Posts Tagged ‘Certified Public Accountants’

Income Taxation of Trusts — Not Just Special Needs Trusts

APRIL 6, 2015 VOLUME 22 NUMBER 13

We have previously explained the income taxation of self-settled special needs trusts and third-party special needs trusts. We focused on special needs trusts because, well, that’s what we do — and also because there seems to be so much confusion about special needs trusts. But that is not the only confusion out there. We find a lot of confusion about taxation of trusts, generally. Let’s see if we can clarify some of the issues.

The income tax issues are actually the same for trusts that are not “special needs” trusts. But the generalizations are a little harder to keep straight, since there is a much broader variety of trusts out in the world. So let’s see if we can lay out some questions and answers to help you understand the issues.

The first question: is the trust a “grantor” trust?

Why is this question the first (and probably the most important)? Because if the trust is a grantor trust it (a) does not need to have a separate taxpayer identification number (what is called an EIN, or Employer Identification Number, in tax language) and (b) should not file a separate tax return. If the trust is a grantor trust, you can (and usually should, if only for convenience purposes) use the grantor’s Social Security Number and report income on the grantor’s personal income tax return.

So how do you know if your trust is a grantor trust? Let’s ask a few qualifying questions:

  • Did you create the trust, or did the money in the trust once belong to you?
  • Is the trust revocable (by you)?
  • Are you the trustee?
  • Are you a beneficiary of the trust?

If you answer the first question “yes” and any one or more of the following questions “yes,” your trust is almost certainly a grantor trust. There are some exceptions, but they are relatively rare. Talk to your attorney and your tax preparer — and we recommend you talk with both. Why? There is a lot of misunderstanding out there, and neither lawyers nor accountants always get the answer right on this question.

What are the most common misunderstandings? You will sometimes hear accountants, bankers, stockbrokers and lawyers assure you that an irrevocable trust that names someone other than the grantor as trustee must have a separate EIN (and, presumably, file a separate tax return). That’s simply not true. It’s also not relevant to whether or not the trust is a grantor trust.

There are also some “magic” provisions in irrevocable trusts that are usually used precisely to make them grantor trusts. If, for instance, your irrevocable trust includes a provision that says the person who set it up retains the right to trade (“substitute”) property in the trust for their own property, it’s pretty likely that was included precisely to make sure the trust is a grantor trust.

What if the trust is not a grantor trust?

Then the trust will need an EIN, and it will file a separate income tax return. That does not necessarily mean it will pay any income tax, but it will need a return filed.

Depending on the language of the trust and the nature of its distributions, some or all (or, rarely, none) of its distributions will be taxed to the recipient — or to the person who benefited from the distribution. So, for instance, if a non-grantor trust sends cash to its beneficiary, the beneficiary will probably pay some income tax on the distribution. Same answer if, instead, the trust pays the beneficiary’s rent, college tuition and car payments directly — all of those distributions are for the benefit of the beneficiary.

Note that not all of the trust’s distributions will be treated as income to the beneficiary. Only the portion of the distributions that would have been taxed to the trust (that is, the trust’s income) will be subject to being passed through to the beneficiary. So, for instance, if a trust has $1,000 of interest income, and pays $15,000 in rent and tuition bills for the beneficiary, no more than that $1,000 figure will be taxable income to the beneficiary. At least some of the administrative costs will probably be deductible before calculating the tax effect.

How does the non-grantor trust report its income for tax purposes?

The federal tax form used by trusts is called the 1041 (it’s similar to, but different from, the individual’s 1040 income tax form). It actually looks a little simpler than the personal income tax return, but that’s misleading — some of the accounting and tax concepts are more complicated and less understood. We recommend that trustees get a professional to prepare the trust’s tax return.

What about state income tax returns?

The trustee will likely need to file state income tax returns that mirror the federal return. But for which state(s)? That’s a hard question to answer, and impossible to generalize about. Some states want trust income tax returns for any trust that has a trustee or co-trustee living in their state. Others look primarily to where any one beneficiary lives. Other states do not have income tax at all, and so do not require a trust to file an income tax return. Your professional tax preparer will want to consider at least: (a) the language of the trust, (b) the residence of all beneficiaries, and (c) the residence of all trustees.

