Legacies & The Finance of Retirement

Trust Planning's Eternal Sunset

Funding beyond 2012 now uses different rules, and creates new opportunities

by Morgan Scott

Mr. Scott is affiliated with Prudential Insurance Company. Connect with him by e-mail: morgan.f.scott@prudential.com. Visit www.prudential.com

In October of 2014, the Internal Revenue Service (IRS) released data on reportable gifts made by Americans in 2012. The amount totaled $335 billion. A large number, certainly, but it’s more impressive when taken in context.

The value of the gifts reported in 2012 was roughly four times the amount reported in tax year 2011. Why the upswing in the gifts reported by taxpayers? To answer this, and to frame our discussion here, we have to recall the legislative and political environment in 2012.

In 2010, as you may remember, the estate tax was temporarily repealed. This was courtesy of a piece of legislation called “The Economic Growth and Tax Relief Reconciliation Act” (EGTRRA). Further, EGTRRA’s provisions relating to the estate and gift tax were set to sunset in 2011, and estate and gift tax rates and exemptions were going to snap back to pre-EGTRRA values ($1 million estate and gift tax exemption). This was prevented – temporarily – by the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act” (TRUIRJCA), which increased the estate and gift tax exemptions to $5 million in 2011 (indexed for inflation in subsequent years).

However, the government had merely kicked the can down the road with TRUIRJCA because this too was due to sunset in 2013. The increased amount of gifts reported in 2012 may be related to the perceived likelihood that the government would allow TRUIRJCA to lapse, and estate and gifts tax rates would return to 2001 levels. In many cases, what occurred was that taxpayers made large gifts to their trusts in haste, in an attempt to have the gifts reported prior to 2013 when the law would sunset. Of course, the law did not sunset, but was made permanent by the American Taxpayer Relief Act (ATRA) of 2012, which was signed into law in early 2013.

Gifter’s Remorse

In some cases, those who made these large gifts to trust in 2012 may be feeling a bit of “gifter’s remorse”. It may be that some taxpayers now wish that they hadn’t gifted – or gifted as much – and would prefer to have these assets back in their estates. Solutions to this concern may lie in the trust document itself: permissibility of loans by the trustee to the grantor; non-grantor spousal beneficiaries; etc. In other cases, trusts may have been drafted too hastily in order to allow for the gifts to be reported prior to the end of 2012. The solution in this instance will depend on the relevant state’s laws, e.g. by taking advantage of decanting laws (where enacted into statute) to move assets from one trust to another. With that said, the concerns above, and other related issues, are for another author and article to address.

This article will concern itself with a different set of issues, and how to plan around them. In the first instance, we’ll look at those trusts which were hastily funded with cash (or cash equivalents) and have remained uninvested, post-gift. In the second instance, we will look at a trust where the asset gifted may not be the most appropriate trust investment for practical or financial reasons.

In both cases, the planning solutions provided will feature income tax management as a central theme.
When a trust is cash funded, the trustee is spoiled for choice in terms of investment options (trust documents generally provide the trustee with broad discretion as to how they may invest trust assets). While perhaps not an overriding concern, income tax management is an important consideration. If the trust is a non-grantor trust, then taxes are paid at trust tax rates.

Trust tax rates are similar in many ways to individual rates, but brackets are compressed to such a degree that trustees are easily accelerated into the highest tax bracket. For instance, in 2015 when a trust generates income over $12,300, they are in the highest income tax bracket (39.6%) and the highest capital gains bracket (20%), AND will be subject to the 3.8% Medicare surtax on investment income. In the event that the trust is a “grantor trust” for income tax purposes – a very popular planning technique – the taxable income generated by trust assets will flow through to the grantor, who will be personally responsible for paying the taxes based on their own personal income tax rate.

While an excellent planning strategy that generally results in a comparative (trust vs individual) reduction in the amount of tax paid, the increased tax burden can be capable of putting financial pressure on some taxpayers. Considering the impact that such tax rates can have on trust investment performance, or on the cash flow of the grantor, trustees may want to consider tax deferred or tax free assets.

Tax-Efficient Options

Let’s consider some tax efficient investment options. Non-qualified tax deferred annuities grow income tax differed (generally speaking, trust owned annuity contracts will maintain their tax deferred character when the trust is acting as an agent for an individual) and can feature fixed, indexed or variable investment options.

