Trust and Beneficiaries Income Tax Planning: Opportunities and Pitfalls


Author: Nadia A. Havard

Originally published in October 2019

Copyright © 2019 Knox McLaughlin Gornall & Sennett, P.C.

Trust Fiduciary Income Tax Matters

65-Day Rule

The 65-day rule election is usually employed for a distribution made in the current tax year to treat it as a distribution for a preceding tax year if it is likely that the beneficiary will pay less tax on the distribution than if it is retained by a trust and is taxable at the trust level.

The 65-day rule election makes more sense for complex trusts which grant a fiduciary a discretion to either distribute or retain the trust income and principal. The election allows to treat an amount paid or credited within the first 65 days of the trust tax year as paid or credited at the year end of the preceding tax year. The best thing about election is that it can apply only to a portion of amounts distributed to a beneficiary within the first 65 days of the trust tax year.

Even though the election can apply to a portion of the trust distribution, it cannot exceed the greater of: (a) the trust's accounting income for the tax year for which the election is made, or (b) the trust's distributable net income (DNI) for that tax year.

In order to determine how much of the trust accounting income and the DNI can be used for amounts paid or creditored to the preceding tax year under the 65-day rule, the trust accounting income and the DNI must first be applied for any amounts paid, credited, or required to be distributed in the preceding tax year without taking into account amounts distributions allocated to such year under 65-day rule.

No election is valid unless the amounts are properly paid or credited and reported by the fiduciary in his election to the IRS.

The 65-days election is annual and must be made for each tax year if such year shall include distributions made within 65 days of following year. Again, as a reminder, such distributions will be treated as made on the last day of the preceding tax year. The election does not apply to the year of actual distribution, but impacts the preceding tax year. For example, of a distribution is made by March 6, 2019 and the election is made on Form 1041 for 2018 to treat such distribution as made on December 31, 2018, then early year distribution of 2018 is treated as the 2018 distribution for federal income tax purposes.

If the election is made, the distributions are treated as made in preceding tax year not only for the trust, but also for the beneficiary. On the facts stated above, the trust beneficiary will have to account of the distribution received by such beneficiary for tax year of 2018 even though the actual distribution was made in 2019.

After expiration of the time allowed for election, the election becomes irrevocable.

The RIA commentators state that “the manner in which the election is made depends on whether or not a trust income tax return is required. (a) If a trust income tax return is required to be filed for the election year, the election must be made by checking box 6 in the “Other Information” section of Form 1041. The election must be made by the due date (including extensions) for filing the return. (b) If no return is required to be filed for the election year, the election must be made in a statement filed with the Internal Revenue office where a return would have been filed if required. In this case, the election must be made by the due date for filing a return if the trust were required to file a return for the election year.

Such a statement can also be used to designate the amount(s) to which the election is to apply. If the statement is filed without the return, it should be signed and dated by the fiduciary in his capacity as a fiduciary. The information that the statement is to contain is not spelled out in the regs. It should be noted that if the election is made on Form 1041 and covers all qualified distributions, the election is effective without any further action on the fiduciary's part.

Authorities: Code Sec. 663(b); Reg § 1.663(b)-1(a); Reg § 1.663(b)-2(a)

Capital Gains

There are three ways how capital gains realized by the trust can be allocated to its fiduciary income. They include:

  • allocations made at the trustee’s discretion,
  • allocations consistently treated as made to fiduciary income, and
  • actual distribution of capital gains to beneficiaries.

Trustee’s Discretion

Allocation of capital gains to income can be made at the trustee’s discretion authorized by the trust document and the state law (such as a power to adjust between income or principal; unitrust).

Consistent Treatment

It is important that consistent allocation of capital gains to income starts with the first taxable year the trust realized capital gains.

Actual Distribution

Capital gains are allocated to principal but actually distributed to a trust beneficiary or, alternatively, capital gains are taken into consideration on making trust distributions (such as mandatory distributions at certain age).

