Posts Tagged ‘income tax’

Same-Sex Married Couples Should Pay Attention to Income Taxes

MARCH 10, 2014 VOLUME 21 NUMBER 10

Income tax filing season is upon us, and so it’s an appropriate time to turn our attention to what’s new (or little-known) in the income tax world. We’re particularly interested, of course, in income tax issues that affect our clients, who usually are more interested in estate and gift taxes than income taxes. But there’s one subset of our clientele that really does need to focus on new income tax rules: same-sex married couples.

What’s new this year, of course, is that the U.S. Supreme Court has struck down a key part of the federal Defense of Marriage Act (DOMA). That federal law had said that even if a state chose to recognize same-sex marriages, the federal government would not accept that state recognition. After the Supreme Court ruling in United States v. Windsor on June 26, 2013, that principle was reversed. Later interpretations by the Internal Revenue Service (along with other agencies of the government) have expanded that reversal.

In the wake of the Windsor decision, the executive branch of the federal government has adopted a new approach to determining the validity and effect of same-sex marriages. The short version: if the marriage was recognized as valid where and when it was solemnized, it will be valid for federal (including income tax) purposes. That has been referred to as the “place of celebration” rule. It is sometimes called the “state of celebration” rule, but it is not limited to states — a marriage valid in a foreign country will work, too. Like, for one example, that of Edith Windsor and Thea Spyer, who were married in Ontario, Canada, in 2007, but lived in New York.

We still see a lot of confusion about the effect of the new IRS rules, though. Our gay and lesbian clients often believe that they are not married because Arizona does not (yet) recognize the validity of their marriage. Sometimes same-sex couples were married years ago and have since drifted apart — believing, perhaps, that they did not need to do anything to end a marriage that their home state stubbornly refuses to acknowledge. The new rules will require a rethinking of those relationships.

Here’s the bottom line for same-sex married couples: if you were legally married in another state or country, you need to file your federal income taxes this year (and for future years) as if you were married — because you are. That may mean that some couples actually pay more in total income tax — the well-known “marriage penalty” in the federal tax code will now apply to same-sex couples in the same way that it has long applied to opposite-sex couples. But it is not optional — a married couple, regardless of gender, can not decide to simply file as two single individuals regardless of what Arizona thinks of the validity of their marriage.

Does that mean that married couples who are no longer together need to file a joint income tax return? Yes — or they have to file as “married, filing separately.” Does that mean separated — but still married — couples have to communicate with each other, and share financial information? No, but if they file separately they are likely to pay more total tax, and it makes sense to talk through the options with a qualified income tax preparer.

Arizona also has a state income tax, of course, and it still refuses to recognize those same sex marriages. Since your state income tax filing starts with your federal tax return, a “married filing jointly” federal return is bound to confuse the state tax folks. So they have come up with their own form to make adjustments: it is called Arizona Schedule S and it is available on the Arizona Department of Revenue website. There are instructions for the Schedule S, and a version for 2012 taxes as well as 2013. (It could be worse: some states are requiring same-sex couples to prepare a federal return as if they were unmarried, just to attach it to their state tax return.)

Why is there a 2012 version of Arizona’s Schedule S? That leads to another point worth considering: if you were married before 2013, you may be eligible to (but you are not required to) amend your federal income tax return to file as a married couple. If you do, you will need to amend your Arizona tax return as well. You clearly have the right to amend your 2012 return, and you may be eligible to amend for 2011 as well — but note that if you amend for 2011 you will also need to amend for 2012 at the same time. Amendment rules are confusing, but the IRS has attempted to make them understandable on their generally excellent website.

There are other tax-related issues concerning same-sex marriages, and more opportunities for federal and state tax law to diverge.One we saw in our office this month: a surviving partner visited with us after the death of her long-time partner. She never mentioned that they had been married, thinking (as she later told us) that the marriage was not valid in Arizona. But when it came time to look at her partner’s Individual Retirement Account (IRA), it made a difference — even in Arizona. As a surviving spouse she had the ability to simply roll over her spouse’s IRA and continue to defer withdrawals until she reaches 70 1/2. If they had not been married she would have been required to begin withdrawals immediately, and faster. The lesson: don’t assume that Arizona’s failure to recognize your marriage means that it has no effect.

Most of the other changes, however, are considerably more arcane; the requirement that same-sex married couples file their federal returns as married (whether separately or jointly) is not arcane, and will have a big impact on those pioneers who got married in another state or country. Ask for advice, and share your marital status with your lawyer and your tax preparer.

Why Do I Need a Lawyer — Can’t I Write My Own Will?

OCTOBER 14, 2013 VOLUME 20 NUMBER 39

“My father hates, absolutely hates, lawyers,” a casual acquaintance tells us at a social gathering. “I know it’s a bad idea, but can’t he just write his own will?”

Let’s get the answer out of the way right up front: yes, he can. And there’s a very high likelihood he will do it just fine.

We can hear the faint and distant voices of thousands of other lawyers from across the country even as we write those words. “You wouldn’t do your own brain surgery, would you?” they ask. Or, more subtly: “go ahead, encourage everyone to write their own wills — lawyers’ children will go to much better colleges as a result.”

We’ll let that one sink in a moment.

