Wills and Trusts

Wyatt, Tarrant & Combs, LLP

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Planning for 2014 and Beyond


The Old Paradigm: When In Doubt, Transfer Out

The year 2013, with the enactment of the American Taxpayer Relief Act of 2012[1] (“ATRA”) and the imposition of the 3.8% Medicare contribution tax on unearned passive income[2] (hereinafter, the “3.8% Medicare tax”) that was enacted as part of the Patient Protection and Affordable Care Act (“PPACA”),[3] will mark the beginning of a significant change in perspective for estate planners.

For years, estate planning entailed aggressively transferring assets out of the estate of high-net-worth individuals during their lifetimes to avoid the imposition of estate taxes at their deaths.  Inter-vivos transfers obviously precluded the decedent’s estate from being entitled to a “step-up” in basis adjustment under section 1014 of the Internal Revenue Code of 1986, as amended (the “Code”).  Because the estate tax rates were significantly greater than the income tax rates, the avoidance of estate taxes (typically to the exclusion of any potential income tax savings from the “step-up” in basis) was the primary focus of tax-based estate planning for wealthy individuals.

By way of example, consider the planning landscape in 2001.  The Federal estate and gift tax exemption equivalent was $675,000.  The maximum Federal transfer tax (collectively, the estate, gift, and generation-skipping transfer tax) rate was 55%, and the law still provided for a state estate tax Federal credit.  Because virtually all of the states had an estate or inheritance tax equal to the credit, the maximum combined Federal and state transfer tax rate was 55%.  The combined Federal and state income tax rates were significantly lower than that.

For example, consider the maximum long-term capital gain and ordinary income tax rates of a highly taxed individual, a New York City taxpayer.  At that time, the combined maximum Federal, state, and local income tax rate for long-term capital gains was approximately 30% and for ordinary income, less than 50%.[4]  As a result, the gap between the maximum transfer tax rate and the long-term capital gain tax rate for a New York City taxpayer was approximately 25%.  In other words, for high income, high-net-worth individuals in NYC, there was a 25% tax rate savings by avoiding the transfer tax and foregoing a “step-up” in basis.  Because this gap was so large (and larger in other states), estate planning recommendations often came down to the following steps, ideas and truths:

  1. Typically, as the first step in the estate planning process, make an inter-vivos taxable gift using the $675,000 exemption equivalent, thereby removing all future appreciation out of the estate tax base.
  2. Use the exemption equivalent gift as a foundation to aggressively transfer assets out of the estate during lifetime (for example, a “seed” gift to an intentionally defective grantor trust (“IDGT”)—a trust that is a grantor trust[5] for income tax purposes but the assets of which would not be includible in the estate of the grantor—to support the promissory note issued an installment sale to the IDGT).[6]
  3. Draft the trusts and other estate planning structures to avoid estate tax inclusion for as many generations as possible (for example, leveraging the generation-skipping transfer (“GST”) tax exemption by applying it to the seed gift to the IDGT and establishing the trust in a jurisdiction that has abolished the rule against perpetuities).
  4. Forego the “step-up” in basis adjustment at death on the assets that have been transferred during lifetime, because the transfer tax savings were typically much greater than any potential income tax savings that might result from a the basis adjustment at death.
  5. Know that the income tax consequences of the various estate planning techniques were appropriately secondary to avoiding the transfer tax.
  6. Know that the state of residence of the decedent and the decedent’s beneficiaries did not significantly affect the foregoing recommendations or ideas because the large gap between the transfer tax and the income tax existing consistently across all of the states.

As a result, there was an enormous amount of consistency in the estate planning recommendations across the U.S., where the only differentiating factor was the size of the gross estate.  In other words, putting aside local law distinctions like community vs. separate property, almost all $20 million dollar estates had essentially the same estate plan (using the same techniques in similar proportions).

The enactment of ATRA marks the beginning of a “permanent” change in perspective on estate planning for high-net-worth individuals.  The large gap between the transfer and income tax rates, which was the mathematical reason for aggressively transferring assets during lifetime, has narrowed considerably, and in some states, there is virtually no difference in the rates.  With ATRA’s very generous applicable exclusion provisions, the focus of estate planning will become less about avoiding the transfer taxes and more about avoiding income taxes.

Turney P. Berry

Louisville, Kentucky

[1] P.L. 112-240, 126 Stat. 2313, enacted January 2, 2013.

[2] § 1411 of the Internal Revenue Code of 1986, as amended (the “Code”).  Hereinafter, all section references denoted by the symbol § shall refer to the Code, unless otherwise noted.

[3] P.L. 111-148, 124 Stat. 119, enacted on March 23, 2010.

[4] Consisting of maximum Federal long-term capital gain tax rate of 28% and ordinary income tax rate of 39.1%, New York State income tax rate of 6.85%, and a New York City income tax rate of 3.59%.  The effective combined tax rate depends, in part, on whether the taxpayer is in the alternative minimum tax, and the marginal tax bracket of the taxpayer.

