Alexander A. Bove Jr. and Melissa Langa,
The Daily Record Newswire
Some time ago we received a call from an attorney who was afraid he might be facing a lawsuit for causing a client to lose the $250,000 federal tax exemption on the sale of the client’s principal residence.
It seemed that, in the process of some elder law planning, the attorney advised the client to place her home in an irrevocable trust to “protect” it in the event of the client’s institutionalization or death.
But then the client decided to sell the home and move in with her daughter, and since the home was in an irrevocable trust, the sale would not be eligible for the capital gains exemption. After all, isn’t it common knowledge that an irrevocable trust pays its own taxes and cannot qualify for the principal residence exemption, which applies only to individuals?
Well, that may be common knowledge, but it is based on a faulty premise. We were happy to set the lawyer’s mind at ease by assuring him that the client would be fully entitled to the capital gains exemption despite the fact that the trust would be making the sale. In the end, the client credited the attorney for a devilishly clever scheme.
Income taxation of trusts can be one of the more confusing areas of the federal tax code among lawyers and accountants alike. Although most practitioners seem to understand that a revocable trust does not pay its own taxes, perhaps the most misconceived notion is that an irrevocable trust always does pay its own taxes because it is irrevocable.
There are certain fundamental rules in the Internal Revenue Code — the tax bible — governing the income taxation of trusts that, if religiously followed, can help practitioners in their tax planning.
One simple rule, for example, says if a person (we’ll call him the grantor) creates a trust that is amendable and revocable by the grantor alone and no other person may make withdrawals, then all income and losses of the trust will pass through to the grantor, whether or not any distributions are made.
The simplicity stops there, however. Irrevocable trusts may or may not pay their own taxes depending on a number of factors, perhaps too numerous and complex to cover here in detail. But we will nevertheless offer a few more basic principles that should help identify when the irrevocable trust is clearly a “pass-through” for tax purposes and when it may not be.
In tax jargon, a pass-through trust is referred to as a “grantor” trust, meaning that all tax consequences are passed through to the “grantor,” who would be either the party who established and contributed to the trust, or the party who is treated as such because of the terms of the trust.
Our tax code has a series of sections (671-679) known as the grantor trust sections that lay down the rules. Some of these rules clearly tax the grantor on trust income (and losses) regardless of whether the trust is revocable or irrevocable, and it is one of these rules that saved our well-meaning elder law attorney.
That rule is, if a person establishes a trust for her own benefit or even for the benefit of her spouse, all of the trust income, deductions, credits and losses will pass through to that person (the grantor of the trust), regardless of whether the trust is irrevocable and regardless of whether any distributions are made.
Thus, the client who put her home in the irrevocable trust with herself as the beneficiary for life fell under this rule, and the sale of the home by the trustee was treated as a sale by the client for tax purposes.
There also can be situations in which the tax consequences pass through to the grantor of the irrevocable trust even though the grantor has reserved no benefits at all for herself or her spouse but has reserved certain powers, such as the right to add or delete a beneficiary, or even when she has given someone else that right.
In fact, one of the more creative and tax-efficient uses of grantor trusts is when the grantor makes a large gift to an irrevocable trust for the benefit of family, remains taxed on the income, but the trust assets are not taxed in her estate for estate tax purposes. The grantor’s payment of income taxes on income that either accumulates in the trust or is distributed to the family is not considered a gift and at the same time reduces the grantor’s estate. And when the grantor wishes to make someone else taxable on the income of the trust, she merely needs to give that person the power to unilaterally withdraw all the income of the trust.
As a further revelation of how our tax code works in mysterious ways, some irrevocable trusts can be part grantor trust (pass-through) and part taxed on their own, depending on the terms of the trust. So, the irrevocable trust might be a grantor trust as to income, but not principal. That could happen for instance when the grantor reserves only a fixed income from the trust and any excess is accumulated in the trust for later distribution to others.
A special and very common version of that is the charitable remainder trust. In that type of trust, the grantor reserves a fixed income typically for life, and the excess is accumulated and paid to charity on the grantor’s death.
Thus, the taxation of a trust has less to do with whether the trust is irrevocable than it does with the terms of the trust itself. One might say the devil is in the details.
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Alexander A. Bove Jr. and Melissa Langa are shareholders at Bove & Langa in Boston, where they concentrate in domestic and international trusts and estate law.