Distribution of In-Kind Property for DNI

If a trust has DNI for its taxable year, the trustee can make an in-kind distribution to a trust beneficiary to pass income to the beneficiary. Section 643(e) of the Code allows the trust to accomplish this either by recognizing capital gain on the distributed in-kind property or passing in-build gain to the beneficiary for the in-kind distributed property.

Distribution of the appreciated property without making a 643(e) election

Section 643(e) of the Code provides the following:

“Treatment of property distributed in kind.

Basis of beneficiary: The basis of any property received by a beneficiary in a distribution from an estate or trust shall be:

  • the adjusted basis of such property in the hands of the estate or trust immediately before the distribution,
  • adjusted for any gain or loss recognized to the estate or trust on the distribution.

Amount of distribution: In the case of any distribution of property (other than cash), the amount taken into account under sections 661(a)(2) and 662(a)(2) shall be the lesser of:

  • the basis of such property in the hands of the beneficiary (as determined under paragraph (1), or
  • the fair market value of such property.

Election to recognize gain.

In the case of any distribution of property (other than cash) to which an election under this paragraph applies:

  • Estate paragraph (2) shall not apply,
  • Gain or loss shall be recognized by the estate or trust in the same manner as if such property had been sold to the distributee at its fair market value, and
  • The amount taken into account under sections 661(a)(2) and 662(a)(2) shall be the fair market value of such property.

Election. Any election under this paragraph shall apply to all distributions made by the estate or trust during a taxable year and shall be made on the return of such estate or trust for such taxable year. Any such election, once made, may be revoked only with the consent of the Secretary.

Exception for distributions described in section 663(a) .”

For example, if the trust has appreciated stock, the trust can distribute appreciated stock to a trust beneficiary in satisfaction of its DNI. In this case, the trust can use only the stock basis (or the FMV, whichever is lower) as the value of the distributed property to count towards the DNI. The beneficiary will get the carry-over basis and when he sells stock, he will recognize gain.

Alternatively, the trust can make the distribution and elect to recognize gain upon distribution. (In that case, the FMV of the stock will be used to count towards DNI, the trust will pay tax on the gain, and the beneficiary will get step up basis. The amount of the gain should not increase the amount of the taxable year DNI. Also, if the election is made, it will apply to all distributions made for that taxable year.

Deductions Under the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act significantly changed what expenses can be deducted by fiduciaries on fiduciary income tax returns. As a result, a trust may incur expense which cannot be deducted thus leaving the trust strapped for cash to pay income tax.

As adjustments to the trust gross income – still allowed (e.g. trade or business under 162, losses under 1231, qualified business under 199A).

Itemized deductions that are unique to the trust – still allowed under Section 67(e) (e.g. fiduciary accounting fees; court petition costs; Form 1041 fees, Form 706 GST fees).

Miscellaneous listed deductions – still allowed under Section 67(b) (e.g. state and local taxes up to $10,000; Section 642(c) charitable deduction; Section 691(c) income with respect of a decedent).

Miscellaneous itemized deductions in excess of 2% AGI under Section 67(g) – disallowed under 67(e) (e.g. investment management fees; investment advisor’s fees; property maintenance fees).

Trust and Beneficiaries Income Tax Planning

Resident vs. Non-Resident Status for State Income - Pennsylvania and Florida

Pennsylvania law taxes its residents on their worldwide income. (72 P.S. 7301). For Pennsylvania income tax purposes, the residence is not the same as domicile. Section 72 P.S. 7301(p) defines “resident” in two ways: either a person who (i) is domiciled in Pennsylvania or (ii) spends more than 183 days in Pennsylvania and has a permanent place of abode in Pennsylvania.

(A person is domiciled in Pennsylvania unless such individual (i) does not maintain a permanent place of abode in Pennsylvania, (ii) the individual does maintain a permanent place of abode outside Pennsylvania, and (iii) the individual spends, in the aggregate, not more than 30 days of the taxable year in Pennsylvania.)

