A trustee is responsible for administering a trust for the benefit of the beneficiary or beneficiaries. Unless the beneficiary is also a trustee, he or she will not have direct access to information regarding the investments, debts, liabilities, expenses, receipts and other financial arrangements of the trust. Without a mechanism for learning this information, the beneficiary might worry that assets will run out, the trustee might misuse funds, or another problem will occur. Therefore, Missouri law, and the law of those states that have adopted similar provisions from the Uniform Trust Code (UTC), provides that a trustee must provide specific information and an annual report to certain beneficiaries so their interests may be protected.

The Missouri Uniform Trust Code imposes upon a trustee a duty to inform and report. A trustee must keep the qualified beneficiaries of a trust “reasonably informed about the administration of the trust and of the material facts necessary for them to protect their interests.” RSMo §456.8-813.1. Under this statute, the trustee must send to the permissible distributees of trust income and/or principal, and to other beneficiaries who request it, an annual report “of the trust property, liabilities, receipts, and disbursements, including the source and amount of the trustee’s compensation, a listing of the trust assets and, if feasible, their respective market values.” RSMo §456.8-813.3. Such a report does not need to be prepared in any particular format or with a high degree of formality – in fact, according to the UTC commentary, the “requirement might even be satisfied by providing the beneficiaries with copies of the trust’s income tax returns and monthly brokerage account statements if the information on those returns and statements is complete and sufficiently clear. The key factor is not the format chosen but whether the report provides the beneficiaries with the information necessary to protect their interests.”

The Missouri statute does allow a beneficiary to waive the annual report requirement. It is typically waived in revocable trusts where the beneficiary is also the trustee and thus has direct access to the information.

Therefore, a trustee is statutorily required to provide an annual report in many circumstances. Even when this requirement is waived, a trustee should still consider preparing an annual report. In addition to the duty to inform and report, Missouri law also imposes upon a trustee a duty to administer the trust in good faith, a duty of loyalty, a duty of impartiality, a duty of prudent administration, a duty to incur only reasonable costs, and a duty to maintain adequate trust records. While there is no particular format or high level of formality required, an accurate, detailed and complete annual report not only demonstrates that the trustee has met its duty to inform and report, but also provides evidence that the trustee has fulfilled its other duties.

Further, such an annual report can be of great help to someone reviewing his or her estate planning. An up-to-date report provides the individual and his or her attorney, financial advisor and/or accountant with current financial information, consolidated in one document that can be used when considering new tax or estate planning strategies. Annual reports are particularly useful when there are estate/gift tax and GST exemption issues to consider in the individual’s estate plan.

If you are a trustee who needs assistance in preparing annual reports for trusts for which you are responsible, or you are a beneficiary questioning what information you are eligible to receive, or you have any other questions concerning annual trust reports, please contact a member of our Trusts & Estates Group.

This is part of a series of posts that will focus on the benefits and uses of corporate trustees. Please stay tuned for future Preservation posts on this topic. A roundup of posts in the series can be found here.

The Internal Revenue Service has released the Applicable Federal Rates (AFRs) for April 2018. AFRs are published monthly and represent the minimum interest rates that should be charged for family loans to avoid tax complications.

Here are the rates for April 2018:

The Section 7520 interest rate for April 2018 is 3.2 percent. The Section 7520 interest rate is the interest used in a common estate tax planning technique called a “grantor retained annuity trust” or “GRAT.” In general, the lower the interest rate, the more effective the transaction is for reducing estate taxes.

For more information, see the full listing from the IRS here.

Similar to individuals, trusts normally pay federal and state income taxes. In 2018, the highest federal rate of 37 percent only applies to single individuals if they have more than $500,000 of income and to married couples filing jointly if they have more than $600,000 of income. However, a trust will be in the highest federal tax bracket if it has more than $12,500 of income. (The maximum long-term capital gains and qualified dividends rate is now 20 percent for trusts with more than $12,700 of income.)

The combination of this 37 percent tax and the 3.8 percent Net Investment Income Tax (on interest, dividends, rents, royalties, capital gains, and passive trade or business income) means that most trusts will effectively have rates of 40.8 percent for ordinary income and 23.8 percent for long-term capital gains. Therefore, federal taxes take a big bite out of the investment returns of trusts before even considering state income taxes.

Trusts are only taxed on ordinary income that is not distributed to a beneficiary. Distributed income passes out to the beneficiary on a K-1 and must be reported on the beneficiary’s personal individual income tax return. Capital gains are almost always taxed to the trust, even if they are distributed to a beneficiary.

