Volume 3, Issue 2

This issue of our newsletter addresses a law change that is important to all wealth planning professionals and their clients. Beginning January 1, 2008 and continuing through at least 2010, a zero tax rate may apply to long-term capital gain and dividend income that would otherwise be taxed at the regular 15% and/or 10% rates. The new zero tax rate is available to the extent that the taxpayer’s other taxable income minus exemptions and deductions is less than a specified amount.

The new zero tax rate thus creates the opportunity for eligible clients to sell certain appreciated assets at no tax cost. By coordinating their efforts to ensure that clients take advantage of this opportunity, the planning team can preserve more of the client’s investible assets or provide resources to fund implementation of the planning team’s recommendations.

The Zero Tax Rate

The zero tax rate applies to eligible individual taxpayers who have “adjusted net capital gain.” Adjusted net capital gain is the sum of:

Net capital gain (generally the excess of net long-term capital gains other than collectibles gain, gain taxed on sales of certain small business stock under IRC Sec. 1202, and unrecaptured IRC Sec. 1250 gain over net short-term capital losses, subject to certain limitations),

plus

Qualified dividend income (generally dividend income from domestic corporations and qualified foreign corporations, including dividends from U.S. possessions corporations and corporations eligible for benefits of a comprehensive income tax treaty with the U.S. that includes an exchange of information program; dividends that are not qualified include dividends from foreign investment companies, dividends from stock held for short periods, and payments in lieu of dividends).

Who Gets the Zero Tax Rate?

For tax years beginning January 1, 2008, the zero tax applies to individuals’ adjusted net capital gain to the extent that it does not exceed:

the threshold for the taxpayer’s 25% income tax bracket, minus

the taxpayer’s taxable income other than adjusted net capital gain.

For 2008, the threshold for the 25% income tax rate is:

• $32,550 for single taxpayers and married taxpayers filing separate returns;
• $65,100 for married taxpayers filing joint returns and surviving spouses; and
• $43,650 for heads of households.

Thus, taxpayers whose ordinary income plus net capital gains and dividend income not included in adjusted net capital gain exceeds their respective 25% income tax thresholds will not be eligible for the zero rate. Conversely, if their 2008 ordinary income plus net capital gains and dividend income not included in adjusted net capital gain is less than their respective 25% income tax threshold, the zero tax rate applies.

Examples

Example 1. Tom and Mary Taxpayer file jointly and have taxable income of $60,000 in 2008, comprised of $50,000 of ordinary income and $10,000 of adjusted net capital gain. Since the Taxpayer’s ordinary income is less than the 25% income tax threshold, the zero tax rate would apply to all of their $10,000 adjusted net capital gain.

Example 2. The Taxpayers have taxable income of $75,000 in 2008, comprised of $50,000 of ordinary income and $25,000 of adjusted net capital gain. In this case, $15,100 (the difference between their 25% income tax threshold and their ordinary income of $50,000) would be subject to the zero tax rate, and the balance, $9,900 ($75,000 – $50,000 – $15,100), would be subject to the 15% rate.

Example 3. The Taxpayers have taxable income of $75,000 in 2008, comprised of $70,000 of ordinary income and $5,000 of adjusted net capital gain. Since their ordinary income exceeds the 25% income tax threshold, none of their adjusted net capital gain would be subject to the zero tax rate – all $5,000 would be subject to the 15% rate.

Planning Tip: To the extent taxpayers have a gap between (1) their ordinary income plus net capital gains and dividend income not included in adjusted net capital gain and (2) their 25% income tax threshold, that gap can be taken up by adjusted net capital gain subject to the zero tax rate, even if they have income that is subject to higher rates.

Example 4. Frank and Susan Taxpayor file a joint return with adjusted gross income (AGI) of $225,000, consisting of $105,000 of wages, plus $120,000 of adjusted net capital gain. For 2008, the Taxpayors claim a total of $55,000 in personal exemptions and itemized deductions, resulting in taxable income of $170,000 ($225,000 AGI minus $55,000 in deductions). The zero rate applies to $15,100 of the Taxpayors’ adjusted net capital gain calculated using the formula above as follows:

the $65,100 maximum threshold for joint filers for 2008, minus

their $50,000 of regular taxable income ($170,000 taxable income minus $120,000 of adjusted net capital gain).