Pennsylvania Fiscal Code differentiates between “domicile” and “permanent place of abode”. “A “domicile” is the place that an individual intends to be his or her permanent home, and to which he or she intends to return, whenever absent. A “permanent place of abode”, on the other hand is merely a dwelling place. (61 Pc. Code Section 101.1) If someone has two or more homes, his or her domicile is the one that he or she regards and uses as his or her permanent home. (61 Pa. Code Section 101.3(d)).

Once established, the domicile of a taxpayer does not change until the taxpayer moves to a new location with the valid intention of making it a permanent home. It is a taxpayer’s intention of maintaining a permanent place of abode that determines domicile. (61 Pa. Code Section 101.3(b)). To qualify as a permanent place of abode, the dwelling must be used on a regular basis.

Section 53 P.S. 6924.501 of Pennsylvania Local Tax Enabling Act of 1965 as amended in 2008, defines the term “domicile” for income tax purposes as” [t]he place where a person lives and has a permanent home and to which the person has the intention of returning whenever absent. Actual residence is not necessarily domicile, for domicile is the fixed place of abode, which, in the intention of the taxpayer, is permanent rather than transitory. Domicile is the voluntarily fixed place of habitation of a person, not for a mere special or limited purpose, but with the present intention of making a permanent home, until some event occurs to induce the person to adopt some other permanent home. In the case of a business, domicile is that place considered as the center of business affairs and the place where its functions are discharged.”

Under Pennsylvania common law, place where a person voluntarily fixed his habitation with a present intention to make it either his permanent home or his home of the indefinite future becomes such person’s domicile. Need both the physical presence in the place where domicile is alleged to have been acquired, and an intention to make it his home without any fixed or certain purpose to return to his former place of abode. (Coulter Estate, 406 Pa. 402, 407, 178 A2d 742, 745 (1965). In Coulter Estate, the Pennsylvania Supreme Court repeated what it previously stated in Publicker Estate, 385 Pa. 403, 405, 406, 123 A.2d 655, i.e. "[t]he domicile of a person is the place where he has voluntarily fixed his habitation with a present intention to make it either his permanent home or his home for the indefinite future. To effect a change of domicile there must be a concurrence of the following factors: (1) physical presence in the place where domicile is alleged to have been acquired, and (2) an intention to make it his home without any fixed or certain purpose to return to his former place of abode. Dorrance's Estate, 309 Pa. 151, 163, A. 303". (Coulter Estate, 406 Pa. 402, 406-407, 178 A.2d 742, 744-745, 1962 Pa. LEXIS 695, *5-7)

In Southwest Regional Tax Bureau v. Kania ( Southwest Regional Tax Bureau v Kania, 49 A.3d 529 (Pa.Cmwlth. 2012), the Commonwealth Court of Pennsylvania agreed that the taxpayer successfully changed his domicile from Pennsylvania to Florida. Taxpayer owned a house in Florida, held a Florida driver’s license, registered to vote in Florida, he and his wife lived in Florida throughout the year and not just in the winter months, “resigned from the boards of numerous Pennsylvania authorities, and became active in a number of Florida organizations …” (Id. at 535). The taxpayer and his wife spent about 3 weeks in Pennsylvania during Thanksgiving and Christmas time. All other time they were either in Florida or travelling. Because the taxpayer was still subject to Pennsylvania state income tax on the income earned in the Pennsylvania partnership of which the taxpayer was a 52% partner, the local revenue office assessed Pennsylvania local income taxes against the taxpayer.