Seriously: writing a will is not brain surgery. It doesn’t require anesthetic, and failure to do a good job doesn’t lead to instant death. For our money, there are much better comparisons. Would you build your own airplane (and then fly it)? Or maybe, more prosaically: are you comfortable doing your own business income taxes? In either of these two cases the project is detailed and complicated, and the negative results flowing from a mistake will not be immediately apparent. In both cases (and numerous others we might draw on) the possible negative repercussions could be far more costly than getting good professional help at the outset.

And yet thousands of people do build kit airplanes and fly them. Millions prepare their own tax returns. So can’t they prepare their own wills?

Yes, they can. There are forms and computer software to help. In our experience most people will do just fine with those kinds of assistance. The product may not be beautiful, but it can be perfectly functional.

Are we saying that you don’t need a lawyer to prepare a will? Absolutely not — there is simply no question that you are better off getting a lawyer’s advice about your estate planning. And the cost is amazingly inexpensive (it is easy to insist on that point after our visit last week to the dentist — her bill was more than we usually charge for estate planning consultations, and the visit was both shorter and more painful). Though you can prepare your own will, here are some of the reasons you should not:

  • We frequently see mistakes in do-it-yourself estate plans. We have seen wills that failed to name a personal representative (what used to be called an executor), and percentage divisions that didn’t add up to 100% of the estate, and attempts at legalese that probably reversed the writer’s actual intentions. We have seen innumerable wills that attempted to leave individual items to someone, even though beneficiary designations (which overrode the will) named someone else as recipient. We once probated a “will” written on the back of an envelope on the way to the airport — the writer, incidentally, didn’t die on that trip but five years later, with the envelope still the most recent signed document.
  • “Holographic” wills — handwritten, signed wills, which are very popular among the do-it-yourself crowd — are not valid in every state. Requirements vary. The result: a lot of self-prepared wills turn out not to be wills at all.
  • So far we have focused on wills — but should you be preparing a living trust? Do you need a Limited Liability Company established? Are there income tax considerations involved in your estate planning? Does your son need a special needs trust? How will you know, without talking with a lawyer? Well-written documents are important, but what your lawyer realizes (and you might not) is that the choice of document is often more important than the words and phrases in the document.
  • Similarly, it is usually not enough to just write a beautiful will (or trust, or power of attorney). Beneficiary designations, titles, and the relative values of your assets all are important considerations in your larger estate plan. And yes, the documents need to be well-written, too.
  • Your estate plan is not immutable. How long will your will, trust, power of attorney and beneficiary designations last? Well, they will “last” forever, or until you change them — but they will likely start being out-of-date within about five (perhaps as many as ten) years of being completed. So your self-help approach, leaving you slightly uncomfortable about whether you have done everything right, will need to be started all over in about five years.

We can go on, but perhaps our point has been made. You hire an attorney to handle your estate plan so that you can be sure the correct questions have been asked (and answered), not just to write elegant-but-wordy documents. What you get from your lawyer is, yes, good documents — but also an effective estate plan and more peace of mind.

A last word: many clients think it might save money if they prepare their own documents and then have a lawyer review them. That almost never works. The lawyer’s fees are largely based on collecting information, analyzing your situation and determining what ought to be done. Those steps have to be completed even if you prepare the documents yourself. And your lawyer probably will take longer to review your documents than to prepare her own, more familiar ones — and she will be less comfortable with the result, too. So the cost is likely to be the same or higher if you take homemade documents in for review.

Oh, and a last last word: when someone tells us that their father just hates lawyers, we have exactly the reaction you might imagine.

 

Taxation of Pooled Special Needs Trusts

SEPTEMBER 23, 2013 VOLUME 20 NUMBER 36

We write a lot about taxation of trusts, and especially of special needs trusts. But there is one type of trust that we haven’t written much about, and we can’t find other explanations for. “Pooled” special needs trusts are a special kind of trust, and there is much confusion about how they should be treated for federal income tax purposes.

First, we don’t think there are a lot of other tax issues about pooled special needs trusts (other than income taxation, that is). They are seldom — perhaps never — large enough to raise gift tax issues or estate tax concerns. We can imagine an occasional parent wondering about the gift tax treatment of contributions to a pooled trust account, but only the wealthiest parents are going to need to worry about that, and they are probably getting an abundance of good tax advice from their lawyers and accountants.

So let’s just talk about income taxation of pooled special needs trusts. But first perhaps we need to define terms.

What is a pooled special needs trust?

Pooled trusts are just what the name suggests: a single trust consisting of money held for the benefit of a number of individuals. Usually those separate trust accounts are managed together but accounted for separately. In other words, your contribution to a pooled special needs trust will be used just for you (or for the other person you designate), not for other beneficiaries. But your money and theirs will be pooled into a single investment structure, so that your administrative costs will probably be lower and your earnings higher than they would be if you were on your own.

By convention pooled special needs accounts tend to be smaller. There is no reason that needs to be true, but it often is. People with substantial money to be set aside in a trust tend to want separate treatment, separate management and different structures. But that is not always true, so some pooled accounts are large.

Most pooled special needs trusts include only money that once belonged to the beneficiary — like personal injury lawsuit settlements, or inheritances from someone who never set up an appropriate trust, or even back payments from Social Security. Increasingly, though, parents (and others) wanting to set aside money for a child with a disability are looking at pooled trusts as a convenient and cost-effective alternative.