Additionally, many annuity products feature popular living benefit riders that can guarantee income for the life of the annuitant, as well as other enhanced benefits, all without the requirement of underwriting. However, earnings in an annuity policy are taxed as ordinary income when distributed (to the extent of earnings in the contract), with the method of distribution controlling whether the entire distribution is potentially subject to taxation (withdrawals), or a pro-rated amount (annuitization).

In some cases, those who made these large gifts to trust in 2012 may be feeling a bit of “gifter’s remorse”. It may be that some taxpayers now wish that they hadn’t gifted – or gifted as much – and would prefer to have these assets back in their estates

Death benefits from annuity contracts are taxable in excess of the basis in the contract, and trusts cannot “stretch” non-qualified deferred annuity death benefits. On the other hand, the interest produced by municipal bonds is generally income tax free. This is an obvious advantage, but the overall suitability is hampered by our historically low interest rate environment.

Life insurance could offer a number of advantages in the trust market. They are tax deferred vehicles; withdrawals may be taken and are generally taxed on a “first in, first out basis”* (non-taxable return of basis); loans can be taken against cash values , income tax free*; and the death benefit is generally income tax free .

Further, proceeds from a life insurance policy are generally not subject to the 3.8% Medicare surtax on investment income. Life insurance policies come in a variety of forms and can feature fixed, indexed, or variable investment features. The downside is that life insurance must be underwritten and the age and health of the client, as well as the insurance need, will dictate the pricing and availability of the product. There is no one-size-fits-all solution for trust investments, but it would serve the beneficiaries’ interest to at least consider tax efficient investments as an option in trust.

In other instances, you may come across trusts that were funded in 2012 that are not cash rich, but hold large positions in a capital asset such as real estate, closely held company stock, securities portfolio, etc. In the case of a client who has gifted away low basis capital assets, they may have lost one of the great tax privileges granted by the IRS: step-up in basis at death. This is only available on those capital assets includable in the decedent’s estate at death.

Thus, capital assets owned by an irrevocable trust at the grantor’s death do NOT receive a step up on cost basis… an error that could cause an increased tax burden on future generations. If a trust does own low basis capital assets, it would serve you well to have the trust reviewed to determine if it is a “grantor trust”, and if it contains a popular provision called a “substitution clause”, or “power of substitution” (IRC Sec. 675(4)(C)). Planners like to have this provision included in trusts because in addition to creating grantor trust status (often viewed as a positive in-and-of-itself), it gives the grantor the power to swap trust assets with personal assets of equivalent value.

Thus, a grantor would be empowered to “swap out” those trust-owned assets with a low basis, and bring them back into their estate in exchange for high basis assets, cash, or cash equivalents. In so doing, the client returns the low basis assets to their estate and avails themselves of the basis step up at death, while also moving assets outside of their estate that would not generate the same tax advantage.

If the client swaps the low basis stocks for cash and is insurable, the trustee can apply for a life insurance policy on the grantor’s life. Please recall that life insurance is tax deferred and produces an income tax free death benefit. What have we done? We’ve accomplished a “double step-up” because the capital assets are now in the estate and receive a step-up in basis at death, and the life insurance death benefit are income tax free at the grantor/insured’s death. A potential “win-win”.

Asset Efficiency

If your clients created and funded trusts in or around 2012, it may make sense for them to review the investments in those trusts with their tax or legal advisors. It may be that trusts had been funded in haste and trust assets are not being utilized in the most efficient manner(s) available. In addition to managing trust assets for investment performance, it may serve the client’s best interests to consider how income tax management can be used to preserve asset values and assist in maximizing the net proceeds passed to their heirs.




This article represents a general discussion of tax information. Clients should discuss their situation with their tax or legal advisors. Because each situation is unique, we cannot provide tax advice.
*The income tax-free treatment of a loan or withdrawal is based on a policy not being classified as a Modified Endowment Contract (MEC). Distributions from MECs (such as loans, withdrawals, and collateral assignments) are taxed less favorably than distributions from policies that are not MECs to the extent there is gain in the policy. However, death benefits are still generally received income-tax free pursuant to IRC §101(a). The death benefit will be reduced by any withdrawals or loans (plus unpaid interest). Clients should consult a tax advisor.
Life insurance is issued by The Prudential Insurance Company of America, Pruco Life Insurance Company (except in NY and/or NJ), and Pruco Life Insurance Company of New Jersey (in NY and/or NJ). Variable life insurance and variable annuities are offered through Pruco Securities, LLC (member SIPC). All are Prudential Financial companies located in Newark, NJ.
Created Exclusively for Financial Professionals. Not for Use with Consumers.
0281130-00001-00 Ed. 08/2015 02/17/2017