The court distinguished this case from Hvizdak v Commonwealth, 50 A3d 788, 2012, where the facts were very similar to Southwest case except for the taxpayer’s wife and children still continuing to reside in Pennsylvania, the taxpayer was not estranged or divorced from his spouse, and the taxpayer provided support for his wife and children. The court quoted the Pennsylvania Supreme Court interpretation of the term "domicile" as follows: "[a] domicile is the place at which an individual has fixed his family home and principal establishment for an indefinite period of time. A domicile once acquired is presumed to continue until it is shown to have been changed and where a change is alleged, the burden of proving it rests upon whoever makes the allegation. A new domicile can be acquired only by physical presence at a new residence plus intent to make that new residence the principal home. Intent is the actual state of facts, not what one declares them to be.” (Id. at 533, quoting In re Prendergast, 543 Pa. 498, 506, 673 A.2d 324, 327-28 (1996)). In Southwest case, the taxpayer successfully established that he and his wife were no longer Pennsylvania residents for Pennsylvania state and local income tax purposes by affirmatively proving a change of their domicile from Pennsylvania to Florida and spending less than 30 days in Pennsylvania during a taxable year.

Florida statutory and common law provides even more guidance in establishing Florida domicile. Fla. Stat. Ann. 222.17 (the statute as to manifesting and evidencing domicile in Florida for homestead exemption purposes) provides, in part, that any person who has established a domicile in the state may manifest and evidence this by filing in the office of the clerk of the circuit court for the county in which such person resides a sworn statement showing that he or she resides in and maintains a place of abode in that county which he or she recognizes and intends to maintain as his or her permanent home. Provision is also made, under the statute for one to manifest and evidence by a statement, filed with the office of clerk of the circuit court of any county in the state, of one's permanent domicile and intention to permanently maintain and continue his or her domicile in such state other than the State of Florida. The statute also sets forth the requirement that sworn statements under the provision must be signed under oath before an official authorized to take affidavits and makes provision as to the recording of such statements. Furthermore, nothing in the statute may be construed to repeal or abrogate other existing methods of proving and evidencing domicile except as specifically provided in such statute.

Also, interpretations of “domicile” and ‘residence” given by Florida state and federal courts are similar to Pennsylvania interpretations. In Jones v. Law Firm of Hill & Ponton, (141 F. Supp. 2d 1349, 2001, U.S. Dist. LEXIS 5759) the court stated that “[i]n determining domicile, a court should consider both positive evidence and presumptions. Mitchell v. United States, 88 U.S. (21 Wall.) 350, 352, 22 L. Ed. 584 (1874). One such presumption is that the state in which a person resides at any given time is also that person's domicile. District of Columbia v. Murphy, 314 U.S. 441, 455, 86 L. Ed. 329, 62 S. Ct. 303 (1941); Stine v. Moore, 213 F.2d 446, 448 (5th Cir. 1954). But because changes in residence are so common in this country, courts also refer to another presumption: once an individual has established a domicile, he remains a citizen there until he satisfies the mental and physical requirements of domicile in a new state. Yeldell, 913 F.2d at 537; McDougald v. Jenson, 786 F.2d 1465, 1483 (11th Cir. 1986). However, these presumptions are merely aids for the court. The objective facts bearing on an individual's "entire course of conduct" determine domicile …. Stine, 213 F.2d at 448. No single factor is conclusive; instead, the Court looks to the "totality of evidence." (Id.)

Also, in McDougald v. Jenson (786 F.2d 1465, 1986 U.S. App. LEXIS 24527), the court stated “[b]ecause everyone must at all times have a domicile somewhere, it is well settled that a domicile, once established, continues until it is superseded by a new one. See, e.g., Warren v. Warren, 73 Fla. 764, 75 So. 35 (1917). See generally 20 Fla. Jur.2d Domicil and Residence §§ 3, 11 (1980). Thus, under Florida law, one's domicile, once properly established, is presumed to continue, and the burden of proof ordinarily rests on the party asserting the abandonment of one domicile to demonstrate the acquisition of another. See, e.g., Miller v. Nelson, 160 Fla. 410, 35 So. 2d 288, 293 (1948). See also Texas v. Florida, 306 U.S. 398, 427, 59 S. Ct. 563, 577, 83 L. Ed. 817 (1939). To establish a new domicile, one must physically reside in a new location with an intent to make his home there permanently. See, e.g., Frank v. Frank, 75 So. 2d 282, 286 (Fla.1954). A temporary removal or absence from one's domicile with an intent to return there will not suffice to establish a new domicile. See, e.g., Bloomfield v. City of St. Petersburg Beach, 82 So. 2d 364, 369 (Fla.1955)” (Id.)

