Much of estate planning today is actually income tax planning
by Herbert K. Daroff, J.D., CFP®, AEP®Mr. Daroff is affiliated with Baystate Financial Planning in Boston, Ma., and is a contributing editor to this magazine. Connect with him by e-mail: [email protected]
Today, with $11.4M federal estate exemptions, a great deal of estate planning is actually income tax planning. You should consider multi-generational tax planning as well as multi-generational creditor protection. And, you should advise your clients of the pros and cons of which State is chosen as the situs of their estate planning trusts. A trust, even though it is irrevocable, can still be quite flexible. It can contain a provision allowing the Trustee(s) or Trust Protector to change the situs (i.e., the State selected for Trust administration). The situs chosen can provide at least the following four benefits:
Reduce or eliminate State income tax consequences for the trust
Revocable living trusts are subject to the tax consequences of the State where the Grantor resides. That also applies to Irrevocable Living Trusts during the life of the Grantor, if they are Grantor Trusts. However, Revocable Living Trusts become Irrevocable Non-Grantor Trusts when the Grantor dies. The same applies to Irrevocable Grantor Trusts. They too become Irrevocable Non-Grantor Trusts when the Grantor dies. Irrevocable Living Trusts can be set up as Non-Grantor Trusts even while the Grantor is alive. All Non-Grantor Trusts are subject to any State’s law it chooses (after meeting a series of State specific requirements). The income tax consequences for distributions from a Non-Grantor Trust are the responsibility of the beneficiary and are subject to the State income tax law where the beneficiary resides. The beneficiary may also be in a lower federal income tax bracket. However, all other income tax consequences are paid by the trust and are subject to the State tax law selected. There are several states, including Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington, and Wyoming that have 0% income tax.
Keep in mind that Trusts are subject to the top 37% federal income tax bracket (for 2019) at income at or over only $12,750. That same 37% tax rate applies to income at or over $612,350 for Married Couples filing Jointly or for income at or over $510,300 for those filing as Single.
Protect assets from beneficiaries’ creditors for assets that remain in the trust. Domestic Asset Protection Trusts
Some states, including Alaska, Delaware, Florida, Illinois, Missouri, Nevada, New Hampshire, Ohio, Rhode Island, South Dakota, Tennessee, and Wyoming have favorable asset protection statutes. In most States you need to create a Limited Liability Company (LLC) or corporation to gain any protection from liability. And, you need a legitimate business purpose to set up an LLC or corporation. Asset Protection Trusts do not require a legitimate business purpose. There may also be opportunities to establish off-shore asset protections.
Keep in mind, however, that once income and/or principal is distributed by a trust to its beneficiaries, the asset protection is lost. The creditors of the beneficiary may be able to access those funds. But, the trustees could retain the assets and pay expenses incurred by the beneficiaries without ever making distributions to them. The beneficiary can be named as co-trustee of their own share provided there is also a disinterested (non-beneficiary) trustee named. The beneficiary or beneficiaries can have the right to remove and replace the disinterested co-trustee.
Extend the number of generations that can skip estate taxation by allowing the trust to exist without being required to make outright distributions (Dynasty Trusts)
There are a number of States that have repealed the Rule Against Perpetuities, including Alaska, Arizona, Colorado, Delaware, District of Columbia, Florida, Hawaii, Idaho, Illinois, Kentucky, Maine, Maryland, Michigan, Mississippi, Nebraska, Nevada, New Hampshire, New Jersey, North Carolina, Ohio, Pennsylvania, Rhode Island, South Dakota, Tennessee, Utah, Virginia, Washington, Wisconsin, and Wyoming. These States allow some version of a perpetual trust. They increase the benefits of Generation Skipping by allowing the trust to benefit multiple generations while skipping estate taxes for those multiple generations. And, if the funds are retained in the trust, they may also be protected from the beneficiaries’ creditors. The beneficiary may be able to serve as co-trustee of his or her own share of the trust provided there is a disinterested (non-beneficiary) co-trustee.
Allow the trust to be more easily amended (even if it is irrevocable) by Decanting or Non-Judicial Amendment by the trustee and beneficiaries
Some states have more favorable statutes than others, including Alaska, Delaware, Illinois, Missouri, Nevada, New Hampshire, Ohio, South Dakota, Tennessee, and Texas. As stated at the outset, a trust, even though it is irrevocable, can still be quite flexible. Not only can it contain a provision allowing the Trustee(s) or Trust Protector to change the situs (i.e., the State selected for Trust administration), but other provisions may be changeable by the Trustee(s) or Trust Protector or by a combination of Trustee(s) and beneficiaries.
However, choosing a State other than your home State results in higher trust administration costs and additional accounting fees.
You and your client should discuss the situs of their trust with the other members of their team of trusted advisors.