When money comes from personal injury settlements or unrestricted inheritances, the resultant pooled trust share is referred to as a “self-settled” or “first-party” pooled trust.  When the trust is set up by a parent or another person, the pooled trust share is called a “third-party” pooled trust. That’s important for income tax purposes.

Taxation of self-settled pooled trust accounts

If a person with a disability transfers funds to a trust for their own benefit (or someone else does it on their behalf), the trust share is called a “grantor” trust. That means that the self-settled share does not pay separate income taxes, or even file a return. The larger trust may have to file a return, but none of the income attributable to the self-settled share (and none of that share’s portion of deductible expenses) gets reported on a trust (or fiduciary) income tax return. For income tax purposes, the self-settled pooled special needs trust share simply doesn’t exist.

That doesn’t mean that there is no income tax. The beneficiary may still have to file an individual tax return, including any income and deductible expenses. Of course, the beneficiary may not have sufficient income — even with the trust’s income added in — to need to file a return, and the fact of the trust won’t change that.

Of course, the beneficiary only knows what he or she has to do if the trustee passes information along to them. So the federal government requires that the trustee give the beneficiary all the information they need to fill out their own tax return. But the trustee doesn’t file anything for the trust, except the brief statement that the trust is a grantor trust and is not filing a separate return.

Taxation of third-party pooled trust accounts

If someone else puts the money into a pooled trust account, that may (or may not) set up a requirement for separate tax filings. Often, the person contributing the money will be treated as the “grantor” and have to report the income and take the appropriate deductions — even if they are not benefiting from the trust. That decision is based on a complicated set of rules known as the “grantor trust” rules. Volumes have been written about the peculiar twists those rules may take, but let’s make the simple over-generalization that, during the lifetime of the donor, it is likely that the donor will be liable for the income tax on a third-party pooled special needs trust share.

If the third-party trust share is not a grantor trust, then the trustee will need to file a federal Form 1041 — the fiduciary income tax return — if the larger trust has more than $600 of income. That return will list all income and deductible expenses, and then may result in taxable income being assigned to the beneficiary — to the extent that the beneficiary receives assistance from the trust. Did the trust pay dental bills, or moving expenses? There may be an income tax consequence to the beneficiary (but only to the extent of taxable income received by the trust — not usually the full value of services or goods purchased by the trust).

Does a pooled special needs trust need an Employer Identification Number — an EIN?

Yes. always. It’s always fun to be able to give a simple and absolute answer. There is a lot of detail behind that simple answer, but the answer is always simple: yes.

We hope that helps. The follow-up questions can be bewilderingly complicated, but go ahead — we’ll see if we can give at least generalized answers. If you have specific legal questions based on your trust’s particular circumstances, you should ask your lawyer (or a lawyer) rather than posting your query online. But we’ll (gently) let you know if we think that’s the case based on your question.

This is Huge: Feds Publish New Rules on Gay Marriage

SEPTEMBER 2, 2013 VOLUME 20 NUMBER 33

Just a few weeks ago we wrote about some of the uncertainties facing legally married same-sex couples living in states (like Arizona) that refuse to recognize the validity of their marriages. If a legally-married couple moves to Arizona, we wondered, would their ability to receive some of the tax benefits available to married couples change just because their new state did not recognize or approve of their marriage? We suggested that same-sex couples ought to be aware of the problem, but assume that they should be able to enjoy the same benefits (and burdens, for that matter) available to their married heterosexual friends.

Well, the United States government weighed in on the subject this week, and the positions taken by two different federal agencies made it clear that a valid marriage is a valid marriage — at least in the federal government’s eyes. The result? Same-sex couples still need to pay extra attention to their estate planning choices, but their choices will be much more palatable.

On August 29, 2013, the Internal Revenue Service released Revenue Ruling 2013-17. Its bottom line: if you are legally married, even though your current state of domicile does not recognize it, you will be treated as married for all tax purposes. Period. Income tax, estate tax, gift tax — it makes no difference. You are married.

In our earlier newsletter we talked about a couple, married in Massachusetts, who had moved to Arizona. Could they file their federal income taxes as “married, filing jointly”? Could they list one another as beneficiary on their IRA or 401(k) accounts, relying on the ability of a spouse to roll those benefits over into a new IRA? Would they get the benefit of a full step-up in basis for income tax purposes, just like other married couples holding community property? It was not clear a week ago. Today it is clear. The answer in each case is “yes” — though perhaps a qualified “yes” in one or two of those cases.

Why a qualified yes? Mostly because community property titling is a special case. Yes, there are federal income tax benefits for married couples titling their assets as community property — but the availability of that option is governed by state property law. Arizona is one of the handful of states recognizing community property designations at all, and it limits the option to couples it thinks are married. If a same-sex couple, legally married in another state, attempts to title, say, real estate as community property (or community property with right of survivorship), will Arizona recognize that title?

We are not sure, and so suggest that the safe approach is to create a trust (probably a joint, revocable trust), provide that all the assets in the trust are held as community property, and title most assets to that trust. That does mean that same-sex couples will end up paying somewhat more for their estate planning than their married heterosexual friends — but they will get the same result at a relatively modest cost.

The other notable change on the federal level involves long-term care arrangements for Medicare recipients. It is far less expansive than the big IRA announcement, but reflects the same general approach: married same-sex couples are to be accorded the same benefits as married heterosexual couples, at least on the federal level.

