Trusts: 2014 Observations & Updates

 Notice: News and articles mentioned here provide only an overview of trusts and their tax implications. Although this article is intended to be helpful, it only provides general knowledge that you must verify with your own research. Some trusts may be simple, but considering state and federal laws and regulations, there are many possible complications that need to be anticipated. For more information about setting up a trust, consult an attorney, or two; and possibly an accountant, or two; or a financial planner if you need more assistance.

This is a review of trust news so far for 2014, based on what I've bookmarked or saved during the year. The year has been a somewhat quiet one for trusts. There has been some clarification of NIIT for trusts, material participation, and what it means to be a real estate professional as a trust. One thing that may be a highlight is the clarification of what is included in the 2% miscellaneous deductions, and a mention of required unbundling for that purpose beginning in 2015. Considering those issues, you may want to do some end of year tax planning. Otherwise, the information here is intended to only highlight some of the features and pitfalls of trusts covered in various publications.


With the introduction of the Patient Protection and Affordable Care Act, commonly referred to as ACA, there may be issues to consider for the 3.8% Net Investment Income Tax (NIIT) imposed on higher levels of investment income. While the threshold is fairly high for individual taxpayers ($200,000 - $250,000 for single, married taxpayers), it is not so much for trusts. Investment income includes interest, dividends, rents, royalties, annuities. For 2014, $12,150 is the threshold for the highest tax rates and the NIIT. Because much of trust income is investment income it is even more important to know the tax liabilities. For a trust NIIT is imposed on investment income included in distributable net income (DNI) which is generally the excess of income over expense. While investment income distributed to beneficiaries is not taxable to the trust, it is subject to NIIT of the beneficiaries, but the threshold is much higher.

Capital gain is also considered investment income although its treatment has a few twists. Since the tax applies to income that is not DNI, whether or not income is included in DNI will be a deciding factor. Treasury Regs. Sec. 1.643(a)-3(b) covers capital gains in detail. If it is included in a distribution it would normally be taxable to the beneficiaries. If the gain is attributed to corpus activity the trust generally must pay NIIT. However, there are several other conditions where the trust could avoid the tax. Capital gains may not be taxable if the capital gains are included in financial accounting income and is normally set aside for beneficiaries. If capital gain is consistently treated as part of distributions, or actually distributed, it is not subject to NIIT. Unitrust provisions and the power to adjust statute are other instances where NIIT may not apply. Obviously grantor trusts and tax-exempt trusts like CRTs are generally not taxable within the trust.

Frank Aragona Trust

A notable tax court case this year involving a trust was at the intersection of Section 469 and Section 1411. According to Section 1411, NIIT does not include amounts earned in the course of a business or trade. Consequently, if the activities of an individual are considered a trade or business rather than an investment, the additional tax doesn't apply. At issue is the idea of material participation by the trust, and one notable Tax Court demonstrates what questions are involved.

Although Section 469 deals primarily with passive loss rules, it's definition of what is considered a trade or business also defines what is not passive, investment income. Since this trust met the requirements of Section 469(h), the activities of a trust can be considered trade or business. Furthermore, although the activity was a rental activity, because of the participation levels of trustees, it meets the requirements of being a real estate professional as outlined in Section 469(c)(7)(B).

Though not a subject of this case, it is also possible that trusts could benefit from the use of grouping rules to lump multiple activities into a group for purposes of calculating hours for material participation. Special IRS provisions allow taxpayers a one-time opportunity to redefine groups when they first become subject to the NIIT. Prop. Reg. Sec. 1.469-11(b)(3)(iv).

2% Miscellaneous Deductions

Another trust issue that received some attention this year was miscellaneous deductions subject to the 2% floor. Following a win/loss at the Supreme Court 7 years ago, the IRS finally released regulations defining clearly what expenses are subject to the 2% floor for trusts. Before that, fees related to investment management were often considered to be subject to the 2% floor, even though trustee fees were not. Like the court decision, the IRS notes that expenses are fully deductible if they would not “commonly” or “customarily” be incurred by an individual holding the same property. That distinction is the overriding consideration in the rest of the regulations, and should be a good guide to remembering what items are subject to the 2% floor.

