A non-grantor trust, depending on its terms, may be able to distribute its income in a way that reduces the family’s total tax bill, although flowing capital out of the trust restrains its ability to grow. Distributions carry out taxable income to the beneficiaries, who then pay tax at their individual rates. Income is taxed at the trust level only if the trust retains it.
“Ordinary income held in a non-grantor trust could be taxed as high as 39.6% plus 3.8% for a total of 43.4%, versus maybe 15% if you kick it out to a young beneficiary,” says Steven Klammer, a senior vice president at Bryn Mawr Trust in Bryn Mawr, Pa. “There is so much greater focus now on distributions, the type of income that’s earned and the tax rates of the beneficiaries.”
But income tax savings are only one factor to consider in making distributions from a trust. “You can’t ignore your fiduciary responsibility just for good income tax planning,” Klammer says. For discretionary trusts, that responsibility includes balancing the interests of the trust’s income and remainder beneficiaries, he says. The more that’s distributed, the lower the remainder will be at the end of the trust term, all else being equal.
The conclusion? Although retaining income to grow a trust may mean paying more in taxes with the passage of the new law, “there’s a point at which that is going to be a cost of effective estate planning and transfer tax planning,” says L. Timothy Halleron, a partner in the private client group at McDermott Will & Emery LLP in Chicago.
More Trusts, More Trust Planning
Apart from the latest tax law changes, the large number of trusts that the wealthy created last year means they need more help, observes Spackman.
For instance, some individuals may not fully appreciate the responsibilities that come with their freshly minted trusts. Spackman says, “If the trust purchased life insurance, premiums need to be paid. If there was an installment sale along with the gift, the trust needs to make payments back to the client. People may need some hand-holding to understand the implications of what they did.”
Others may be ripe for more planning, especially if they rushed to plan at year’s end, Halleron points out. Last-minute-Johnnies probably funded their trusts with cash or marketable securities. Depending on how a trust was drafted, Halleron says it’s possible those assets “can now be swapped back into the client’s hands in exchange for an interest in a business, hedge fund or private equity fund—assets that would have been difficult to transfer into a trust in a hurried time frame.”
Or you could suggest one of the leveraged techniques that remains permitted, at least for now. For example, the client may be able to sell assets to the trust—thereby moving them out of his estate—in exchange for a promissory note bearing interest at the Applicable Federal Rate, which is pretty low these days. “If the trust was initially funded with $5 million, the client may be able to sell it up to $45 million in assets,” says Halleron, explaining that ninefold is a rule of thumb for this type of transaction. “That’s a huge planning opportunity.”