[5] §§ 671-679.

[6] See, e.g., Stuart M. Horwitz & Jason S. Damicone, Creative Uses of Intentionally Defective Irrevocable Trusts, 35 Est. Plan. 35 (2008) and Michael D. Mulligan, Sale to Defective Grantor Trusts: An Alternative to a GRAT, 23 Est. Plan. 3 (2006).


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Planning and Drafting for the New 3.8% Medicare Tax

1.               Section 1411 of the Affordable Care Act (technically two acts – – the Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act) imposes a surtax of 3.8% on the unearned income of individuals, estates, and trusts for taxable years beginning after December 31, 2012.  In common parlance this is called the Medicare Tax (or sometimes the Obamacare Tax).  This is a new tax, not simply an increase in tax rates.  The IRS has issued final regulation (T.D. 9644) and proposed regulation (REG-130843-13) covering various issues.

For individuals, the tax is 3.8% of the lesser of (a)   the individual’s modified adjusted gross income in excess of a threshold amount ($200,000 for individuals and $250,000 for couples), and (b)   the individual’s net investment income.

For estates and trusts, the tax is 3.8% of  the lesser of (a)   the estate or trust’s adjusted gross income (under  §67(e)) in excess of the highest income tax bracket threshold ($12,150 for 2014), or (b)   the estate or trust’s undistributed net investment income.

Interestingly, the threshold for individuals is not indexed but for estates and trusts it is the dollar value for the highest income tax bracket for estates and trusts, which is indexed.  Of course, the threshold is very low.

Section 643(f) prevents the use of multiple identical trusts to lower the tax.

2.             The effect of the Medicare Tax is to increase the tax rate on trusts.  To the extent that beneficiaries are in a lower income tax rate, there is an incentive to make trust distributions that must be balanced against the tax and non-tax reasons for retaining distributions in trust.  If distributions may be made to charity that may be helpful, assuming the relevant beneficiary or beneficiaries are charitably inclined.

3.             The Medicare Tax is not imposed on grantor trusts, but items of income, deduction or credit are treated as if they had been received or paid directly by the grantor for purposes of calculating that person’s individual net investment income.  Prop. Reg. §1.1411-3(b)(5).  The Medicare Tax increases the benefits of grantor trusts and consideration should be given to having trust income made taxable, at least in part, to beneficiaries by giving them powers of withdrawal.

4.             Trusts and estates are exempt from the Medicare Tax to the extent interests are wholly charitable.  Treas. Reg. § 1.1411-3(b)(1).  Pooled income funds are subject to the Medicare Tax.  Charitable remainder trusts have a special method, now tied to the four tier tax system for such trusts.  The Preamble to the final regulations explain:

ANII [accumulated net investment income] is defined as the total amount of net investment income received by a charitable remainder trust for all taxable years beginning after December 31, 2012, less the total amount of net investment income distributed for all prior taxable years beginning after December 31, 2012.  The final regulations apply the section 664 category and class system to ANII by providing that the Federal income tax rate applicable to an item of ANII, for purposes of allocating that item of ANII to the appropriate class within a category of income as described in §1.664-1(d)(1), is the sum of the income tax rate imposed on that item under chapter 1 and the rate of the tax imposed under section 1411.  Thus, if a charitable remainder trust has both excluded income (such as income received by the trust prior to January 1, 2013, or other income received after December 31, 2012, but excluded from net investment income) and ANII in an income category, such excluded income and ANII will constitute separate classes of income for purposes of §1.664-1(d)(1)(i)(b).

5.             Net investment income includes income from interest, dividends, rents, royalties, annuities, gains, income from passive activities, reduced by all “properly allocable” expenses.  Net investment income specifically does not include (a) distributions from IRAs in qualified plans, (b) active trade or business income, (c) tax-exempt income and tax-exempt annuities, and (d) guaranteed payments from partnerships.  Note that gain upon the funding of pecuniary bequests will be subject to the Medicare Tax.

6.             To be an active trade or business for Medicare Tax purposes requires that (a) there be an activity that involves a trade or business (within the meaning of §162) and (b) is a passive activity within the meaning of §469, which requires material participation by the taxpayer.  There is no separate definition of a “trade or business” for the Medicare Tax.  Generally, most of the income of estates and trusts will be net investment income unless the trust is carrying on an active trade or business.  The IRS has not issued regulations on what “active” means for a trust or estate.  The IRS ruling position is that the trustee must actively participate, a position that may be questioned (see the discussion in section A-4).  In its discussion of the passive activity rules for small businesses the IRS describes the seven tests for material participation as follows:

A trade or businesses is a passive activity if the taxpayer does not materially participate.  The taxpayer materially participates if and only if he or she meets one of the following seven tests provided in Reg. § 1.469-5T(a):

The taxpayer works 500 hours or more during the year in the activity.