An August 29, 2013, announcement from the Department of Health and Human Services affects Medicare Advantage beneficiaries. It is not very far-reaching, but it is nonetheless important. In cases where one spouse is already admitted to a skilled nursing facility (what most of us call a “nursing home”), when the second spouse requires placement he or she must be permitted to choose the same facility. In other words, Medicare Advantage plans must have rules supporting spouses’ ability to stay together. And those policies must apply to same-sex married couples, too — even if their marriages are not recognized in the state where they live.

Why is this modest change important? Because, like the IRS declaration, it indicates that the federal government will be extending protections to validly married same-sex couples regardless of their state of residence.

Legal rights and responsibilities are evolving quickly for same-sex marriage. The first few states permitting same-sex marriages debated whether to even permit out-0f-state couples to marry. In the next wave of legal developments, it seemed clear that couples living in Arizona probably would not benefit from traveling to, say, Canada or Iowa to get married, only to return to Arizona and have their marriages all but invalidated. This week’s announcements make it clear that a committed same-sex couple should seriously consider whether they want to get married in a friendlier jurisdiction, even if they intend to return to Arizona to live.

The federal pronouncements also make it that much more difficult for states like Arizona to continue to resist the pressure to change. If a legally married same-sex couple, living in Arizona, wants to get divorced, do they have access to the Arizona court system? The current legal thinking in Arizona is that they might be able to seek annulment of their marriage (which, in Arizona’s legal view, never validly existed), but not a divorce (or dissolution).

Consider, for instance, the dilemma facing Phoenix-area resident Anne Armstrong (not her real name) earlier this year. She and her partner Roberta Reynolds had been married in California, but Anne wished to end the marriage. She filed a petition for annulment of the marriage in the Arizona Superior Court in Phoenix. Roberta did not respond, but the Judge Eartha K. Washington nonetheless refused to annul the marriage. Because same-sex marriages are invalid in Arizona, ruled the judge, there was nothing she could do to help Anne end her California marriage.

The Arizona Court of Appeals reversed that decision and sent the case back to the judge for further proceedings to annul the marriage and divide the couple’s property. Atwood v. Riviotta, May 16, 2013. While Anne’s legal problems were addressed, the decision left two huge issues unresolved: (1) what about same-sex married couples who don’t want to end their marriages, and (2) why should the legal process for ending same-sex marriages be different in the first place? Furthermore, the Court of Appeals resolution was by an unpublished decision, meaning it could not even be cited as precedent for other, similar cases as they arise.

What about resolution of child custody issues, or property divisions? What about bigamy laws, or other societal norms affecting married couples? If a couple is permitted to file income tax returns as married under federal law, why should it be different for state income tax returns? The pressure on Arizona (and other resistant states) is intense: it is time for our legal system to deal with changes sweeping across the country, and the federal government’s pronouncements this week will add to that pressure.

Tax Issues for Trusts — Simplified

JULY 29, 2013 VOLUME 20 NUMBER 28

Judging from the questions and comments we get here, taxation of trusts is one of the most confusing issues we regularly write about. We’re going to try to collect the most important rules here for your convenience. Note that we will not try (in this summary) to touch on every exception, every caveat — we want to try to spell out some of the major categories of trusts and of taxation, and see if we can help you figure out what tax issues you have to face. We will try to give very concise answers, a little explanation and a warning about some of the more common or important exceptions in each category.

Do I need to get an EIN for my revocable living trust?

Short answer: no.

More detail: if you created a trust, put your money in it, and retained the right to revoke it — the IRS doesn’t think of it as a trust at all. It is not a separate taxpaying entity. Not only do you not need to get an Employer Identification Number, you can’t get one. A revocable living trust is always a grantor trust, and it does not file its own tax return.

Important exception: if you are trustee of a revocable living trust created by someone else, you can get an EIN but you are not required to do so. Even if you do get an EIN, the trust does not file a separate trust tax return.

I am setting up a special needs trust for my child, who has a disability. I plan on leaving his share of my estate to the trust. Does it need an EIN?

Short answer: probably not — yet.

More detail: while you are still alive you probably will be the “grantor” of the trust for tax purposes — and that may even be true if the trust is irrevocable. Probably you will pay the taxes on any income the trust receives (note: your contributions to the trust are not “income” for tax purposes). But probably this is not important — you really are probably asking about what happens when you die and your estate flows to this trust. THEN it will need an EIN and it will file its own tax returns. Probably it will be what the IRS calls a “complex” trust.

Important exception: if the trust is both irrevocable and immediately funded, it probably does need an EIN even before you die and leave a larger share of your estate to it.

My daughter’s special needs trust was funded with money from a personal injury settlement. Does it need an EIN?

Short answer: almost certainly not.

More detail: even though it is irrevocable, and even though your daughter is not her own trustee, this trust is almost unquestionably going to be a grantor trust for tax purposes. That means it does not need to have a separate EIN; it uses your daughter’s Social Security number as its taxpayer identification number.

Important exception: although it does not have to get an EIN, this kind of trust may get an EIN. But even if it does, the trust does not file a separate income tax return — all the trust’s income gets reported on your daughter’s individual return.

My father established a revocable living trust to avoid probate, and he died earlier this year. Do I need to get an EIN for his trust? Can I just keep using his Social Security number?

Short answer: Yes, you do. No, you can’t.

