We hesitate to publish this, because as soon as we do, Congress will do a roundoff back handspring with a twist and things will change.  However, as of this writing, the versions of the Build Back Better Act passed by the House and recommended by the Senate Finance Committee do not include any of the measures that estate planners have been concerned about since the beginning of 2021: no inclusion of grantor trusts in the estate of a decedent, no deemed realization of capital gains at death or upon the passage of time, not even a decrease in the estate and gift tax exemption amounts.  So as we start the new year, it is unclear whether the Build Back Better Act, if it is ever passed, will contain any of the provisions concerning estate and gift taxes that we have been watching with anxiety.  We doubt many people are ready to exhale just yet.  However, dealing with the unknown is exhausting for both planners and clients.

For a breather, let’s talk about one of the certainties in life: taxes.  This is one aspect of planning that does not seem to be in serious danger of current or immediate change – the need to prepare for and build in options to deal with income tax planning for trusts, particularly those that are intended to be long-term trusts.  As we know, estates and trusts are subject to highly compressed tax brackets which reach the highest marginal rate at $13,450 (in 2022) and are also subject to the 3.8% net investment income tax.  Both the version of the Build Back Better Act passed by the House and the version approved by the Senate Finance Committee include a 5% surcharge on the income of estates and trusts if modified adjusted income (“MAGI”) exceeds $200,000 and 3% on the amount by which MAGI exceeds $500,000.  (MAGI means adjusted gross income as determined under Section 67(e) and reduced by the amount allowed as deductions under sections 642(c), 651(a) and 661(a).  In simple terms, this means that MAGI takes into account amounts of income that are distributed to the beneficiaries.)  The surcharge, if passed into law, only increases the pressure on estate planners to find creative ways to use the bracket run-up available to the individual beneficiaries of a trust instead of having the income tax paid by the trust.  Even if the current legislation does not include provisions designed to make planning with grantor trusts less appealing, there is no reason to believe that such changes could not come about in the future and, in any event, upon the death of the grantor, all trusts other than Sec. 678 trusts (which are deemed owned by the beneficiary for income tax purposes) will become non-grantor trusts, subject in most cases to higher income tax overall.

Of course, one solution to the trust tax bracket issue would be to distribute all the distributable net income (DNI) defined in Section 643(a) of the trust out to the beneficiaries on an annual basis.  This would enable the trustee to use the run up in all the individuals’ income tax brackets in order to minimize the amount of income tax payable on the trust’s earnings.  (Remember that a distribution of the trust’s DNI to the beneficiaries “shifts” the trust’s income to those beneficiaries to the extent of the DNI distributed.)  However, such a solution also exposes all of the income to the creditors of the beneficiaries and, in some cases, could make a beneficiary ineligible for government benefits.  Perhaps, a better solution is to allow the trustee additional flexibility in terms of the beneficiaries who can receive trust income distributions.  These “flexible” beneficiaries can assist in the shifting of the income tax burden from the trust to an individual beneficiary while still maintaining some level of continuing asset protection and asset management.  This post discusses three possible subsets of additional beneficiaries other than the primary trust beneficiaries (e.g., descendants), referred to herein as the “intended beneficiaries,” that may allow flexibility in planning:  1) spouses of the intended beneficiaries, 2) charitable remainder unitrusts in which intended beneficiaries hold the non-charitable interests, and 3) S-Corporations which are owned by intended beneficiaries, or by Qualified Subchapter S Trusts (“QSSTs”) of which an intended beneficiary is the beneficiary.  These flexible beneficiaries were recently added to some of the trusts in InterActive Legal’s Wealth Transfer Planning program.  We’ll consider each category of beneficiary separately.

Spouses of Intended Beneficiaries

Although some clients will love the spouses of their descendants sufficiently that they will want to include them in their own right as beneficiaries of their wealth, most clients seem more interested in assuring the welfare of their descendants or other chosen beneficiaries, rather than descendants-in-law.  However, even for those clients, including the spouse of a descendant (or other intended beneficiary) as a potential beneficiary can serve the clients’ primary beneficial desires by offering benefits to the spouse of a descendant while maintaining a level of creditor protection for that descendant.  For instance, if the intended beneficiary (e.g., the descendant) has creditor issues, distributions could be made instead to his or her spouse, which would both be of benefit to the intended beneficiary, albeit tangentially, and remain out of reach of the beneficiary’s creditors.  If desired, the Trustees could be required to obtain the consent of the descendant-beneficiary before distributions could be made to the spouse. (As long as the interest of the descendants is purely discretionary, it seems the consent of the beneficiary should not be a gift or, if one, extremely small.)  In addition, distributions to the spouse could be limited to times in which the spouse is living with the descendant beneficiary.  Using either or both limitations on the Trustees’ power to make distributions to the spouse of an intended beneficiary should make the client comfortable that wealth will not be passed exclusively for the spouse instead of the intended beneficiary, without good reason.  In the event that the descendant-beneficiary dies leaving minor children, distributions to his or her surviving spouse may be an effective support tool for such children (e.g., paying a mortgage for the home in which the descendant’s surviving spouse and minor children are living).  Including the spouse of the intended beneficiary also provides an opportunity to shift the trust’s income to an individual beneficiary even when other considerations may otherwise cause a Trustee to withhold distributions to the intended beneficiary and be forced to pay taxes at the trust’s compressed brackets.