Florida common law regarding “domicile” and “residence” is summarized in Florida Jurisprudence as follows. (20 Fla Jur Domicile and Residence § 3, 9, 18, 20)

“The terms "domicile" and "residence" are frequently employed synonymously, but when accurately used, they are not interchangeable terms. … Notwithstanding the proper distinctions in point of law between the terms "domicile" and "residence" as words of art, even the most erudite savants of the law sometimes fall into the common error of using the terms interchangeably. This tendency occurs no less frequently in the legislative branch of government. That said, although the concepts of "residence" and "domicile" are not interchangeable, they do overlap in some cases.

“Residence" has, in general, a more precise and limited application than does "domicile," which is properly used to refer broadly to personal rights, duties, and obligations. A legal residence or "domicile" has been defined as the place where a person has fixed an abode with the present intention of making it his or her permanent home. A legal residence or "domicile" is not only the place where a person has fixed an abode but also such place where the person has the present intention of making such place his or her permanent home. "Residence" usually denotes merely a place of abode, whether permanent or temporary. Any place of abode or dwelling place constitutes a residence, however temporary it may be, while the term "domicile" relates rather to the legal residence of a person, or his or her home in contemplation of law. As a result, one may be a resident of one jurisdiction although having a domicile in another.

Although a person may have only one domicile, a person may have more than one residence and, in this regard, may have several temporary local residences. Furthermore, that there is a difference in meaning between "residence" and "domicile" is shown by the fact that a person may have his residence in one place while his domicile is in another. And although everyone must in law be domiciled somewhere at all times, residence is considered to be exclusively a matter of privilege.

In addition, there is recognized distinction between a "legal residence" and an actual residence; the phrase "legal residence" is sometimes used as the equivalent of domicile, and the courts have frequently used the two words interchangeably….

A domicile of choice can be acquired on presence plus intent to make one's home permanently or for an indefinite period. And as sometimes stated, to effect a change of domicile, there must be a removal and an intent; that is, a change of legal residence may be accomplished by a good faith intention to acquire a new domicile coupled with actual removal. Thus, the effectiveness of such change is dependent upon the concurrence of both fact and intention, and the mere intention to acquire a new domicile without the fact of actual removal avails nothing neither does the fact of removal without an intention. The intention to acquire a new domicile must be to make a home at the moment and not to make a home in the future.

A person's statements of his or her intent as to domicile are admissible and should be considered in determining the person's domicile. Thus, declarations contained in such writings as election registers, hotel registers, marriage licenses, pleadings in court proceedings, sworn statements regarding domicile made and filed with the circuit court clerk pursuant to statute, wills, or other legal instruments may constitute evidence of domicile. The same applies to oral declarations by the party that a particular place was his or her "home" and that he or she "would like to live and die there.

Although it has been said that the best proof of one's domicile is his or her own statement on the subject, written and oral declarations are of very little weight when they are contradictory. Such declarations may be controlled by other factors or circumstances, they are subject to the infirmity of any self-serving declaration and may be contradicted by other declarations and inconsistent acts. Evidence indicative of one's intent to establish a domicile includes: (i) the filing of tax returns, (ii) the payment of income taxes; (iii) the payment of other taxes; (iv) the preparation of plans and specifications for construction of a new home; and (v) the leasing of an apartment. Domicile may be established by: (i) evidence as to the location of one's business, profession, or trade; (ii) membership in lodges, clubs, and churches; (iii) the purchase of a family burial lot; (iv) the purchase of other land or real property; (v) residence in a particular place; (vi) the sale of a former home; and (vii) the transfer of bank accounts.

