trust. Another critical role is the distribution advisor, who directs the trustee on distribution decisions. The distribution advisor can be the same person as the directing advisor or a different individual altogether. It should be noted however, that in most scenarios, the grantor should not act as distribution advisor.

Sometimes, a trust protector may also be appointed to oversee the trustee’s actions and ensure the trust’s terms are followed correctly. In addition, the trust protector may have other powers defined in the trust, such as removing the trustee and appointing a successor or changing the trust situs.

The roles and responsibilities of each participant are defined in the trust document. Depending on how the trust is drafted, it can be directed for investment, distribution, or both. This means that the directing advisor and distribution advisor can direct the trustee on specific investment choices and distribution decisions, allowing for a more tailored and customized approach to managing and distributing the trust assets.

Modern Trusts: Directed Versus Delegated

Before the inception of the modern-day directed trust, most trusts were drafted the old way: either a single trustee held all powers and responsibilities, or joint trustees shared equal authority and responsibility. The problem with this structure is that trustees, in many cases, were not the best choice for managing the trust assets. At the same time, a manager of a closely held family business or an investment advisor was not fully equipped to undertake all aspects of trust administration. If the trustee lacked the expertise to perform all necessary trustee functions, such as investing trust assets, the trustee’s only option was to delegate those duties to a professional equipped to perform the function. The solution to this problem? Update modern trust laws to allow for the separation of trustee duties and responsibilities – hence the modern-day directed trust.

"In a directed trust, the advisor has the power to direct the trustee, while
in a delegated trust, the trustee is responsible for making investment and distribution decisions.”

The main difference between directed and delegated trusts is the trustee’s level of responsibility. In a directed trust, the advisor has the power to direct the trustee, while in a delegated trust, the trustee is responsible for making investment and distribution decisions. In a delegated trust scenario, the trustee is responsible for all trustee duties, including investment and distribution decisions, and can delegate some or all of those duties to other professionals. However, the trustee remains responsible for ensuring the delegated duties are appropriately executed. In contrast, since a directed trust separates the powers and responsibilities between the trustee and other participants, the trustee responsible for carrying out the directives of the other participants is relieved of liability for complying with those directives, unless the trustee acted in bad faith. This division of responsibilities allows for greater flexibility and customization for trust management.

Solving for Separation of Trustee Duties: “Old and Cold” Trust Documents

What about all the trusts drafted without the flexibility of the directed trust? Plenty of “old and cold” trust documents were drafted before the widespread inception of directed trusts. These trusts do not provide for the separation of trustee duties. As a result, regardless of who controls the trust assets, the trustee remains responsible which often results in difficulty finding a trustee willing to serve with an outside investment advisor who manages the trust assets. In these cases, there are generally three options.

  • Option 1: Decant the Trust to a Directed Trust with Updated Terms or Create a Non-Judicial Settlement Agreement
    Nevada has favorable laws which give trustees the ability to decant a trust to one with updated, modern terms that allow for separation of trustee duties. This will involve the help of a skilled trust attorney familiar with complex trust structures. Nevada also has a well-established Non-Judicial Settlement process, which allows interested parties in a trust agreement to correct mistakes, address ambiguities, and change administrative provisions without the need for court approval.
  • Option 2: Find a Trustee Who Will Delegate
    Another option, if the terms of a trust do not provide for the separation of trustee duties, is to find a trustee willing to delegate investment management authority to a non-trustee investment advisor. However, because of the increased liability to the trustee under this arrangement, delegated trusts generally incur higher trust administration fees than directed trusts. In addition, under this arrangement, the trustee is required to take on additional monitoring, due diligence, and oversight actions with respect to the investment activities.
  • Option 3: Create an “LLC Wrapper” for Trust Assets to be Managed by Non-Trustee Advisor
    A third option to mitigate risk for the trustee and allow a non-trustee to manage trust assets is to create an LLC and structure ownership so that the only asset at the trust level is an LLC of which the trust is a sole member. In this scenario, the investment advisor or a family member may be appointed as manager of the LLC and will manage the underlying assets held in the LLC.

Summary

Estate planning attorneys should consider using directed trusts because they can be a valuable tool for clients seeking more control over investment and distribution decisions than traditionally structured trusts. Directed trusts have gained popularity in recent years, and Nevada has become a popular state for directed trusts due to its favorable trust laws. Directed trusts offer flexibility and customization for trust management, allowing for tailored investment and distribution decisions. Compared to delegated trusts, where the trustee is responsible for all trustee duties, directed trusts divide powers and responsibilities between the trustee and other participants. However, as always, it is important to carefully consider all aspects of a trust structure and seek the guidance of legal and financial professionals when creating a trust.

If you have more questions about Nevada Directed Trusts, get in touch with a trust officer at Peak Trust Company today!

Taxation of Trusts: Basic Terms and Concepts

Grantor or Non-Grantor Trust?

