- Consumer
Ode to the Trust – 2nd Sonata
Summary: Here’s part two of the exciting, can’t catch your breath
topic, how to operate your trusts. Many folks seem to think if they’ve signed a
trust they’ve done the deed, but as the Carpenter’s song goes: “We’ve only just
begun.” Just like a good golf swing, follow through is essential to achieve any
of your personal, tax, legal or other objectives. The 2nd part of
this article highlights a few of the myriad of matters to address. If you don’t
heed the follow up warning, you’ll be relying on the line from the Carpenter’s
song: “A kiss for luck and you’re on your way,” when the IRS or a claimant
come’s a knockin, your estate planner will be singing the Buddy Holly words
back at ya: “Don’t come back knockin’ at my offices’ closed door.”
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Income Tax Filings:♫Form 56 notice of a
fiduciary relationship should be filed with the IRS office where the income tax
Form 1041 is filed. File Form 56 When: The first return for a trust is filed; When
there is a change in trustees (as a new trustee you have personal liability for
unpaid taxes and if the IRS has no notice of the trustee name and address tax notices
could be missed); On termination of a trust (attach the document terminating
the trust). Keep a copy of every Form 56 in the trust permanent file. ♫ Estimated Tax non-grantor
trusts may be required to make estimated tax payments. Determine whether the
fiduciary should elect to have any of the estimated tax allocated the
beneficiary (e.g., if distributions result in the income being passed out to
the beneficiary who as a result may have underpaid his/her estimated tax). File
Form 1041-T by the 65th day after the trust’s tax year. ♫ Grantor Trust Reporting – which method
will be used to report income: 1) some accountants don’t file – bad move; 2)
some CPAs use a bare bones “skeleton” return – a Form 1041 with only a
statement: “This trust is a grantor trust and all income and deductions are
reported on the grantor’s income tax return Form 1040, Social Security No. 111-22-3333);
3) Some CPAs attach a complete schedule of income, deductions, etc. with a
statement – better still. For legal and tax purposes detailed disclosure demonstrate
the independent operation of the trust, and confirm which assets the trust owns.
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: Determine whether the trust is properly
characterized as a grantor trust for income tax purposes. ♫ Tax Version of the Clapper: “Clap on
Clap off, the Clapper!” Who could forget that memorable moment of Americana. Some grantor
trusts are inadvertent, others intentionally include provisions to turn grantor
trust status on or off (toggle) and you must confirm which direction the switch
is flipped to for the tax year you are preparing a return for. ♫ Lay Down Sally: Bet you never knew Eric
Clapton was a CPA? “SALY” (same as last year) the favorite phrase young CPAs use
in their work papers, is not a valid explanation, for why a trust is a grantor
trust. Too often the prior year return may not have reached the appropriate
conclusion. Confirm whether grantor trust status has changed from prior years.
Obviously if the grantor has died grantor trust status will terminate, but
there are less obvious ways the trust’s status can change that require inquiry.
If the trust relies on a particular mechanism to achieve grantor trust status,
such as the right to substitute assets or add charitable beneficiaries, if
those rights were waived, grantor trust status might have terminated. There
should be a clear note in the trust records as to why the trust is classified
as grantor or non-grantor trust. Ideally, obtain a confirmation for the trust
records from the various fiduciaries as to which specific powers were waived, exercised
or not exercised. This extends well beyond the determination of grantor trust
status and can affect many significant aspects of the trust. For example, if a
person is granted the authority to add a charitable or other beneficiary, did
they? An affirmative executed statement confirming that they did not is probably
necessary to determine with certainty who the beneficiaries were for the year. The
ideal approach is to have an annual trust meeting and have every fiduciary
execute a statement annually as to the status of their position and any
actions, or confirmation of no actions, during the prior period.
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If the trust owns interests in entities that generate
losses a determination has to be made as to whether the trust is a material
participant in those activities such that the losses will be deductible against
passive income. In evaluating whether a particular taxpayer has materially
participated the participation of that taxpayer’s spouse is attributed to the
taxpayer. Temp. Reg. Sec. 1.469-5T (f) (3). How this test should be addressed
in the context of trusts is uncertain. The IRS in TAM 200733023 reached the
opposite conclusion as to how this should be determined from the court in The
Mattie K. Carter Trust v. US., 256 F. Supp. 2d 536 (Tex. 2003). Advise the
trustee of uncertainty in the law and determine what types of disclosure should
be made with the return. Time has not resolved this dichotomy. The IRS is
sticking to its tough passive loss guns requiring trustees to materially
participate. PLR 201029014.
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normal;”> If there are non-resident alien
beneficiaries the trust may be required to withhold income tax on certain
distributions. The trustee should be certain to confirm the requirements and have
the trust CPA file Forms 1042 and 1042-S if required. The trustee may also have
an obligation to file Form 1040-NR for that foreign beneficiary unless the
alien has handled the filing or has appointed an agent to do so.
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normal;”> Determine in which states the trust
must report income or file returns. Don’t assume that last year’s
determinations necessarily apply. If a trustee, or depending on the state
another fiduciary like the investment adviser, moved to a different residence,
the determination of which states can tax the trust income may have also
changed. ♫The general
paradigm (subject to many exceptions and variations) is that a state will tax a
resident trust on world-wide income, and a non-resident trust only on income
within the state. ♫A trust is
characterized as a resident trust based on the residence of the grantor,
beneficiaries and/or trustees, and/or on the basis of the situs of trust assets
or the specifications in the trust agreement. Some states tax based on
residency of the fiduciaries. So depending on the state if a fiduciary moved
his or her home to a different state, the old state may no longer tax the
trust, or tax it less, while the new state may for the first time exert tax
authority. Trustees should document the residence of beneficiaries and other
factors that may affect this before filing returns. ♫ A change in fiduciaries (trustee, trust
protector, investment adviser, etc.), or the location of trust real estate
assets, or the operations of an active business in which the trust owns an
interest could all affect state tax nexus. If there is no requirement to file
in a particular state it is best not to do so. It will prove much more
difficult to cease filing, then never to have filed if not necessary.
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normal;”>♫ Expenses of a non-grantor trust may be subject to the
2% of adjusted gross income floor. IRC Sec. 67(e)(1). The rules as to which
expenses are unique to the administration of a trust and not subject to this
have been subject to considerable controversy.
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Gift Tax Filings:♫Form 709
Filing gift tax return should be considered more broadly
then many CPAs have done in the past. It might have been common in the past for
many CPAs to encourage gifts under the annual gift tax exclusion (now $13,000)
to avoid filing returns. On the other hand, as Bob Dylan croons: “The Times
They Are A-Changin’.” Many practitioners would now recommend a more pro-active
approach to filing gift tax returns, attaching a complete trust, reporting
annual gifts under Crummey powers, attach full appraisals of the assets given,
affirmatively allocating generation skipping transfer (“GST”) tax exemption (or
affirmatively not), and more. ♫Adequate
Disclosure Telling all (your accountant would call this
“adequate disclosure”) will begin the running of the period of time (tolling
the statute of limitations) for an IRS audit of the return.