The exercise of various forms of civil and political rights in a particular locality may constitute evidence of domicile. However, the exercise of voting rights is deemed to be merely a criterion of intention with respect to the issue of domicile and has been held entitled to little weight.”

Change of Trust Situs and Governing Law

Both Pennsylvania and Florida statutes specifically address the ways to change situs and governing law for irrevocable trusts. (As far as revocable trusts are concerned, their situs and governing law can be changed by the settlor amending such trusts at any time.)

Section 20 P.S. 7708(c) of Pennsylvania Probate Estates and Fiduciaries Code (the “PEF Code”) provides that “the trustee may transfer the trust’s situs to another jurisdiction if either immediately before or immediately after the proposed transfer: (1) a trustee’s principal place of business is located in or a trustee is a resident of the proposed jurisdiction; (2) all or part of the trust administration occurs in the proposed jurisdiction, or (3) one or more of the beneficiaries reside in the proposed jurisdiction”. The trustee must give a 60-day written notice to qualified beneficiaries (i.e. all current and contingent beneficiaries entitled to receive income and/or principal either upon death of another beneficiary or trust termination). (20 P.S. 7708(d)). No court approval is needed if all qualified beneficiaries consent in writing.

Section 20 P.S. 7707(1) of PEF Code provides that trusts must be governed by the law designated in the trust instrument. Correspondingly, if the trust instrument provides how the governing law can be changed, these steps should be followed. Pennsylvania, however, attaches its mandatory rules to all trusts that were originally subject to Pennsylvania law. (20 P.S. 7705). The governing law and the trust situs weigh on the meaning and effect of the trust instrument provisions (20 P.S. 7707) and the venue for court filings and judicial proceedings (20 P.S. 7708). Neither the governing law nor the situs deal with taxation of trusts for state income tax purposes.

Similarly to Pennsylvania law, Florida law allows a trustee to change the trust situs and the governing law by trustee’s actions with beneficiaries’ consent. Section Fla. Stat. Ann 736.0108(5) and (6) allows a trustee to change the trust situs upon giving a 60 day written notice to qualified beneficiaries. No court approval is needed if beneficiaries do not object by filing a lawsuit. (Fla. Stat. Ann. 736.0108(7)). Section Fla. Stat. Ann. 736.0107 provides that the governing law is as designated by the trust terms, provided there is sufficient nexus to the jurisdiction, or during the trust administration, the location of real property held by the trust, or residence or location of an office of the settlor, trustee or any beneficiary is in the State of Florida.

Change of Resident Trust Tax Status

Indeed, Section 72 P.S. 7301(r) of Pennsylvania tax law defines a Pennsylvania “resident” trust as “any trust created by, or consisting in whole or in part of property transferred to a trust by a person who at the time of such creation or transfer was a “resident” of Pennsylvania. Pennsylvania taxes resident trusts on all income categorized under the eight enumerated taxable classes (72 P.S. 7303(a)).

Pennsylvania is one of the states that uses single factor (i.e. settlor’s residence at the time of trust creation or funding) to determine whether such trust is a resident trust. This concept was challenged in 2013. In Robert L. McNeil Jr. Trust et al. v Pennsylvania, the Commonwealth Court ruled against the Pennsylvania Department of Revenue which tried to tax two inter vivos trusts located in, administered in, and governed by DE law and which had no Pennsylvania income or assets during the years at issue. (Robert L. McNeil J. Trust et al. v. Pennsylvania, 67 A3d 185 (Pa. Commw. 2013). The Commonwealth Court stated that the settlor’s and discretionary beneficiaries’ residency in Pennsylvania was not enough to establish substantial nexus to Pennsylvania to justify the income tax, was not fairly apportioned and was not related to benefits Pennsylvania provided to the trusts. (Id.)