Section 67(e) regulations do attempt to define which fees are, and are not, subject to the 2% floor, as well as those fees not considered miscellaneous expenses. Five categories of fees are mentioned, including ownership costs, tax preparation, investment advisory fees, appraisal fees, and certain fiduciary fees. Whether or not fees are subject to the 2% floor, however, depends on the specific fee. Under ownership costs, for example, while condominium fees, insuranace and maintenance are considered 2% costs, other ownership costs are not mentioned (as previously included in the proposed regulation). Notably, one omission is real estate taxes, apparently because they are fully deductible. See the article referenced or the regulations for all the details.

One other issue covered in the new regulations involve bundled fees.When fees are bundled, it may be necessary to unbundle them to determine which expenses are 2% . The method used to allocate bundled fees, however, is not defined, and the regulations say any reasonable method is acceptable. There is also a specific test available when the fees are not based on an hourly rate. The regulations applies to tax years beginning on or after May, 9, 2014.

The long history of the controversy is also fascinating, though it appears the new regulations will finally settle all of the disputes. Or will it?

Interesting Trusts

While the news was generally limited to the few subjects above, I did learn some other things in 2014 related to trusts that you might find informative.

Crummey (crackdown?)

I've heard about Crummey trusts before, but I found it interesting that politicians decried the use of Crummey type trust strategies to avoid income tax. It was later found that the politician was using those same tactics in their own affairs. I, for one, don't blame politicians for using a legal tactic to minimize his taxable income. I take advantage of benefits that I don't particularly agree with. But I also believe crackdowns on trust manipulations will be quite slow, since so many in politics use them. This one, however, is more likely than others to see some regulation.

Essentially, Crummey trusts are funded by gifts to beneficiaries. When beneficiaries fail to claim their gift during the limited time available to do so (usually 30 days), the funds become part of the trust. The most popular use of Crummey trusts is as a way to set aside money for dependents in such a way that the beneficiaries cannot access it early and waste it. As an irrevocable trust, it escapes estate and GST taxes as well as creditors.


INGs have also been around, but with something of a new name. I first heard of the Incomplete Non-Grantor trust when it was called the DING (Delaware Incomplete Non Grantor trust). In one way, this is just the opposite of a Crummey. Instead of having contributions treated immediately as a gift, the trust is structured so that the contributions are incomplete gifts. The grantor does this be reserving powers over the trust, such as the ability to change beneficiaries.

The two main goals of INGs are to preserve terminal basis adjustment, and to escape the penalty of living in a high state income tax state. As irrevocable trusts, INGs are also protected from creditors. Delaware and Nevada are the two states that are most popular for this trust, and the IRS blessed the use of INGs in 2013.


Yet another trust tactic is the (Intentionally) Defective Grantor Trusts (IDGT). The IDGT (supposedly pronounced "I dig it") is set up with an irrevocable gift of property to the trust. When the grantor reserves certain powers over the trust, it becomes defective. The grantor is taxed on the trust income, but the trust is not included in his gross estate.

Credit Shelter Trusts

Although this type of trust provides some protection from creditors, the primary use of the trust is often to preserve the assets of a deceased spouse for the survivor, avoiding state estate taxation. In Texas, credit shelter trusts are not as crucial as in other states with a state estate tax, however there are other reasons to set up a credit shelter trust, such as preserving inheritance for their children.

One of the popular subjects discussed in relation to the credit shelter trust is portability. Portability is the ability to use the remainder of one spouse's estate tax exemption. Instead of relying on portability, each spouse will leave their portion of the estate to the trust, providing income to the surviving spouse and meeting exceptional needs when necessary.