To understand the basic concepts of the taxation of trusts, we must first understand the concept of a grantor trust versus a non-grantor trust. All trusts are either grantor or non-grantor trusts. With a grantor trust, the trust creator retains certain powers over the trust, which may include certain powers over the trust’s assets and income. With a non-grantor trust the trust creator has no interest or control over trust assets. This distinction determines how and to whom a trust is taxed. A grantor trust is taxed to the grantor. With a non-grantor trust, the trust either pays out income to beneficiary(ies) and then taxed at the beneficiary level or is taxed at the trust level for any income accumulated in the trust.

Many plans using trusts are set up to result in trust income being taxed at an individual level (taxed to the grantor or beneficiary) rather than at the trust level (taxed to the trust). This is because the income tax brackets for trusts are significantly compressed, compared to the tax brackets for individuals. A trust reaches the top tax bracket of 37% at only $13,450 of income, as opposed to the individual bracket where the top tax rate is not reached until over $647,850 of income.1

 

Grantor Trusts

A grantor trust is a trust over which the grantor has retained certain interests or control. The grantor trust rules in IRC 671-678 prevent the grantor from taking tax advantages from assets that have not left his or her control. The grantor trust rules treat the grantor (or in some cases a beneficiary) as owner of all or a portion of the trust income and losses. The grantor is subject to tax on trust income, even if he or she does not actually receive the income.

In most cases grantor trusts do not file separate income tax returns, as opposed to non-grantor (simple or complex) trusts. Because assets in a grantor trust are still considered the grantor’s property under the grantor trust rules, the grantor generally reports the income from the trust assets using his or her own social security number on the grantor’s Form 1040.2

 

Revocable vs Irrevocable Trusts

If the grantor retains the ability to revoke the trust and revest the trust assets in the grantor, the trust is revocable, and the income is taxable to the grantor under the grantor trust rules. All revocable trusts are necessarily grantor trusts. Assets in a revocable trust are included in the grantor’s gross estate for federal estate tax purposes. Revocable trusts, also called living trusts, are one of the more frequently misunderstood trust concepts. They are used primarily as a will substitute. Assets in a revocable trust avoid the cost, time, expense, and publicity of probate. Upon the grantor’s passing, a revocable trust becomes irrevocable.

An irrevocable trust is one that, by its terms, cannot be revoked. An irrevocable trust can be either a grantor or non-grantor trust, depending on the terms of the trust and the powers retained by the grantor in the trust. An irrevocable trust is simply one that cannot be revoked, whether or not it qualifies as a grantor trust under IRS rules. All revocable trusts become irrevocable upon the death of the grantor.

 

Non-Grantor Trusts: Simple or Complex

Non-grantor trusts will generally be classified as either simple or complex for tax purposes. It’s not always an easy distinction between a simple versus complex trust. A trust may be a simple trust for one year and a complex trust for another year.3 In Form 1041, the trustee can identify whether the trust is a simple or complex trust for that particular taxable year.

For non-grantor trusts (simple and complex trusts) the trustee must obtain an employer identification number (EIN) in order to file Form 1041, the US Income Tax Return for Estates and Trusts. A trustee must file Form 1041 if the trust has any taxable income or gross income of $600 or more.

If a trustee makes distributions to the beneficiaries, the trustee must file Schedule K-1 together with Form 1041. Schedule K-1 is the IRS form that reflects the beneficiary’s share of the trust’s income, deductions, and credits. When distributions have been made to beneficiaries, the beneficiary pays the income tax. When income is retained by the trust, the trust pays the income tax. This is important because the beneficiary and trust have different tax brackets. The trust has a higher tax rate than an individual. Thus, the beneficiary will use Schedule K-1 to report his share of the trust income in the beneficiary’s Form 1040.

 

Criteria for Simple vs Complex Trusts

Under the IRS Code,4 a simple trust must pass all three criteria in a taxable year in order to be considered a simple trust (for that tax year):

  • It must distribute all income to the beneficiaries
  • It cannot distribute principal
  • It cannot make distributions to charity

On the other hand, a complex trust is a trust that does any one of the following in a taxable year (for that tax year):

  • It accumulates income
  • It distributes principal
  • It makes charitable distributions

 

Split Interest Trusts

A third type of non-grantor trust is a split interest trust. A split interest trust is a trust that has both charitable and non-charitable interests. The most common types of split interest trusts are charitable remainder trusts, charitable lead trusts and pooled income funds, each with their own set of rules under the IRS Code.

 
NOTE: This information is general and educational in nature and is not intended to be and should not be construed as legal or tax advice. Peak Trust Company does not provide legal or tax advice. The taxation of trusts is highly complex in nature and should only be executed under the guidance of appropriately skilled legal and tax counsel.

 
1 As of the 2022 tax year.

2 In some cases, a grantor trust may have its own employer identification number (EIN), in which case, even though it remains a grantor trust, it should file a form 1041. The return is marked as a grantor trust for federal tax purposes with a note that all income, expense, and other activity is being reported on the grantor’s federal tax return and not the Form 1041. The tax return filing provides the IRS notice that although the grantor trust has its own tax ID number, the income and related trust expenses are reported on the grantor’s federal tax return.

3 26 CFR § 1.651(a)-1

4 26 CFR § 1.651(a)-1