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 TAX ISSUES FOR SUPPLEMENTAL NEEDS TRUSTS
When using a trust to maintain eligibility for public benefits, the trust principal will earn income. The questions then arise, who will be responsible for paying the income tax -- the beneficiary of the trust or the trust and how should the trustee report the trust income to the IRS?
Income Tax With the compression of trust income tax rates, the tax burden imposed on trust income will be greater than if it had been imposed on the beneficiary. In 2002, a non grantor trust will reach a maximum tax bracket of 39.6% at only $8,900 of income, compared to the maximum tax rate of 38.9% for an individual with gross income over $307,050. Because of this compression of tax rates for trusts, it is usually desirable for tax planning purposes to have the income taxed to the beneficiary, and not to the trust. The statutory requirements of a Disability trust created pursuant to 42 U.S.C. 1396p(d)(4) and at C.R.S. 15-14-412.8 require that the trust be created by a parent, grandparent, guardian or court. When someone other than the beneficiary creates the trust, the first question is who will be treated as the owner of the trust for income tax purposes? Generally, it is the beneficiary, even though the trust document names a third party as having created the trust. The IRS considers the beneficiary to be the owner of the trust assets for the following reasons: The action is initially commenced for an injury sustained by the plaintiff, whether the plaintiff is a minor or an adult. Any recovery from the lawsuit is for the injured party’s benefit. If another party is appointed as guardian or conservator for the beneficiary, or if a parent, grandparent, guardian, or court is creating a disability trust as required by the statute, the parties creating the trust are acting only in a representative capacity. If a trust is established to receive the proceeds, whether by cash or a structured settlement annuity, the trust is still created by the injured party, regardless of whether someone else is named grantor or settlor of the trust -- even if the beneficiary is unable to execute the trust or settlement documents due to incapacity or age. Since the beneficiary is considered the owner of the assets transferred to the trust, the next question is whether the grantor tax rules will require the income generated from the trust assets to be taxed to the injured party. While this section will not provide a detailed analysis of the grantor trust provisions of the Code, certain provisions of the grantor tax rules should be noted because of their impact on trusts funded with proceeds of a personal injury settlement. For example, a grantor will be treated as the owner of any portion of the trust when the trust income, “without the approval or consent of any adverse party, or in the discretion of the grantor or non adverse party, or both, may be (1) distributed to the grantor . . . ; (2) held or accumulated for future distribution to the grantor . . . ; or (3) applied to the payment of [life insurance premiums] on the life of the grantor. In addition, “the grantor shall be treated as the owner of any portion of a trust in which he has a reversionary interest in either the trust corpus or the income therefrom.” The grantor is also treated as the owner if, without the consent of an adverse party, the grantor has power to revest title of the trust property in himself, or to purchase, exchange or otherwise deal with the trust corpus or income. An “adverse” party is one having a substantial interest in the trust that will be adversely affected by the exercise or non exercise of the power. The rule is based on the premise that if the power must be exercised by or in conjunction with an adverse party, it is unlikely that the grantor will control the decision. When a trust is established for the benefit of either an incapacitated or a minor beneficiary, most courts will require that a corporate fiduciary be used to manage the funds. The trust document usually provides that the corporate fiduciary has broad discretionary powers over distribution of income and principal. Generally, the corporate fiduciary will be considered a “non adverse” party for purposes of the grantor trust rules. Since the beneficiary is the owner of the trust, and the trust is classified as a grantor trust, all net income earned by the trust will be taxed to the beneficiary and not to the trust, regardless of whether any of the income was actually distributed to the beneficiary. Although the trust is required to file Form 1041 (Fiduciary Income Tax Return) to report the trust’s income and expenses, all income, deductions, and credits of the trust are reported on the injured party/beneficiary’s Form 1040 Individual Tax Return.
Gift Tax A gift can occur when a beneficiary’s property is transferred to a trust. A basic explanation of the gift tax rules is necessary to understand when a gift may occur involving the transfer of property to a disability trust. Gift tax liability attaches whenever a person making a gift (the donor) makes a completed gift. A completed gift occurs when the donor gives up dominion and control of the transferred property to the point that the donor has no power to change the disposition of the property, whether for the donor’s benefit or for the benefit of another. Under the Code, “the tax imposed by §2501 shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. . . .” A transfer subject to a reserved power must be examined to determine if the transfer is “complete” and subject to gift taxation. The following examples are referenced under Treas. Reg. 25.2511-2: If a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift. If the donor had not retained the testamentary power of appointment, but instead provided that the remainder should go to X or his heirs, the entire transfer would be a completed gift. However, if the exercise of the trustee’s power in favor of the grantor is limited by a fixed or ascertainable standard . . . , enforceable by or on behalf of the grantor, then the gift is incomplete to the extent of the ascertainable value of any rights thus retained by the grantor. Since preservation of the trust corpus for the injured party’s care is usually paramount, payment of any gift tax on the transfer of assets into the trust should be avoided. If a gift tax is required to be paid, extraordinary hardships will occur to the beneficiary and threaten the purposes for which the trust was established. Any taxable gift made by a donor will be offset by the donor’s applicable credit amount. Any taxable gift in excess of the applicable credit amount will require the donor to pay gift tax. To avoid a completed gift from occurring on a transfer of a damages award into a trust, the trust agreement should contain a testamentary power of appointment.
Estate Tax If a completed gift does not occur on the transfer of the settlor’s assets to the trust, the trust assets will be included in the settlor’s estate for federal estate tax purposes. For most beneficiaries, inclusion of the trust assets in their estates for federal estate tax purposes is not a major concern because most of the assets will be expended for their care during their lifetime and with the increase in the applicable exclusion amount. However, estate taxes can create major planning problems as illustrated in the following private letter ruling. The IRS’s holding in Private Letter Ruling 9437034, illustrates the estate tax problems that will occur when using a structured settlement with a guaranteed payment. In that case, the plaintiff was severely injured in an automobile accident. The litigation was settled with a lump- sum payment, coupled with periodic payments payable for the longer of the plaintiff’s life or ten years. Since the plaintiff was mentally incapacitated, the settlement funds were paid to an irrevocable trust established for his benefit. Five months after settlement of the case, the plaintiff died. Thus, at the time of plaintiff’s death, the trust was funded with the lump sum payment and was entitled to ten years of periodic payments under the structured settlement. The IRS concluded that the decedent’s taxable estate for federal estate tax purposes included the trust corpus and the ten years of guaranteed payments under the structured settlement. The IRS also concluded that the transfer into the trust was an incomplete gift, so that a taxable transfer did not occur until the plaintiff’s death. Therefore, no gift tax occurred upon the funding of the trust. To establish that it was subject to estate tax, the IRS held that the decedent was the transferor of the funds, regardless of the designation of his mother as settlor of the trust. The IRS emphasized four elements in reaching the conclusion that the settlement was subject to estate tax:
Based on these elements, the IRS concluded that the plaintiff was the transferor of the funds into trust and that the designation of his mother as settlor was superfluous. The IRS further concluded that the retained testamentary special power of appointment made the gift incomplete until the decedent’s death. The result in Private Letter Ruling 9437034 should alert everyone to consider estate tax ramifications with disability trusts. This is especially true when the recovery is paid by a structured settlement with a guaranteed payment for a period of years. The problem illustrated in Priv. Ltr. Rul. 9437034 would have been avoided had sufficient money been set aside in the cash portion of the settlement to pay the anticipated estate tax. Other means to minimize the estate tax problem include:
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