More detail: With your father’s death his trust became a different entity. It is no longer a “grantor” trust, so should be filing its own income tax returns for the rest of the calendar year of his death and for the future (if the trust continues).

Important exception: While the trust should have its own EIN, it will only have to file a return if it earns $600 in income in any one year after his death. So if the trust gets resolved fairly quickly, and/or does not hold any income-producing property, it may not need a tax return. In that case, and that case only, it may also not need to have a separate EIN.

As a separate exception to the general rule, note that there are some limited circumstances in which your father’s trust may not have to use a calendar year. That can have significant favorable income tax consequences, so be sure to discuss the tax issues with your accountant and/or attorney.

My wife and I created a joint revocable living trust. She died two years ago, and I was simply too busy dealing with everything to do anything about the trust. Are there tax issues I need to resolve, or am I going to get into trouble for not doing anything quickly?

Short answer: You probably are not in any serious trouble, but you should talk with an accountant and/or attorney soon. Don’t continue to put it off, please.

More detail: It may be that nothing needs to be done regarding your trust. It may be that your trust was supposed to be divided into two shares upon the first death. It may be that such a division no longer makes tax sense — but it might still be necessary to deal with it. It’s too hard to generalize about all those possibilities, and your lawyer needs to look at the trust document AND know how assets are titled. Make an appointment and start gathering information. If you don’t do anything before your own death, your children (or whomever you have named as ultimate beneficiaries) will have a much more complicated time dealing with it than you do now. Incidentally, in our experience it is fairly rare that a surviving spouse does not want to make any changes whatsoever — even if all you want to do is to accelerate the pace at which your children receive your estate, it is a good idea to meet with your attorney.

Important exception: If you are certain that your trust does not require division into separate shares on the first spouse’s death, AND you still want the same people to administer your estate, AND you still want everything divided the same way as the original document provides, then it may not be necessary to make any changes. Most lawyers will tell you that it still makes sense to update powers of attorney and your will to remove your late wife’s name (just so your back-up agent doesn’t have to produce a death certificate before banks and doctors will talk with her), but it may not be critical to do so. Still, talking with lawyers is kinda fun, and almost everyone should do it more often.

There you have it. Our most-asked-about trust taxation questions, with simplified answers. Please be careful about this information, though — there is a lot of nuance we have glossed over. Talk to your accountant and your lawyer to confirm what we have told you here before relying on it. Our goal is to give you a bit of a roadmap, not to answer complex legal questions with oversimplified generic answers. But we hope we have helped.

Special Needs Trusts and the New Medicare Tax

MARCH 25, 2013 VOLUME 20 NUMBER 12
You may have heard about a potentially significant new tax liability for special needs trusts. With adoption of the Patient Protection and Affordable Care Act (what is often referred to as “Obamacare”) Congress created a new tax intended for high earners to contribute to Medicare. A fairly complicated formula attempts to capture investment income (as distinct from income from employment) and impose a tax.

Enter the doctrine of unintended consequences — or at least we hope this consequence was unintended. Because of the definition of income subject to the tax, it is possible that some special needs trusts will end up paying a significantly higher tax. Here’s how it works:

The new tax is imposed on “net investment income.” That is defined as dividends, capital gains, interest, rents, royalties — pretty much income other than wages. It was intended to cover relatively higher-income individuals, so it will kick in only for the highest tax brackets for each category of taxpayer. That means, for instance, that a married couple will owe the 3.8% Medicare tax only if their total income (including that investment income) exceeds $250,000.

But here’s the problem: the highest tax bracket for trusts kicks in at a much, much lower figure — $11,950 in 2013. So a special needs trust subject to income taxation will pay an extra 3.8% on any investment income in excess of that amount.

Let’s use an illustration. Mildred’s will included a special needs trust for her daughter Diana. Mildred died in 2011, and the trust was funded with $500,000 of property from her estate. The trust is now invested in an appropriate mix of stocks and bonds, and last year it generated about 4% in interest, dividends, recognized capital gains, etc. That means income of about $20,000; the tax would be about $6,000 on that amount. Because of the 3.8% surtax, however, the tax bill will rise by almost another $1,000.

That’s not too bad, but of course the tax on Mildred’s trust is already much higher than it would have been had it been taxed to Mildred herself. The trust paid the highest marginal tax rate (39.6%) on nearly half of the total income — whereas Mildred herself would have still been in the 15% tax bracket if she were still alive in 2013. Now the total tax paid by the trust has gone from more than double to nearly three times Mildred’s individual tax burden.

Don’t panic. It’s not as bad as that. There are several reasons why the new Medicare tax will have an effect on special needs trust planning, but not that broad of an effect on the actual tax paid.

First, let’s clear up one confusion: the higher tax rates — both the Medicare tax and the highest, 39.6% rate on trust income — only applies to trusts set up by someone else to hold an inheritance or gift, and usually only after the death of the donor. A special needs trust set up to handle personal injury settlement proceeds does not have any separate tax effect at all — it is what is called a “grantor” trust, and is taxed as if it actually was the individual whose money went into the trust. The Medicare surtax, and the highest marginal tax rate, will only affect that kind of special needs trust if the total income is at least $200,000.