State income tax rates

There are seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Of the remaining states, the highest tax rate is California’s 13.3 percent and the lowest is Pennsylvania’s 3.07 percent. 

State taxation of trust income

Unless a trust is a resident of the state, the state can only tax the trust on “source income” that is connected to the state (such as rental income from real estate located in the state or income from a business located in the state). An individual is deemed to be a resident of a state if he or she is domiciled in that state.

Trusts are more complicated. A state can tax a trust based on the location of the creator of the trust, the trustee and/or the beneficiary. If the trust is a resident of the state, then the state can tax all of the trust income, not just the income connected to the state. Each state has its own definition of what is a resident trust. Due to these different definitions, it is possible for a trust to fall within more than one state resident trust definition and be subject to state income taxes in multiple states. It is also possible for a trust to not be a resident trust of any state and thereby avoid paying any state income taxes.

For example, a trust will be an Illinois resident trust if the trust is created by an individual domiciled in Illinois (thereby subjecting the trust to Illinois taxes forever). A trust will be a Missouri resident trust if the trust was created by an individual domiciled in Missouri and the trust had at least one income beneficiary who was a resident of Missouri on the last day of the taxable year. Kansas only treats a trust as a resident if the trust is administered in Kansas.

States where you can avoid income taxes

In states such as Kansas you can avoid state income taxes by moving the location of the trustee and administration of the trust to another state. Other states with similar resident trust definitions are Arizona, Colorado, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Massachusetts, Mississippi, Montana, New Jersey, New Mexico, Oregon, South Carolina, and Utah.

Therefore, if a trust is paying income taxes as a resident trust in one of these states, you may be able to avoid it with proper planning.

Incomplete Non-Grantor (ING) trusts

This same type of planning (avoiding a trust being treated as a state resident) can also be used to avoid state income taxes on an individual’s income. This works by an individual transferring income-producing property to an irrevocable trust that is designed to avoid being a resident trust in all 50 states. In most cases, this planning also only works for individuals living in the states mentioned above.

If you would like to discuss in more detail the state-level tax planning opportunities available for trusts, please contact a member of our Trusts & Estates group.

The Internal Revenue Service has released the Applicable Federal Rates (AFRs) for March 2018. AFRs are published monthly and represent the minimum interest rates that should be charged for family loans to avoid tax complications.

Here are the rates for March 2018:

The Section 7520 interest rate for March 2018 is 3.0 percent. The Section 7520 interest rate is the interest used in a common estate tax planning technique called a “grantor retained annuity trust” or “GRAT.” In general, the lower the interest rate, the more effective the transaction is for reducing estate taxes.

For more information, see the full listing from the IRS here.

When Michael Jackson died in 2009, he left behind a convoluted legacy that has presented issues for fans and tax collectors alike, and the legal repercussions are ongoing.

At the time of his death, Jackson’s reputation had suffered from allegations of child abuse, drug use and erratic behavior. The circumstances of his death, however, heightened fans’ sympathy for the tragic “King of Pop.” Because of this, Jackson’s estate is embroiled in a legal dispute with the IRS over the value of Jackson’s name and likeness.

In valuing Jackson’s estate for estate tax purposes, executors John Branca and John McClain valued Jackson’s name and likeness at only $2,105, citing his tarnished reputation. Not surprisingly, the IRS has taken issue with this low value, arguing that Jackson’s name and likeness should be valued at a whopping $434 million and assessing more than $700 million in taxes and penalties against the estate.

Further complicating the valuation of Jackson’s name and likeness is the post-mortem influx of revenue to the Jackson estate. As a result of the shrewd business decisions of Jackson’s executors, Jackson’s estate has flourished. The “This Is It” documentary of footage from the rehearsals for Jackson’s last scheduled tour grossed $290 million globally; Sony agreed to a $250 million deal to release 10 albums; two Cirque du Soleil tribute shows have gained over $360 million in box-office revenue; and the Sony Corp.’s acquisition of Jackson’s stake in Sony/ATV Music Publishing earned Jackson’s estate $750 million. These revenue streams have grown Jackson’s estate to record-breaking size.

The value of assets for estate tax purposes should be determined as of the date of death. The success of Jackson’s estate, however, calls into question the estate’s low valuation of Jackson’s name and likeness at that time. The IRS claims that each of the estate’s deals was foreseeable and should have been taken into account. Conversely, the estate argues that its success was a result of the business acumen of the executors, resuscitating the Jackson image despite Jackson’s estimated $400 million of debt and tarnished reputation.

