Much has been written about use of a testamentary charitable unitrust as a technique to mimic the deferral aspects permitted under pre-SECURE law. Before concluding whether or not such a statement is true, there needs to be understanding of how noncharitable trusts can be beneficiaries of an IRA account.
Taxpayers sometimes create “look-through,” “pass-through” or “conduit” trusts. Prior to the SECURE Act, a properly drafted trust could use the life expectancy of each beneficiary to determine the amount of required distributions. If the trust were defectively drafted, the trust was required to pay the account out under the five-year distribution rule. After the SECURE Act, this strategy needs to be reassessed. Since many (if not most) conduit trusts provide for payment of the required minimum distribution to a non-spousal beneficiary each year, they would not need to make a distribution until ten years have passed.
Not only would the entire account be taxed in year ten to the beneficiary, the settlor’s original intent likely would be frustrated since the funds would be available to creditors. Given this result, many estate planners and their clients are looking to preserve the spendthrift protection of a trust yet continue the income tax deferral beyond ten years.
To understand the economics of conduit trusts and the trustee’s discretion to distribute more than a required minimum distribution amount, it is essential to understand the fundamental income rules for the taxation of trusts.
Small amounts of taxable income retained by a trust generate tax at highest marginal rate
The undistributed income of the trust is taxed at 37% on taxable income as low as $13,050. That is dramatically less than the entry point for the 37% rate on single ($526,600) or married filing jointly ($628,300) taxpayers. The 3.8% income tax on “net investment income” also applies at $13,050 which again is dramatically less than the entry point for individuals ($200,000) and married filing jointly ($250,000). These rates schedules for trusts discourage the accumulation of income. Let’s examine ways of managing the tax bite through the “distribution deduction.”
The basic tool for avoiding taxation on trust income: the distribution deduction
Fortunately, the Code allows a way to avoid the double taxation of distributed income. Trusts are allowed a deduction for what is distributed to its beneficiaries provided the trust instrument permits or mandates distribution. Only when there is income retained by the trust is it subject to income taxation. The distribution deduction is available to the extent the distribution carries out Distributable Net Income (DNI). So the trustee uses this provision to have income taxed at the likely lower rates of the beneficiaries. Whether or not the trustee is able to execute this income shifting strategy depends on how the trust is drafted.
The trap for the unwary: the “separate share rules”
The “separate share rule” applies to a trust that is allocated into separate shares which are functionally equivalent to separate trusts. The result is favorable to the beneficiaries if they both receive and are taxed on their share of DNI.
When a trust subject to the separate share rule receives an IRA distribution, the resulting gross income generally must be allocated proportionately among the shares—regardless of who it is actually paid out to—for DNI purposes. The result can be beneficiaries being taxed on “income” they have not received.
Example
Francine leaves her IRA to a trust that is to be paid on her death in equal shares to her daughters, Ann, Betty and Cathy. The trust has DNI of $60,000. The trustee cashes out the $60,000 IRA and distributes it to Ann in the current year because of her deductible losses from a business. Later in the year, the trustee plans to distribute assets to Betty and Cathy to equalize distributions. What is the tax result? Since the trust instrument permitted equal allocations to the beneficiaries, Betty and Cathy are deemed taxed on $20,000 they each did not receive! In effect the DNI rules treat Ann, Betty and Cathy as each receiving a third of the DNI.
Trust and retirement planning
In my next post, I will explain further the complications of qualifying for the distribution deduction. The planning, drafting and administration of a trust receiving an IRA requires great care to reach desirable results and avoid unintended taxation.
By Professor Chris Woehrle, Chair & Professor of Tax & Estate Planning Department, College for Financial Planning, Centennial, Colorado
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