Trust investing never seems to get simpler. The combined impact of the fiscal cliff tax deal - increased marginal tax rates, the new Medicare tax on passive investment income and changing techniques for drafting and planning trusts - have changed the ground rules for many estate planning strategies.
For financial planners, the challenge of investing trust assets, planning for liquidity to fund distributions and identifying optimal asset location decisions is now probably greater than ever.
To illustrate some of the new or different issues and challenges planners will face, let's use a simplified hypothetical: Jane Smith, 65, a widow with $8 million in assets. She is in the top income tax bracket and is subject to the new 3.8% Medicare tax on unearned net income.
Let's assume, also for simplicity's sake, that she has a 50/50 allocation to bonds and equities. Her assets might also be divided between various accounts in the following way:
* An IRA, designed to shelter income, holds $2 million of bonds.
* An irrevocable trust formed for her benefit by her parents holds $2 million in equities, with a goal of growing assets outside of her estate.
* A grantor trust that Jane established in 2012 holds another $2 million of equities. (A grantor trust is a trust that is taxed to the settlor - that is, the person who set up and funds the trust.)
* In her own name, she holds another $2 million of bonds.
Is this really an optimal plan? What considerations might be relevant to the planning process under the new tax paradigm? What lessons can be learned for other investment or trust situations?
SHIFTING TRUST ASSETS
The trust set up by Jane needs to be reviewed carefully. Is Jane the only current beneficiary? Can distributions be made to Jane's heirs?
This could be particularly important. Under the new income tax paradigm, it might be possible to allocate more income-producing assets to the irrevocable trust and then distribute income out to Jane's heirs, who are in lower tax brackets.
This type of trust, commonly called a "sprinkling" or "spray" trust, can be an incredibly useful tool in the current environment. Making a distribution to a lower-bracket family member will pull the income with it, and could potentially let the family avoid the higher marginal income tax rates and 3.8% Medicare tax.
So perhaps favoring income-producing assets in this trust would provide the family an overall income tax savings.
Advisors will also need to consider other complications, such as the "kiddie tax" and alternative minimum tax.
What if only Jane is listed in the trust as a current beneficiary and her heirs are beneficiaries on her death? In that case, the use of "decanting" might be helpful. This is the process of pouring an existing trust into a new trust to achieve desired legal or tax benefits.
Decanting into a new trust that makes the heirs current beneficiaries would provide an income tax planning opportunity. Can that be accomplished? Will there be gift-tax or other adverse consequences from the decanting?
The key point for planners is this: Don't assume that an irrevocable trust is what it is. If a trust is not optimally drafted, you may have options - perhaps including a decanting - and failing to pursue them may shortchange your client.
INCOME TAX CONSIDERATIONS
The recent round of tax changes also create another potentially thorny issue that planners should gear up to address.
Suppose Jane's trust has all her descendants as heirs. Although there had been an income tax cost in prior years, the trustee may never have made a distribution - perhaps because of the potential estate tax savings from growing assets outside the transfer tax system, and maybe for personal reasons, as well.
Now, more than ever, trustees who limit distributions so that income is taxed to the trust may face challenges by beneficiaries. Bear in mind that trusts face a very compressed tax rate structure, so that a trust will bear the maximum income tax rate plus the 3.8% Medicare tax on about $12,000 of income.
If beneficiaries are in lower brackets, they may demand distributions and justify the requests by the tax savings - in effect arguing, "I don't pay the Medicare tax, but the trust does. So give me the money."
That limited, self-serving perspective may not comport with the realities facing a trustee or advisor.
To make the decision, the trustee or advisor will need to consider the following factors:
* The detailed terms of the trust. Bear in mind that a general reading of trust distribution provisions might have sufficed in prior years, but it may no longer be adequate to address these issues. Are distributions optional or mandatory? Is there language that suggests when and if distributions should be made?
* The amount of income involved and the potential for tax savings.
* Income tax status information on the beneficiaries, including federal tax bracket, adjusted gross income, state of residence and more. Not all fiduciaries, especially family trustees, have always gathered this information. It may now be even more advisable. And what happens if one beneficiary is in a much lower bracket than another? The real world complications may make this process quite daunting.
* The Prudent Investor Act in the state whose laws govern the trust. The act lists a number of factors besides taxes to consider in determining a trust's investment policy. If a distribution is not being made, or investments that reduce income are favored, planners should be certain to document each relevant factor.
* The trust's own investment policy statement, which should support the decisions made. Revisions to the policy statement may be required to address the new tax environment and the possibility that beneficiaries will demand distributions.
BYPASS TRUST ALLOCATIONS
Traditionally, a typical estate plan involved the formation of a bypass trust and marital trust on the death of the first spouse. Once the death occurred, the bypass trust and marital trust would be funded. And generally, the bypass trust was weighted disproportionately with equities, in order to shift as much appreciation as possible outside the surviving spouse's estate.
After the fiscal cliff tax deal, however, some clients will opt for outright bequests or marital trusts so that the assets bequeathed will be included in the taxable estate of the surviving spouse to receive a step-up in income tax basis on the second spouse's death. In contrast with past strategies, these clients will likely rely on portability to avoid federal estate tax on the death of the second spouse. Those opting for non-trust "simple" distribution plans will expose assets to creditors, remarriage and other risks that could prove more devastating than the estate or income tax.
Many clients who live in states that have decoupled from the federal estate tax may opt for bypass trusts to reduce state estate taxes, even if they are never going to be subject to federal estate tax. Here's an example:
Tom and Mary Johnson live in New York, which has an exemption of only $1 million. Their estate is worth $4 million total, so they will probably never have a federal estate tax. But on the second death, their heirs would face a New York estate tax on $3 million (the $4 million total less the $1 million exemption).
Now if, upon the first death, $1 million was put in a bypass trust, they would reduce the ultimate New York estate tax by an additional $1million. But for those opting for a bypass trust, the issue is whether the state estate tax savings will outweigh the loss of the basis step-up.
This is because the $1 million put in a bypass after the first spouse dies will be outside of the surviving spouse's taxable estate (which will help save on state estate tax) - but that also means no basis step-up on the survivor's death, so the heirs could face more capital gains cost.
What does all this mean to investment location decisions?
In the past, it might have been best to pack equities into the bypass trust to maximize estate-tax savings. Under the new paradigm, however, it might make more sense to have 100% bonds invested in a bypass trust in order to limit the potential for growth.
Putting equities in the marital trust (or in the surviving spouse's personal investment portfolio) should result in concentrating appreciation in the surviving spouse's estate, where those assets can qualify for a step-up in basis. This is the opposite of what was typically done in the past.
The key is that - given the flurry of new tax changes - advisors must revisit past assumptions about investment planning and, in particular, asset location.
Martin M. Shenkman, CPA, PFS, JD, is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.