The trial to determine whether Jackson’s estate owes estate taxes and the resulting penalties concluded in February 2017. In December 2017, the Tax Court determined that the IRS was barred from seeking the full amount of penalties initially sought because of failure to comply with certain procedural requirements. It remains to be seen how the Tax Court will value the estate and penalties, though the conclusion of this trial could have significant repercussions for how celebrities plan their estates. Stay tuned for updates.

On Dec. 22, 2017, President Trump signed into law what is commonly known as the Tax Reform and Jobs Act of 2017 (2017 Act). As explained in more detail below, the 2017 Act increased the estate, gift, and generation-skipping transfer (GST) tax exemptions. This legislation expires at the end of 2025 and the tax laws will revert to where they stood prior to the 2017 Act unless Congress makes additional changes before then.

Gift, estate, and GST tax laws for 2018 through 2025. The 2017 Act increased the estate, gift, and GST tax exemptions to $10 million per person, indexed for inflation (projected to be $11.18 million per individual in 2018, or $22.36 million for married couples). You can now make lifetime gifts up to a maximum of $11.18 million without incurring a gift tax. Any gifts made during your lifetime in excess of the annual exclusion ($15,000 in 2018) reduce the estate tax exemption available at death. If you make no taxable gifts during your lifetime, then you will have the full $11.18 million estate tax exemption available at death. The GST exemption now allows you to shield $11.18 million of gifts to grandchildren from the GST tax. Unless Congress acts sooner, the 2017 Act will be automatically repealed on Jan. 1, 2026, reverting to $5 million exemptions for estate, gift, and GST tax (to be adjusted for inflation).

Review your estate plan. In light of these increased exemptions, it is important to review your estate plan. Many wills and trusts include formula clauses that leave a certain amount of assets to individuals based on the exemption amount available at the time of death. With the change in exemptions, these formulas could drastically change your estate plan as you may not have anticipated, and your documents may even unintentionally disinherit someone.

An unprecedented opportunity to make gifts. The gift tax exemption is significantly larger than it has ever been, and larger that it was ever expected to be. Therefore, this may be the perfect time to make gifts. If you have a large enough estate that you expect to be paying an estate tax when you die, then it is more tax efficient to use the gift tax exemption while you are alive as opposed to using estate tax exemption when you die. The benefit of a lifetime gift is that all of the future income and appreciation on the gifted assets passes estate tax-free to the donee. For example, if you gave $11.18 million to a trust for your children in 2018 and lived another 20 years, then you would exclude $25 million (assuming income taxes are paid by you as grantor) more from your taxable estate than if you had waited until your death to use the $11.18 million exemption (assuming 6 percent annual growth). With a 40 percent estate tax rate, this excluded $25 million results in an estate tax savings of $10 million. However, it is also especially important to evaluate and consider the potential income tax impact of gifting certain assets.  

Discount planning. If you expect to pay estate taxes, making gifts of discounted assets (partial interests in partnerships, limited liability companies, and real estate) will continue to be important. IRS regulations meant to eliminate discount planning were never implemented, so this continues to be an effective planning tool.

Clawback. The 2017 Act directs Treasury to create regulations to address any difference in the exemption amount at the time of a gift and at the time of death. Some refer to this as a “clawback.” For example, if you make an $11.18 million gift in 2018 and die in 2026 when the gift tax exemption is $5.5 million and estate tax rate is 40 percent, your estate may owe over $2 million in estate taxes at your death due solely to the prior gift. It appears this is not what Congress intended and hopefully the regulations will clarify this.

Missouri estate tax laws. Missouri’s estate tax is equal to the federal credit for state estate taxes paid (referred to as “pick-up tax”). As there is currently no federal credit for state estate taxes (there is only a deduction), there will continue to be no Missouri estate tax.

Illinois estate tax laws. Illinois has an estate tax with a $4 million exemption. If a married couple uses a traditional credit shelter trust to take advantage of the full $11.18 million federal estate tax exemption in 2018, then, assuming the trust is fully funded at the death of the first spouse, there will be an Illinois estate tax in excess of $1 million. However, Illinois law allows your executor to make a special election, called a “QTIP” election, to defer the Illinois estate tax on any portion of your estate passing to a credit shelter trust for a surviving spouse so long as the credit shelter trust contains certain provisions. This would essentially create a separate QTIP trust for that portion of your estate that exceeds the $4 million exemption. As a result, instead of being subject to Illinois estate tax at the first spouse’s death, the value of the QTIP trust will be subject to such tax at the surviving spouse’s death. Therefore, if you wish to take advantage of this Illinois QTIP election, it is important to make sure that the trust terms will meet the requirements.