Can any tax preparer handle a trust’s income tax return?

Yes. Probably. Maybe. Wait — let us ask you a question: have you asked the tax preparer how often he or she prepares trust income tax returns? If not, we suggest you might want to ask. The returns are not bewilderingly complicated, but they are unfamiliar to people — even professionals — who are not used to working with them. Your best bet: get a professional (probably a CPA, perhaps a lawyer or law firm) who does this kind of tax return on a regular basis.

Good luck getting through this tax season. We hope this helps. Be careful, though — there are exceptions and qualifications to the general rules we’ve outlined. Check with your experienced tax preparer or attorney before actually preparing returns. Better yet: let the professionals do it.

Accounting Requirements for Irrevocable Trusts in Arizona

FEBRUARY 4, 2013 VOLUME 20 NUMBER 5
Arizona adopted a version of the Uniform Trust Code in 2008, to be effective at the beginning of 2009. The UTC has been the subject of much discussion across the country — it has been adopted in about half the states, and soundly rejected in a few others. Despite all that discussion, however, there are relatively few court cases addressing what the UTC provisions actually mean.

One concern commonly raised about the UTC has been its requirement that trust accounting information must be given to beneficiaries, including those who receive no benefit until after the death of a current beneficiary. Take, for instance, a common situation: in a second marriage, a wife establishes a trust for the benefit of her husband for the rest of his life, with the remainder to be paid out to her children (from her first marriage) after the husband’s death. Then the wife dies, leaving her house and brokerage account to the trust. Her surviving husband is trustee. Under Arizona’s version of the UTC, her children are entitled to receive at least annual reports from the husband.

But what should those reports contain? The Trust Code is less than completely explanatory. It says that the wife’s children are entitled to “a report of the trust property, liabilities, receipts and disbursements, including the source and amount of the trustee’s compensation, a listing of the trust assets and, if feasible, their respective market values.”

In a recent Arizona Court of Appeals case, the meaning of that requirement was questioned. The history was slightly more convoluted than the scenario we describe above: the trust had been established by a husband and wife for the ultimate benefit of the husband’s two daughters. First the husband and then the wife died. The trust, by its terms, then divided into two shares — one share outright to  one daughter, and the other share to a local Certified Public Accountant as trustee for the benefit of the other daughter.

To try to make this convoluted story a little clearer, let’s identify the parties. In keeping with our usual attempt to avoid family names popping up in internet searches, and to make it easier to keep track, we’ll give everyone shortened names. We’ll call the combined trust — the original one set up by the husband and wife — the G Trust, and the trustee of that trust Geraldine. We’ll call the trust for the benefit of one daughter the S Trust, and the CPA/trustee of that trust Scott. The other daughter will be Doris.

Doris filed a court action asking for determination of the proper division of the G Trust. She noted that she had been named as beneficiary of an annuity and asked that it be determined that it was not part of the trust. Geraldine, the trustee of the G Trust, filed a proposed distribution schedule for the G Trust. Both Doris and Scott (the Trustee of the S Trust) objected, each arguing that their share should be increased. The probate court found that the annuity belonged to Doris, and that Geraldine should make her own calculation as to how to distribute the G Trust.

Months later, Scott filed a request that the court order Geraldine to file an “accounting” with the court. Geraldine objected that she had done everything the Arizona UTC required — and that all she was required to provide was a “report” under that statute. Scott argued that he was entitled to a more formal accounting. Ultimately the probate judge denied that request, finding that Geraldine’s reports (consisting of account statements and other documentation) were sufficient for Scott to protect his trust’s interest. Scott appealed.

With that background, the question before the Court of Appeals was straightforward: does the Arizona version of the Uniform Trust Code allow a beneficiary to make a demand for a formal, detailed accounting? No, ruled the appellate court. In fact, the UTC made the accounting requirements less onerous, rather than imposing more detail: the prior Arizona law had required “a statement of the accounts of the trust annually,” but that statute was repealed when the UTC was adopted.