The $104,900 balance of the Taxpayors’ adjusted net capital gain ($120,000 minus $15,100) will be subject to the 15% rate.

Application of the “Kiddie Tax”

Also new for 2008 is that the “kiddie tax” (which applies to the child at his or her parents’ highest marginal rate on the child’s unearned income over $1,800) affects many more children.

For tax years before 2008, the kiddie tax applied only to children under 14. Effective January 1, 2008, a child is subject to the kiddie tax if he or she is (a) under 18; or (b) age 18, or a full-time student and 19-23 years old, and his or her earned income constitutes one-half or less of that child’s support.

Conclusion

The zero tax rate for adjusted net capital gains presents a significant opportunity for those clients whose ordinary income is less than their 25% income tax rate threshold (no matter how high their other income), as well as clients with college-aged children whose earned income is greater than one-half of their support. Like so many other areas, this is one where the client’s planning team needs to work together to ensure that clients pay the least amount of tax possible while still accomplishing personal goals and objectives. Paying no tax on eligible adjusted net capital gains can provide additional investible assets or increased liquidity to fund the planning team’s recommendations.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 3, Issue 1

This issue of our newsletter examines exciting new developments in business succession planning – specifically, the use of LLCs or partnerships to own life insurance for buy-sell planning purposes. Such a structure obtains the advantages of cross-purchase and stock redemption buy-sell agreements without many of the disadvantages of either traditional structure. This development is significant to all wealth planning professionals and their business-owner clients.

Background

For many business owners, the business itself is their primary source of income both during working years and in retirement. Thus, buy-sell planning is critical for not only death planning but also disability and retirement planning during lifetime.

Unfortunately, the two traditional types of buy-sell agreements ((1) stock redemption (aka entity purchase) and (2) cross-purchase agreements), have significant limitations and disadvantages that often prevent business owners from adequately preparing for many business succession issues.

Stock Redemption (Entity Purchase)

With a Stock Redemption arrangement, the corporation owns the life insurance and agrees to redeem the shares of a deceased shareholder at that shareholder’s death. The shareholder in turn agrees that his estate will transfer the shares back to the corporation for an agreed-upon price.

The advantages of this arrangement are:

1. The simplicity of only one life insurance policy per shareholder;
2. The shareholders allocate all premium costs according to their percentage ownership in the corporation; and
3. This arrangement ensures compliance with the terms of the buy-sell agreement.

The disadvantages of stock redemption arrangements are many:

1. There is no change to the surviving shareholders’ basis at the owner’s death so the surviving shareholders will incur larger capital gain tax upon a lifetime disposition;
2. The insurance policies are subject to attachment by the corporation’s creditors;
3. If the corporation is a C corporation, the death proceeds may also be subject to the alternative minimum tax (AMT);
4. If corporate-owned buy-sell policies are over-funded to provide non-qualified retirement benefits to the owners, the benefits are generally subject to income tax; and
5. Potential taxation on redemption of the stock to the extent of earnings and profits where the attribution rules of IRC Sec. 318 apply.

If the corporation is an S corporation, the results of a stock redemption arrangement are better, because the AMT and attribution rules do not apply where the business has always been an S corporation. Also, the life insurance cash value and death proceeds give the shareholder some stock basis adjustment, reducing the amount of capital gain tax that may be triggered on a sale during life or at death.

Cross-Purchase

Under a cross-purchase arrangement, each owner/shareholder owns a policy on every other owner, and each surviving owner agrees to buy the deceased owner’s interest directly from the deceased owner’s estate.

The advantages of this structure are:

1. The survivors use income-tax-free death benefit to buy stock directly from the decedent’s estate, thereby increasing their average share basis;
2. Use of the “wait and see” approach allows surviving shareholders to keep the insurance proceeds for themselves to the extent that retained corporate earnings are available to effectuate a redemption; and
3. Policies are protected from the corporation’s creditors.

The disadvantages of cross-purchase arrangements are:

1. The number of policies required to accomplish funding (each owner must own a policy on each other owner) quickly becomes unwieldy as the number of shareholders increases;
2. Policies are subject to attachment by the owner’s creditors;
3. An owner may fail to pay premiums or refuse to pay death benefits pursuant to the buy-sell agreement;
4. The premium burden is allocated based on the cost of insurance of each other owner; and
5. Application of the transfer-for-value rule (when surviving owners purchase from the deceased owner’s estate the policies on the other survivors) or need to buy new policies to cover increased values.