Charitable Remainder Trusts

Charitable remainder unitrusts (CRUTs), of which an intended beneficiary is the non-charitable beneficiary and receives a percentage unitrust payout each year, could be used not only to shift the payment of income tax to an intended beneficiary but also to defer the payment of income taxes on a trust’s DNI.  The charitable remainder trust (“CRT”) itself is exempt from income tax under Code Sec. 664 (although unrelated business income received by the CRT will be subject to a 100% excise tax) so the distribution from the client’s trust to the CRT will shift the trust’s income to a non-taxable entity.  Eventually, the non-charitable beneficiary includes in his or her income the income paid out pursuant to the CRT instrument.  If the CRT is structured as a “net income with make-up” charitable remainder unitrust (also known as a “NIMCRUT”), the payment of income tax may be deferred for a significant period of time if the fiduciary accounting income is less than the annual unitrust amount, during which time the assets held by the CRT will grow free of income tax.  When the unitrust amounts are “made-up”, the distributions will be taxed to the non-charitable beneficiary at his or her own individual rates. 

However, to be a CRT described in Code Sec. 664, it must, among other things, be “a trust with respect to which a [charitable] deduction is allowable under section 170, 2055, 2106, or 2522….” Reg. 1.664-1(a)(1)(iii)(a). Reg. 1.664-3(b), which allows additional contributions to a CRUT if the requirements of that regulation are met, has no requirement of a further charitable deduction. This suggests that distributions be made only to a pre-existing charitable remainder trust that holds at least some property that qualified for a charitable deduction.  Hence, distributions likely should be made only from the primary trust to CRUTs (or NIMCRUTs) and not charitable remainder annuity trusts, which cannot accept additional contributions. And they must be pre-existing CRUTs or NIMCRUTs because the distribution from the primary trust to a CRT likely will not produce any charitable deduction under Code Sec. 170, 2055, 2106 or 2522.

S Corporation or QSST

To be a QSST, a trust must have one beneficiary and require that all fiduciary accounting income (“FAI”) be paid out to that beneficiary.  However, a QSST is not necessarily entitled to a distribution from the S corporation that it owns, and accordingly may not have any FAI to distribute.  Simultaneously, the S corporation’s income, whether distributed to a shareholder (such as the QSST) or not, must be included in the shareholder’s income for income tax purposes.  Therefore, the beneficiary of the QSST must include the income that “passes through” to the QSST from the S corporation in the beneficiary’s income for tax purposes, regardless of whether the QSST (and hence the beneficiary) actually receives any of the income.

Because of this disconnect, it is possible to shift DNI to the beneficiary of the QSST for income tax purposes while accumulating income and principal in the S corporation, without making any distribution to the QSST (or the QSST beneficiary).  This allows for the insulation of the assets from the creditors of the beneficiary until actually distributed, while also reducing the tax on the income otherwise earned by the client’s trust – the original trust’s DNI, distributed to the S corporation, is taxed through to the beneficiary of the QSST owner of the S corporation, and thus able to benefit from the beneficiary’s income tax brackets, even though no income was actually distributed to the beneficiary.

For beneficiaries who receive or could potentially receive need-based government benefits, the imputed income from the S corporation should not disqualify the beneficiary from receiving such benefits as long as the income is not actually distributed to the QSST, although additional explanation to the office administering the benefits may be required.  (It should be noted, however, that the imputed income to the beneficiary may be an issue for the pension “aid and attendance” benefit from the VA.).  It would be important, however, for the structure of the plan to be correct.  For instance, the beneficiary should not create the QSST or transfer assets to it.  Doing so would make the trust a self-settled trust by the beneficiary for purposes of resource testing for government benefits and the assets of the trust (and possibly also of the S corporation) would likely be attributed to the beneficiary.  Instead, the client or the Trustee of the client’s trust should create and fund the QSST and the S corporation.  Further, the QSST for the benefit of an individual who needs to qualify for government benefits should not be the controlling shareholder of the S corporation and the Trustee of the QSST should not have the power either as a shareholder of the S corporation or as a manager of the S corporation to cause the S corporation to make distributions to the QSST.  It may also be beneficial to make the QSST a supplemental needs trust with respect to the principal. 

Conclusion

Planning in an uncertain tax environment is hard, but you can focus your drafting on providing better tools for the Trustee to cope with known issues like the compressed tax brackets for trusts and the need for creditor protection for some beneficiaries.  By providing the Trustee with additional methods of making distributions that will benefit the intended beneficiaries of the client’s wealth but with potentially better tax results, changing circumstances – whether it is a changing income tax environment or a beneficiary’s changing circumstances – may not prove an insurmountable challenge.

---

Meet the Authors