Next, even the “third-party” trust established by Mildred (the third party in the trust’s name) has a significant way out of paying high taxes. It just has to provide some benefits for Diana. If, for instance, the trust paid for a companion to take Diana out of her assisted living apartment once a week in 2013, the income tax gets paid by Diana and not the trust. The higher tax levels never kick in, because Diana’s income is not high enough to be subjected to the top level OR the Medicare tax.

It’s actually even better than that. Mildred’s trust is almost certainly a “qualified disability trust.” That means it gets to take the equivalent of a personal tax exemption, as if it was Diana — meaning that the first $3,900 of the trust’s income escapes taxation altogether. Plus the administrative expenses (trustee’s fees, some of the investment fees, lawyer’s and accountant’s fees) are all deducted from income. So Mildred’s trust’s $20,000 of income only gets reported on Diana’s return to the extent of about $5,000 — and Diana probably won’t pay any income tax at all.

Diana is lucky in another way, and Mildred’s trust shares that luck. Diana is pretty healthy, and does not have significant medical expenses. In another, similar trust with large medical payments, the ultimate tax paid can also be reduced simply by claiming large medical deductions on the beneficiary’s return.

Nonetheless, the new Medicare tax is a concern for trustees of third-party special needs trusts — especially very large trusts. Double the size of Mildred’s trust (or quadruple it) and it is easy to see that the tax burden might rise steeply. The trustee of a third-party trust with several million dollars might find it prudent to invest in assets that will appreciate in value but not throw off much income — presuming, of course, that the appreciating assets will not be sold during the beneficiary’s lifetime.

Special Needs Trusts: How Much Trouble Are They to Manage?

SEPTEMBER 3, 2012 VOLUME 19 NUMBER 34
I’m thinking about setting up a special needs trust for my son, who has a developmental disability. Will it mean a lot more work for my daughter, who will be handling the estate?

It’s a fair question, and one we hear a lot. No one ever asks: “could you please give us the most complicated estate plan possible?” Everyone wants things as simple as they can be.

When you think about providing an inheritance for your child — or anyone, for that matter — with a disability, there are some realities you just have to deal with. Those realities almost always lead to the same conclusion: a special needs trust is probably the right answer. There are a number of answers to the “can’t we keep it more simple?” question:

  1. In most cases there’s going to be a trust, whether you set it up or not. If you leave money outright to a person suffering from a disability, someone is probably going to have to transfer that inheritance to a trust in order to allow them to continue to receive public benefits. The trust set up after your death will be what’s called a “first-person” (or “self-settled”) trust, and the rules governing its use will be more restrictive. There will also have to be a “pay-back” provision for state Medicaid benefits when your son dies — so you will lose control over who receives the money you could have set aside. Even if no trust is set up, there is a high likelihood that your son will (because of his disability) require appointment of a conservator. The cost, loss of family control and interference by the legal system will consume a significant part of the inheritance you leave and frustrate those who are caring for your son. If you prepare a special needs trust now it sidesteps those limitations.
  2. The trust you set up will not be that complicated to manage. People often overestimate the difficulty of handling a trust. Yes, there are tax returns to file, and summary accounting requirements. Neither is that complicated; neither is anywhere near as expensive as the likely costs of not creating a special needs trust.
  3. Your daughter can hire experts to handle anything that she finds difficult. There are lawyers, accountants, care managers and even trust administrators who can take care of the heavy lifting for your daughter — or whomever you name as trustee. The costs can be paid out of the trust itself, so she will not be using her portion of the inheritance you leave, or her own money. Yes, they add an expense — but they can actually help improve the quality of life for both your daughter the trustee and your son with a disability.
  4. Your daughter does not have to be the trustee at all. We frequently counsel clients to name someone else — a bank trust department, a trusted professional, or a different family member — as trustee. That lets your daughter take the role in your son’s life that she’s really better suited for: sister. If it is right for your circumstance, you might even consider naming her as “trust protector.” That could allow her, for instance, to receive trust accountings and follow up with the trustee, or even to change trustees if the named trustee is unresponsive, or too expensive, or just annoying. Trusts are wonderfully flexible planning devices — but that does mean you have to do the planning.
  5. If your son gets better, or no longer requires public benefits, the trust can accommodate those changes. Depending on your son’s actual condition and the availability of other resources, you might reasonably hope that he will not need a special needs trust — or at least might not need one for the rest of his life. The good news: your special needs trust will be flexible enough to allow for the use of his inheritance as if there were no special needs. The bad news: that is only true if you set up the trust terms yourself — the trust that will be created for him if you do not plan will not have that flexibility.
  6. Simply disinheriting your son probably is not a good plan. Sometimes clients express concern about the costs and what they perceive as complicated administrative and eligibility issues, and they decide to just leave everything to the children who do not have disabilities. “My daughter will understand that she has to take care of my son,” clients tell us. That’s fine, and it might well work. But do you feel the same way about your daughter’s husband? What about the grandkids and step-grandkids who would inherit “your” money if both your daughter and her husband were to die before your son (the one with the disability)? What about the possibility of creditors’ claims against your daughter, or even bankruptcy? Most of our clients quickly recognize that disinheriting the child with a disability is not really a good planning technique.
  7. But who knows what the public benefits system, the medical care available, or my son’s condition might look like twenty years from now? Indeed. That’s exactly why the trust is so important.

