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.”

  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.

 Grantor Trust Status. Is it or Isn’t It: 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.

Passive Loss 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.

 Non-Resident Beneficiary 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.

State Income Tax Status 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.

Investment and Other Deductions 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.

 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.

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