Undoing unnecessary planning. With the increased exemption, estate tax planning may no longer be needed for some clients. An estate plan that formerly provided estate tax benefits may now have negative income tax consequences. Your estate plan should be reviewed to determine if it should be altered or simplified. This may include terminating or modifying irrevocable trusts or liquidating partnerships or LLCs.

Estate planning continues to be important. Even with the increased exemptions, it will be important to plan to protect inheritances from creditors and divorce claims. Income tax planning for trusts will continue to play an important role due to the compressed trust income tax brackets. Avoiding state income taxes for trusts is also an overlooked area that should be reviewed.

Partnership audit rules. New partnership audit rules went into effect in 2018. These rules were not changed by the 2017 Act. All existing partnership agreements and LLC operating agreements (for LLCs that are taxed as partnerships) will need to be reviewed in 2018 to determine if changes need to be made based on these new laws.

Dividing assets among trusts. There is now a $10,000 limitation on the annual state and local tax deduction, which also applies to trusts. Consider dividing assets among several trusts to more fully utilize the deduction.

Business entity planning. Other areas that will be important in coming years are evaluating the most tax efficient business entity structure (S corporation, C corporation, partnership), and deciding whether it saves income taxes to be an independent contractor versus a W-2 employee based on the new 20 percent deduction for pass-through entities and sole proprietorships.

Flexibility. The key to estate planning in 2018 and beyond is drafting for flexibility, as we never know what the future brings. Your documents should contain provisions that account for the possibility of changes in the law, changes in your wealth, and changes in family circumstances. Also, consider whether including a “trust protector” in your estate plan could provide additional flexibility. 

If you would like to discuss the changes made by the 2017 Act or possible planning opportunities in more detail, please contact an attorney in our Trusts & Estates group.

The Internal Revenue Service has released the Applicable Federal Rates (AFRs) for February 2018. AFRs are published monthly and represent the minimum interest rates that should be charged for family loans to avoid tax complications.

Here are the rates for February 2018:

The Section 7520 interest rate for February 2018 is 2.8 percent. The Section 7520 interest rate is the interest used in a common estate tax planning technique called a “grantor retained annuity trust” or “GRAT.” In general, the lower the interest rate, the more effective the transaction is for reducing estate taxes.

How many times have you prepared your income tax returns for the previous year, only wishing you knew then what you know now, so you could go back and make more advantageous tax decisions? In most cases, you are stuck with the decisions you made before the new tax year began, even though you may not have all of the relevant tax information available to assist with those decisions until several months into the new tax year. Too bad for you, says the IRS, unless you are an estate or trust.

Under Section 663(b) of the Internal Revenue Code, any distribution by an estate or trust within the first 65 days of the tax year can be treated as having been made on the last day of the preceding tax year. For example, a distribution of $500 of trust income by the trustee to a beneficiary on Jan. 22, 2018, can be treated as having been made in the 2017 tax year or the 2018 tax year. In most years (including 2018), the last day to make a distribution count toward the previous tax year is March 6; but in leap years (next in 2020) the last day is March 5.

The election to treat the distribution as being made in the previous tax year must be made by the fiduciary on a timely filed income tax return (including extensions) for the tax year to which the distribution is meant to apply. A fiduciary may make the election for only a partial amount of the distribution(s) within the 65-day period, but once made the election is irrevocable.

The main advantage of this tax rule is that it may provide an opportunity for tax savings. An estate or trust pays income taxes at graduated rates similar to individuals, but for 2017 the top tax rate (39.6 percent) applies to income in excess of $12,500. However, married couples filing jointly pay the top rate when income exceeds $470,700 (or $418,400 for single filers). In some cases, an additional 3.8 percent Medicare surtax (also known as the Net Investment Income Tax) on the net investment income of the estate or trust may apply, resulting in a total marginal tax of 43.4 percent. To avoid paying such a high tax rate, income from the estate or trust may be distributed to a beneficiary, and the beneficiary will then pay any income taxes associated with the distribution, rather than the estate or trust, at the beneficiary’s individual tax rate. For example, a beneficiary who pays income taxes at a rate of 25 percent would pay less income tax on the distribution amount than a trust already paying at the top rate of 39.6 percent (or even 43.4 percent). In cases of estates or trusts with large taxable income and beneficiaries in lower tax brackets, the tax savings can be significant.

State income tax consequences may also apply to distributions made from a trust or estate, and there may be limitations on the amounts of distributions a fiduciary can apply using the 65-day rule. It is recommended that you discuss all possible consequences with your tax advisor before trying to apply the rules discussed above.

This is an updated version of a post originally published on Dec. 14, 2016.