On June 21, 2019, the US Supreme Court entered its opinion in North Carolina v Kaestner, 568 US (2019) on whether North Carolina could tax accumulated but not distributed trust income based on the single factor involving the residency of the trust beneficiary. (North Carolina v. Kaestner, 568 US (2019), Kimberly Rice Kaestner 1992 Family Trust v North Carolina Dept. of Revenue, 814 S.E. 2d 43 (N.C. June 8, 2018), aff’g, 789 S.E. 2d 645 (N.C. App. 2016) and Fielding v Commissioner of Revenue, 2018 WL 3447690 (Minn. July 18, 2018), aff’g, 2017 Minn. Tax LEXIS 28 (Minn. T.C. 2017)). Among other things, Kimberly Rice Kaestner 1992 Family Trust case cited Pennsylvania Robert L. McNeil J. Trust case in support of its position. When the US Supreme Court issued its decision, it also indirectly opined on Pennsylvania Robert L. McNeil Trust case.

The commentators caution that on its face the North Carolina taxing statute might have been unconstitutional based on the Due Process Clause of the United States of America. However, as applied to particular facts of the case, the statute may be upheld. At this point, it will be safe to presume that Pennsylvania still has a legal position in defining irrevocable trusts as resident trusts for income tax purposes based solely on the settlor’s residency at the time of creation or funding. However, it may be prudent for trustees to file protective claims for refund with Pennsylvania and any other single factor states, as applicable, for income taxes paid by the trust if such states had no any other nexus with trusts, its beneficiaries, and sources of income except for statutory factors authorizing taxation.

Another strong point to be taken from Kaester case is that both, North Carolina and the US Supreme Court did not dispute trust decanting undertaken in prior years for the trust at hand and reviewed the case facts as applied to the decanted trust, not the originally drafted trust. It may be prudent for trustees to explore possibilities of decanting trusts to income tax favorable jurisdictions.

Opportunity Investment Zone

On April 17, 2019, Treasury and the IRS proposed regulations regarding Opportunity Zones and investments in Qualified Opportunity Funds (QOFs). Under Tax and Job Creation Act, the capital gains are deferred if reinvested in other QOFs, or, if earlier, until December 31, 2026.

As noted by Howard Zaritsky, “these regulations include several important provisions relating to gifts and transfers at death of interests in a QOF, among the most important of which are that:

  • a gift of an investment in a QOF would trigger the deferred gain, whether made to a charitable or noncharitable donee, with an exception for transfers to a grantor trust deemed owned by the transferor. (Prop Reg § 1.1400Z2(b)-1(c)(3));
  • a grantor trust that holds an interest in a QOF that ceases to be a grantor trust, other than on account of the grantor's death, will recognize the deferred gain. (Prop Reg § 1.1400Z2(b)-1(c)(5));
  • the death of the owner of a QOF would not trigger recognition of the deferred gain, whether the interest passes by intestacy, survivorship to a joint owner, or the provisions of the deceased owner's will or revocable trust. (Prop Reg § 1.1400Z2(b)-1(c)(4));
  • the distribution of a QOF interest to a beneficiary of the estate or revocable trust would not trigger recognition of the deferred gain. (Prop Reg § 1.1400Z2(b)-1(c)(5));
  • the distribution of an interest in a QOF by an estate to a trust that was a grantor trust before the grantor's death, or from that trust to a beneficiary, also will not trigger recognition of the deferred gain. (Prop Reg § 1.1400Z2(b)-1(c)(4));
  • an interest in a QOF held at the owner's death is treated as an item of income in respect of a decedent; and
  • the five-, seven-, and 10-year holding periods in a QOF interest carryover to the recipient who receives the interest at the owner's death or by a gift to a grantor trust. (Prop Reg § 1.1400Z2(b)-1(d)(1)(iv))”

Trust Modifications

Trust modifications as allowed by state laws, (a) by beneficiaries’ agreement, (b) by a court petition, (c) by an independent person, such as a trust protector, allowed by trust terms or state law to modify trusts, or (d) by decanting to new trusts with new trust provisions.