The taxpayer does substantially all the work in the activity.

The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.

The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.

The taxpayer materially participated in the activity in any 5 of the prior 10 years.

The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.

Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

Note: The first four tests look to a set number of hours of participation in the tax year.  The next two tests look to material participation in prior tax years.  The final test looks to the facts and circumstances, but is highly restrictive.

7.             Rental income is generally passive except for real estate professionals who devote 750 hours to working in the real estate business, or those who really do materially participate.  An important issue to be aware of is that where real estate is rented to a closely held business, for income tax purposes the rental income may be active, but for Medicare Tax purposes it is likely passive and thus subject to the new 3.8% tax.  Where planning involves separating a business and real estate, for instance, giving real estate to one beneficiary and business assets to another, the added tax burden ought to be considered.

8.             Expense allocations may be helpful.  Where expenses are directly attributable to an item that generated the income – – e.g. real estate expenses and rental real estate – – they are directly allocated, but general expenses appear to be allocable against different classes of income as desired under §652.

9.             Capital gains are included in net investment income and may only be allocated out to beneficiaries in certain circumstances as set forth in Treas. Reg. §1.643(a)-3.

10.           The so-called kiddie tax creates special consideration.  The unearned income over $2000 of a person under age 19 (or a full-time student under age 24) is taxed at the parent’s tax rate.  A child’s adjusted gross income is looked at separately from a parent’s for purposes of the Medicare Tax.  This will often be helpful.  To benefit, the child ought to file a separate income tax return rather than having the child’s unearned income included on the parent’s return.

11.           S corporations require special analysis.  Where S corp stock is held in a grantor trust, if the grantor materially participates in the S corp, then income from the S corp should not be passive activity as to the grantor and would avoid the Medicare Tax.  As an example, compare the treatment of S corp stock transferred directly to non-participating children, and to grantor trusts for the children; which is better depends in significant part on the amount of income of the S corp and whether it exceeds the Medicare Tax threshold of the children.  On the other hand, a qualified subchapter S trust pays all of its income each year to the sole beneficiary of the trust and has neither income taxed in the trust or Medicare Tax.  Thus, the Medicare Tax threshold of the beneficiary is key.  Finally, an electing small business trust is not particularly efficient unless the trust actively participates in the S corp’s business.  See Treas. Reg. §§1.1411-3(c), 1.1411-3(c)(3) for special rules (and an example).

12.           In Mattie K. Carter Trust v. U.S., 256 F. Supp.2d 536 (N.D.Tex. 2003) the court held that in determining material participation for trusts the activities of the trust’s fiduciaries, employees, and agents should be considered.  The government argued that only the participation of the fiduciary ought to be considered but the court rejected that argument.

Notwithstanding the only reported case on the issue, the IRS ruling position is that only the fiduciary’s activities are relevant.  The IRS reaffirmed this ruling position in TAM 201317010.  The ruling explains the IRS rationale as follows:

The focus on a trustee’s activities for purposes of § 469(h) is consistent with the general policy rationale underlying the passive loss regime. As a general matter, the owner of a business may not look to the activities of the owner’s employee’s to satisfy the material participation requirement. See S. Rep. No. 99-313, at 735 (1986) (“the activities of [employees] . . . are not attributed to the taxpayer.”). Indeed, because an owner’s trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity. A trust should be treated no differently. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of business owners, therefore, it is appropriate in the trust context to look only to the activities of the trustee to determine whether the trust materially participated in the activity. An interpretation that renders part of a statute inoperative or superfluous should be avoided. Mountain States Tel. & Tel. Co. v. Pueblo of Santa Ana, 472 U.S. 237, 249 (1985).

At issue in the ruling were the activities of “special trustees” who did the day to day operations and management of the companies in question but lacked any authority over the trust itself.  The ruling states:

The work performed by A was as an employee of Company Y and not in A‘s role as a fiduciary of Trust A or Trust B and, therefore, does not count for purposes of determining whether Trust A and Trust B materially participated in the trade or business activities of Company X and Company Y under § 469(h). A‘s time spent serving as Special Trustee voting the stock of Company X or Company Y or considering sales of stock in either company would count for purposes of determining the Trusts’ material participation. However, in this case, A‘s time spent performing those specific functions does not rise to the level of being “regular, continuous, and substantial” within the meaning of § 469(h)(1). Trust A and Trust B represent that B, acting as Trustee, did not participate in the day-to-day operations of the relevant activities of Company X or Company Y. Accordingly, we conclude that Trust A and Trust B did not materially participate in the relevant activities of Company X or Company Y within the meaning of § 469(h) for purposes of § 56(b)(2)(D) for the tax years at issue

The need for a trustee to be active may affect the organization of business entities held in trust.  For instance, a member-managed LLC may be more efficient than a manager-managed LLC unless a fiduciary is the manager.

Turney P. Berry
Louisville, Kentucky