Another popular trust used to guard against actions of creditors is the domestic asset protection trust (DAPT), and it is now available in over a dozen different states. Trusts assets are protected against creditors after a certain period of time. In Nevada, that period is two years. With a DAPT, although an irrevocable trust, discretionary distributions can be made to a beneficiary. All distributions are made by a trustee, and no beneficiary can be a trustee. Based on Mr. Google's analysis of all DAPTs on the web, one common use of DAPTs is to protect assets in a divorce, or incidental to a prenup.

GRAT (The Walton trust)

A Grantor Retained Annuity Trust is setup by contributing assets to a trust that makes (annuity) distributions to the grantor for a period of years with the remainder going to another beneficiary. Sounds simple except that the calculation of the value of a GRAT is based on Section 7502 rates (locked in), and that is taken in consideration when defining payments. Often however, the remainder, now valued at zero by the code, is often actually quite large when distributed.

If you've read anything about the history of the GRAT, you'd remember that the loophole the GRAT uses to shelter family wealth was created to close another trust loophole. And because the loophole is legal, court cases have repeatedly sided with taxpayers using GRAT techniques. Unlike a Crummey trust which generally limits the contributions to $225,000, millions can be contributed to a GRAT, and thus escape estate tax, that is, of course, if the grantor lives. If not, the remainder is included in his gross estate. But, then, that is where rolling GRATs come into play. With short-term GRATs, the final distribution from the GRAT becomes the asset to create a new GRAT.

By locating a GRAT in another state, the taxpayer can also avoid state taxatios, and South Dakota is the preferred site for creating a GRAT. The GRAT is another trust that is under verbal attack by polititians.

Charitable Trusts

A Charitable Remainder Trust (CRT) is just what it sounds like. The trust is set up with one or more beneficiaries who receive a regular distributions for a period of time. The remainder of the trust is then assigned to a charitable organization, or at least, that's the principle. Distributions are actually made at different tiers, with different levels of taxability. The trust itself, however, is not taxed.

Although there are various forms, the code only describes the Charitable Remainder Annuity Trust and the Charitable Remainder Unitrust is Section 664. CRTs have been around for many years and have been useful in reducing capital gain, but now with the NIIT, there's been a surge in its use. It is a popular alternative for funding retirement. Although a CRT is exempt from income tax, special rules do apply under Section 1411 for calculating investment income of beneficiaries. Also, a CRT may be subject to excise tax for UBTI.

One of the beauties of a CRT is that capital gains escape taxation, so contributing appreciated property is a primary means of funding the trust. Even better, when the contribution is finally made to a charitable organization it could be deductible. It's even possible to accelerate the deduction by terminating the CRT early. When that is done, the terms NICRUT, NIMCRUT, or Stan CRUT have important meanings and Section 7520 comes into play.

Changing trusts

It's obvious that a grantor can change a revocable trust, but an irrevocable trust can also be changed or corrected. Non judicial settlement agreements and decanting are two ways to accomplish that. I say "corrected" because the changes must accomodate some amount of similarity to the purpose of the original trust. By decanting the trust is changed to handle some incident or condition that was not considered when the trust was first drawn.

Trusts: Not just for the rich

A notable article in ultimate estate planner says trusts aren't just for the rich. While often used to shelter large sums of money, trusts are useful for insuring certain things or people are taken care of. Some trusts are set up to take care of disabled family members, or for members that might become physically or mentally incapacitated. Insuring against Alzheimer's is one concern that comes to mind.

At the same time, trusts could be used to provide for a spouse when there are no children or other family members. Trusts can be used to insure business continuity, and may be essential in small business partnerships. True, some provisions can be included in a will, but trusts may have characteristics that make it more useful, with less legal interaction. Finally, trusts can be used to provide for pets. Our 10-year old will says our pets should be taken care of, but it doesn't say how, or provide a means for providing that care.

Big Winners

But, if you do hit it rich, like in the lottery, a trust could be very helpful. Aside from possibly allowing you to remain anonymous (in some states ), many lottery winners end up wasting all of their new found wealth. Creating a suitable trust not only protects you from others; it protects you from yourself.

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