What does that mean for your planning? If you have a child, spouse or other family member with special needs — OR if you have a loved one who may have special needs in the future — your plan should include an appropriate trust. The cost is relatively small, and the benefits are significant. There are really only three downside concerns for special needs planning:

  1. The cost. But the cost of not doing anything is probably higher — and the opportunity loss from failure to plan is especially high.
  2. The nuisance value. Yes, that does mean you need to go see a lawyer. Need a place to start? Look at the membership of the Special Needs Alliance. There’s likely someone near you who understands the importance of special needs planning.
  3. The name. Don’t want to tag your loved one as “special needs”? Then don’t. Call your trust The John Doe Maximum Opportunity Trust. Or the Panorama 2012 Trust. Or Green Acres Fund. With your lawyer’s help, customize the language of your child’s trust to speak in your voice, and to identify what you think is important. Take advantage of the flexibility offered by trust planning.

 

Helping Care for Your Relative Provides Income Tax Benefits

APRIL 9, 2012 VOLUME 19 NUMBER 14
Federal and Arizona state income tax returns are due next week. It’s a good time to review tax deductions for one of the common situations we deal with: in-home (or, for that matter, institutional) caregiving for an infirm family member.

We wrote about an individual case involving long-term care deductions last fall. In that case no returns had been filed, so the taxpayer was playing catch-up — but the U.S. Tax Court agreed that she could deduct the expenses of in-home caregivers. The Court articulated a three-item test to determine whether the taxpayer was a “chronically ill” individual; once she had met any one test, the taxpayer could deduct her medical expenses, including the caregivers.

But what if the caretaking expenses had been paid by someone other than the taxpayer herself? If, for example, she had lived with her adult daughter and the daughter had paid for caretakers to come to the home?

In such a case the daughter should be able to deduct the expenses of care — provided that the patient is a “dependent.” That requires the taxpayer using the deduction to have provided more than half of the patient’s support, and is only available if the patient is a relative OR lived with the taxpayer.

The details about deducting medical expenses for a relative or someone who lives with you are spelled out in IRS Publication 502. Don’t fret about the official-sounding title — it’s actually straightforward and understandable. It also explains exactly what the IRS is looking for when you deduct your own OR a dependent’s medical expenses, and what documentation you will need to provide (or maintain in case you are challenged).

Of course the medical deductions only affect your federal income tax to the extent that they total more than 7.5% of your Adjusted Gross Income (AGI). For many people that limitation is hard to meet. Anyone paying for in-home caregivers, though, is likely to have gotten near to or exceeded the 7.5% threshold.

What about listing a relative (other than your minor children) as a dependent on your own tax returns? Is it possible that the daughter in our earlier scenario might be able to list her mother as a depedent if the mother lives in her home? For that matter, can she list her mother as a dependent if she lives in a nursing home or assisted living facility, but the daughter pays the bill?

The short answer in both cases is “yes.” A parent can be a dependent. That can mean, as described above, that their medical expenses may be listed as deductions on your return — but it also leads to a more direct benefit. If you can list your parent (or another relative) as a dependent, you can get an additional exemption — which reduces your taxable income even before looking for eligible deductions like medical expenses.

Can your parent be your dependent? Yes, but the requirements can be a little complicated. First, they must EITHER be a “qualifying relative” (pretty much any kind of relative you can name, including stepchildren and foster children) OR live with you. In addition, they may not have more than $3,700 (in 2011) of their own income. You must also provide at least half of their support. There are limited exceptions to some of those rules, but that’s the basic test for determining whether you can claim a parent or another person as a dependent. NOTE: these rules are not the same as the ones determining whether you can claim your minor children as dependents — THOSE rules can be much more detailed and complicated.

How can you figure out if you meet all the tests (and their exceptions)? You may not be surprised to learn that the IRS has a Publication to explain that. It is IRS Publication 501, and (just like the earlier Publication we mentioned) it is actually helpful and understandable information.

Can you get a direct credit for the caretaking services you provided for your mother yourself last year? Generally, no — and if you think about it that shouldn’t be too surprising. If you could deduct the value of those services, you would need to claim a similar amount as “income.” But that doesn’t mean that there is no tax benefit to having provided those services. First, they will help you establish that you have provided more than half the support necessary for your parent or family member. Second, you might be eligible to deduct expenses (but not the value of your caregiving) for a dependent. Look at IRS Form 2441 for Child and Dependent Care Expenses; the separate instructions for Form 2441 are (wait for it) straightforward and understandable.

Summing up: taking care of a relative (or someone who lives with you, even if they are not a relative) may be personally and emotionally rewarding. It will not usually be profitable. At least, though, there are some slight tax benefits for those who undertake what is usually a labor of love. Make sure you claim deductions and exemptions you are entitled to by virtue of your caregiving services.

Tax Identification Numbers for Trusts After Death of Spouse

MARCH 26, 2012 VOLUME 19 NUMBER 12
Here at Fleming & Curti, PLC, we keep tabs on what brings people to our website. We look at referring pages, at search terms and at a variety of other items. We are intrigued by what persistently tops the search-engine list. The most common search? It’s some variation of: “do I need a new tax ID number for my living trust?” (For those keeping score, the second-most-common question seems to be “can I leave my IRA to a living trust?“)

Why the enduring interest? Because the question is so much less complicated than people think it is. There is a surprising paucity of clear information about when you need to have a new tax ID number (an EIN, if you want to use the correct acronym). And much of the information out there is contradictory.