According to the appellate decision, requiring an “accounting” would have included “establishing or settling financial accounts” and “extracting, sorting, and summarizing the recorded transactions to produce a set of financial records” (quoting from Black’s Law Dictionary 9th Ed.). The court also quoted from the commentary prepared by the UTC’s original, multi-state drafters: “The reporting requirement might even be satisfied by providing the beneficiaries with copies of the trust’s income tax returns and monthly brokerage account statements if the information on those returns and statements is complete and sufficiently clear.”

The bottom line: the main concern of the UTC is to assure that beneficiaries have the information they need to be able to protect their interests. Scott had sufficient detail that he could calculate whether Doris had received more than her share of the G Trust, and Geraldine was not required to prepare a more formal report. In the Matter of the Goar Trust, December 31, 2012.

Principles Governing Third-Party Special Needs Trusts

OCTOBER 3, 2011 VOLUME 18 NUMBER 35
Last week we tried to demystify some of the principles of self-settled special needs trusts, and to distinguish them from third-party trusts. This week we continue that education effort, focusing on the rules governing third-party trusts.

Generally speaking, there are two kinds of special needs trusts. Those set up to handle money owned by the beneficiary (like a personal injury settlement, for instance) are usually called “self-settled” special needs trusts. Those set up by someone other than the beneficiary, to handle money not belonging to the beneficiary, are usually called “third-party” special needs trusts. It is the latter kind of trust we want to explain here.

What kind of property can go in to a third-party special needs trust?

Any property someone wants to leave or give to a person with a disability can (and usually should) be placed in a third-party special needs trust. Homes, cash, stock and bonds are all common third-party trust assets.

Are all inheritances properly viewed as third-party trusts, since they come from someone other than the beneficiary?

This is one of the common confusions for those not closely familiar with special needs planning. An inheritance can be left outright to someone, or in a trust for their benefit. In the case of a trust, it can be designated for the “support and maintenance” (or similar language) of the beneficiary, or for their “special” and/or “supplemental” needs (or similar language).

If an inheritance is left outright to a person with a disability, it might be transferable to a trust — but probably only to a self-settled special needs trust, since the beneficiary had an absolute right to possess the property outright. If an inheritance is left in what we might call a “support” trust, it may be a third-party trust but not necessarily a third-party special needs trust. Only if a trust contains money from someone other than the beneficiary and includes language limiting its use to special or supplemental needs will it be considered a third-party special needs trust.

Can an inheritance which is not left to a third-party special needs trust be “fixed”?

Sometimes. State law varies greatly. Fact patterns are very different. This is an important question which should be asked of a qualified attorney. Expect the response to be “let me ask you a few more questions.” The likelihood is high enough, though, that the possibility should definitely be addressed.

Are all third-party trusts funded with inheritances?

Absolutely not. Many people create third-party trusts for their children, loved ones, friends or family members while the person creating the trust is still living. Perhaps a wealthy family is eager to reduce assets in the first generation’s name, but unable to transfer funds outright to a child with a disability. Perhaps friends want to band together to provide assistance to someone who is or has become disabled. Perhaps one generation wants to create a vehicle for other family members — including other generations — to make contributions to the welfare of a person with a disability.

Are all third-party special needs trusts irrevocable?

No. Self-settled special needs trusts must be irrevocable, but the same is not true for third-party trusts. Usually a trust established during the life of the trust’s grantor (rather than in their will) is revocable during the grantor’s life. It is important that the beneficiary not be able to revoke the trust, but there is no reason someone who is not the beneficiary can not be given the authority to terminate it.

Who is the “grantor” of a third-party special needs trust?

“Grantor” is a term that has meaning in the tax code — and that meaning is not always synonymous with the general understanding of the language. A grantor is the person who created a trust and is still liable to pay the income taxes on the trust’s earnings. In the case of a revocable third-party special needs trust, the grantor will usually be the person who (a) contributed the money and (b) has the power to revoke the trust — though even that general statement will not always be true. In the case of an irrevocable third-party special needs trust, the person contributing the money may still be the grantor. This is a question best addressed in individual cases by a qualified attorney and/or Certified Public Accountant.