Step-Up Basis

As a general rule assets acquired from the decedent receive a step-up basis under Section 1014 of the Code. Due to increased federal estate tax exemption, there is a strong trend among practitioners to focus on reducing or eliminating capital gains by the next generation rather than reduction of estate taxes in the first generation. The cost benefit analysis involves consideration of (i) total death taxes upon the decedent’s death, (ii) built in capital gain of the assets held by the decedent prior to his death, and (iii) the income tax bracket of the person receiving the assets either from the decedent upon the decedent’s death or by gift during such person’s life.

For example, if the person holds investment securities with the built-in net long-term capital gain and the recipient of such securities is within 10% or 15% federal income tax brackets, then it might be better to gift such securities to the recipient rather than leave them at death.

There are certain assets that do not receive step-up basis due to their character. These are (i) cash or cash equivalent accounts (such as savings accounts, certificates of deposit, money market accounts or cash on hand in any brokerage or equivalent accounts); (ii) property that constitutes income in respect of a decedent as described in Code Section 1014(c), including, but not limited to, IRAs and the like; (iii) any interest in any Roth IRA accounts or Roth variants of other retirement plans, such as Roth 401(k)s, 403(b)s, 457(b)s, and the like; and (iv) any interest in any property that has a cost basis for federal income tax purposes that is greater than or equal to the fair market value of the property at the time of the owner’s death.

If it is concluded that more tax savings are generated by eliminating capital gains rather than incurring death taxes, certain steps can be used to achieve this goal. At this point it is presumed that the build-in capital gain assets are already held by an irrevocable trust for assets protection purposes. Here are the ways to get step-up basis in such assets in the estate of the grantor: (i) substituting assets of equal value by the grantor in the grantor’s trust, (ii) granting the grantor a testamentary general power of appointment in favor of the grantor’s creditors by either modifying the trust or drafting in either the power itself or an ability held by an independent person to grant such power. Caution needs to be taken with regards to the irrevocable trusts which are already exempt from generation-skipping transfer tax. Trust modifications aimed to cause inclusion of the trust assets in the estate of the grantor may cause the need to allocate new generation skipping transfer exemption.

Also, depending on the initial intent of the grantor, the underlying trust can be (i) a revocable trust, (ii) a grantor retained annuity trust, (iii) split-interest trusts with charities as remainder beneficiaries; or (iv) community property trust. The nature of these trusts will cause inclusion of the trust assets in the grantor’s estate for death tax purposes thus creating step-up basis in the underlying assets.

If it is desirable to cause inclusion of the trust assets in the estates of the next and more remote generations other than grantors, the trust terms can be either modified to for the following or have specific terms already included in the trust instrument: (i) general power of appointment; (ii) substitution of the assets with high basis held by a beneficiary for assets with low basis, (iii) triggering DE tax trap by exercising special power of appointment.

Conclusion

Income tax planning has always been one of the focal points on planners’ radar. The new tax laws brought income tax planning front and center for a large number of people. The planning ranges from shifting ordinary income and capital gains to lower income tax bracket taxpayers residing in low income tax states to completely eliminating capital gains via step-up basis and investments in Qualified Opportunity Funds.

The discussed income tax planning opportunities are allowed under Internal Revenue Code and Treasury Regulations. As with any other planning, income tax planning should be considered together with (i) asset protection planning, as well as (ii) estate, gift and generation skipping transfer tax planning. The planners should avoid focusing on one aspect of taxation (such as income tax on ordinary income or capital gains) and inadvertently causing generation skipping transfer taxation for trust distributions or exposure of the trust assets to taxpayer’s creditors. The planning should be comprehensive and well thought out.

Author: Nadia A. Havard

Originally published in October 2019

Copyright © 2019 Knox McLaughlin Gornall & Sennett, P.C.