We have written about the question several times before. In 2009 we asked and answered the question: “Do you need a new tax ID number for your living trust?” Just last year we reviewed the question, along with some other reader questions, and provided a little more detail on when your trust needs an EIN. Since those two explanations the rules haven’t really changed — but your questions have gotten a little bit more sophisticated.

Several of those questions deal with the same basic scenario: what happens when a husband and wife have a joint trust, using one spouse’s Social Security number, and then that spouse dies? The answer will depend on what the trust provides.

First, a word about joint trusts for spouses: they are common in community property states (like Arizona), not as common in those states where community property principles do not apply. Remember, please, that we are Arizona lawyers, and so we write here about Arizona rules. Attorneys from other states are more than free to add their comments; we will post them as we receive them — but we are not vouching for the accuracy of their advice in states other than Arizona.

Let’s set up a scenario, drawn from our common experience: Husband and wife created a joint revocable trust, and their bank accounts, brokerage accounts, insurance — all of their assets, in fact — listed the husband’s Social Security number. They could do that because, as with a joint account outside of a trust, tax rules allow one owner’s identifying number to be used rather than having to use all owners’ numbers. But now the husband has died. What should the (surviving) wife do about the TIN (Taxpayer Identification Number)?

Before we answer, we need to know what happens to the trust on the death of the first spouse. Let’s assume, for a moment, that it remains in one trust, that the wife now has the power to amend or revoke it in its entirety, and that she is the sole trustee. In that case, the direction is easy: tell the bank, the brokerage house and the insurance company to change the name of the trustee from the couple to the wife, and to change the TIN to the wife’s Social Security number. How do you do that? Send them a death certificate and a letter instructing them to make the changes. Assume, incidentally, that they won’t — it will often take you two or three tries, several phone calls, and some wheedling to get the task done. But that’s what should happen.

What if the wife is not the sole trustee? Let’s say, for a moment, that the oldest daughter now becomes co-trustee with her mother, but that the trust remains revocable and amendable by the wife. In that situation, we have the same answer: switch to the wife’s Social Security number.

What if the wife has the power to revoke or amend the trust, but she is now incapacitated? The oldest daughter is the sole trustee, and isn’t sure what to tell the financial institutions. The answer is still the same: the trust is still revocable (even though there may be no practical way to revoke it if the only person with power to do so is incapacitated), and the wife’s Social Security number is the trust’s TIN (expect to have an argument with the financial institutions over this one). Is a bank trust department the successor trustee instead? Same answer — but with the ironic twist that the argument between trustee and financial institution will now occur between two branches of the same organization.

Sometimes a joint revocable trust becomes irrevocable on the death of one spouse. More commonly it splits into two (or sometimes three) portions, one (or two) of which are irrevocable. What happens then? The answer, as you might expect, is a little bit more complicated — and may not be the same in every case.

Generally speaking, an irrevocable trust that does not contain the assets originally belonging to the beneficiary is likely to need its own EIN. That may mean that one (sometimes two) of the trusts resulting from the death of one spouse needs a new EIN, and one just uses the surviving spouse’s Social Security number.

Let’s use a specific example: in our earlier scenario, after the death of the husband the joint revocable trust splits into a “Decedent’s” (sometimes “bypass”) share and a “Survivor’s” share. The Decedent’s Trust is irrevocable. Wife is the trustee, and she is entitled to all the income from the trust. She may even have the ability to distribute trust principal to herself, or to decide how the Trust is divided among the couple’s children at her death. But this trust is not  “grantor” trust — it gets taxed as a separate entity. Hence, it needs its own EIN, and it files its own tax returns.

Mechanically, the process of dividing the trust is a little more complicated than in our earlier scenario. An estate tax return may be required (although it may not). A division of trust assets needs to be completed (the assistance of a competent lawyer and a good accountant is essential here). The share to be assigned to the Decedent’s Trust needs to be identified, and then physically transferred into a new account — often titled something like “The Jones Family Trust — Decedent’s Trust” (yeah, we know — your name isn’t Jones. Stick with us anyway). And that new account needs to use the Decedent’s Trust’s new EIN.

Note that we said that the assets need to be transferred into the new account. Most financial institutions will insist on opening a new account, with a new account number, rather than simply changing the name on an existing account. But when the process is completed — however you and the financial institution get there — the Decedent’s Trust should be physically separated from the Survivor’s Trust, it will have its own EIN, and it will need to file tax returns. Note: it probably will not pay any tax as a separate entity — all its income will  probably be imputed to the surviving spouse.

Meanwhile, the remaining trust assets in our example will continue to use the wife’s Social Security number. It may not be crucial to change the name on that account to “The Jones Family Trust — Survivor’s Trust” (those Joneses — they end up will all the money anyway). If you long for clarity, we would certainly support a transfer of the Surivor’s Trust share into a new account, titled as part of that sub-trust, and bearing the wife’s Social Security number — even if it is not required.

Recall, please, that there are lots of variations on this basic scenario. Be careful about generalizing from this information to your precise circumstances. Our goal here is to give you some general notions about what needs to be done — we do not think of ourselves as a substitute for good, personalized legal advice. We think, in fact, that you should get some of that, because your situation might well be more complicated than you think it is. But we hope we’ve given you some idea of what your attorney will be asking you, and what he or she is likely to tell you.

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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