The income tax definition of a “grantor” is important. The grantor will be taxed on the trust’s income, even though he or she may not receive any benefit from those earnings. Though this sounds ominous, it may well be a desirable result — the tax rates on a trust are usually higher than those on an individual, and a wealthy donor might actually prefer to bear the income tax burden rather than have the trust depleted by having to pay taxes. The income tax filings for a third-party trust created by a living grantor can be very complicated, and almost always require the tax preparation skills of a CPA or other experienced professional.

Can a third-party special needs trust be a “Qualified Disability Trust?”

Yes, it can — but only if it is not a grantor trust, taxed to the person who put the money into the trust in the first place. If a trust is a Qualified Disability Trust, there can be important income tax benefits. Basically, such a trust is permitted to claim an “extra” personal exemption, reducing income tax liability in some (but not all) cases. For more detailed information about Qualified Disability Trusts (or to help educate your tax preparer), consider the Special Needs Alliance article authored by Fleming & Curti partner Robert Fleming and friend Ron Landsman.

What happens to the “grantor” status of a third-party special needs trust when the grantor dies?

The trust is no longer a grantor trust. It is now almost certainly what the Internal Revenue Service calls a “complex” trust, and will need to file a separate income tax return (and pay its own income taxes). One important note, though: distributions for the benefit of the beneficiary — the person with a disability — will be treated as income to him or her, reducing the trust’s income tax liability but possibly creating income tax liability for the beneficiary.

Does a third-party special needs trust need its own tax identification number?

If it is still a “grantor” trust (to the person putting the money into the trust) then it might not need a separate tax number or any income tax filings. Upon the death of the grantor, and earlier in many cases, the trust does need to have an Employer Identification Number (an EIN) and to file separate income tax returns. Even though it may not need an EIN while the grantor is still alive, it is usually permissible for it to obtain one, and to file informational returns (though the tax liability all flows to the grantor, and trust administration costs are probably not deductible). This is one of the areas of greatest confusion, and is yet another good reason for the trustee of any special needs trust to seek out an experienced and qualified tax preparer, usually a CPA who has prepared many returns for special needs trusts.

What kinds of things may a third-party special needs trust pay for?

Though there may be limitations in state law and Medicaid rules about what a self-settled special needs trust can pay for, there are almost no limitations on third-party trust distributions. The trustee must remember this, though: some distributions may have the effect of reducing — or even eliminating — some or all of the beneficiaries public benefits.

That may not always be a bad result. Many times a thoughtful trustee will make distributions that affect public benefits in at least these kinds of scenarios:

  • The effect is to lower, but not eliminate, benefits — and the positive outcome is worth the reduction in benefits (as, for instance, when the trust pays housing expenses and causes a small reduction in Supplemental Security Income payments but improves the beneficiary’s quality of life)
  • The effect is temporary (as, for instance, when the trustee makes cash distributions that allow the beneficiary to pay off old debt that the trust can not tackle directly, or replenish depleted cash reserves, or purchase food or shelter directly — or all of those things)
  • The benefit of distributions outweighs the loss of public benefits (as, for instance, when the special needs trust is very large, the beneficiary’s disability is slight and his or her quality of life is better enhanced by allowing the trust to pay all bills and eliminate public benefits — and the limitations on eligibility — altogether)

Where can I get more information?

One excellent resource is the Special Needs Alliance’s “Handbook for Trustees.” It covers both third-party and self-settled special needs trusts, and provides a wealth of practical information for trustees. It is also available in Spanish.

So what, again, are the differences between third-party and self-settled special needs trusts?

The take-away message: third-party special needs trusts are much more flexible and can be much more beneficial to a person with a disability than the more-restrictive self-settled trust. That means that the trustee of a third-party special needs trust often has a more challenging job, having to weigh intangibles and balance the wishes of the original donor of the funds, the hopes and aspirations of the beneficiary (and family members, friends and supporters) and general trust principles. That is why professional help and advice are so important.

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