Use of LLCs to Structure and Fund Buy-Sell Agreements

In a recent Private Letter Ruling, PLR 200747002, the IRS accepted a strategy that has the advantages of both cross-purchase and redemption agreements without the disadvantages of either. With this structure, the shareholders execute a cross-purchase agreement and form an LLC, taxed as a partnership, to own the life insurance. The cross-purchase agreement and LLC operating agreement have provisions that reference each other.

Special provisions of the LLC include:

1. The LLC manager is a corporate trustee, and any replacement must be a corporate trustee;
2. Members cannot vote on life insurance matters;
3. The manager must use life insurance proceeds as required in the buy-sell agreement; and
4. The LLC must maintain a capital account for each member, with special allocations of premiums and proceeds.

Upon examination of this structure, the IRS ruled that the life insurance death proceeds would not be includible in the estate of the deceased LLC member. Thus, this structure contains the advantage of the traditional buy-sell structures without the disadvantages.

“LifeCycle” Buy-Sells

This ruling adopts an approach similar to the “LifeCycle” Buy-Sell Agreement, first written about in “Using a General Partnership to Structure and Fund Buy-Sell Arrangements,” by James C. Peterson and William S. White, from the January 2000 issue of the Journal of Financial Service Professionals.

There are some differences, however, between the PLR and “LifeCycle” structures, in particular:

1. The PLR uses term insurance – LifeCycle uses cash value insurance to also accomplish retirement planning objectives;
2. The PLR limited its ruling to funding a death buyout – LifeCycle can also be used for non-qualified retirement benefits; and
3. The PLR LLC has a more restrictive operating agreement – for example, LifeCycle does not require a corporate trustee as manager (only requires an independent trustee) and restricts a member against voting only on policies on that member’s life. Counsel who submitted the PLR believes that these more restrictive provisions are only necessary for those seeking a letter ruling.

Conclusion

Buy-sell planning is critical for business owners, but many defer implementation of a business succession agreement because of either the cost or tax disadvantages, or both, of the traditional buy-sell structures and common alternative. Use of an LLC or partnership to own the life insurance for a buy-sell arrangement eliminates both of these impediments and thus is much more attractive to business owners.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 2, Issue 12

For many clients, pets are members of the family. These clients often say that if something happens to them, they are more concerned with what will happen to their pets than to their children or spouse.

This issue of our newsletter examines the issues surrounding caring for pets after the disability or death of the pet’s owner. Given many clients’ feelings towards their pets, and the costs of care and longevity of some types of pets, this is an area where the planning team can differentiate itself and provide real client value while also generating additional revenue for multiple team members.

What Will Happen to the Pets When the Owner Becomes Disabled or Passes Away?

Most pet owners do not want their pets killed if something should happen to them. However, without proper planning, the death of the pet is almost certain in some areas. For example, in some Nevada counties, if the client does not provide for a pet by way of a trust, when the client dies Animal Control must take the pet to the local kill shelter if there is not a family member present who is willing to care for the pet. Some kill shelters euthanize animals 72 hours after they arrive at the facility, making it virtually impossible for anyone to adopt the pet. Clients can avoid this unintended and unfortunate result by creating a trust that names a caregiver for their pets.

Alert Card including the owner’s name, number of pets, and multiple caregivers’ names and phone numbers. Laminate the card and ask each client to place it in their wallet behind their driver’s license. If something happens to the client, someone searching for their identity will see the Pet Alert Card and know there are pets that need care.

Providing for Pets Upon the Owner’s Death

Outright Gifts

The law treats pets as property. Because property cannot own other property, money and other property cannot be left or transferred outright to a pet. One can transfer or leave assets to a caretaker with the request that the caretaker care for his or her pets. However, because the caretaker receives the gift outright, no one is responsible for ascertaining whether a pet is receiving the care requested by the pet owner.

Once the caretaker receives the gift and the pet’s owner is gone or incompetent, there is nothing to stop the caretaker from having the pet euthanized, throwing it out on the street, taking it to a local kill shelter, or using the assets in ways unrelated to the care of the pet. In addition, once in the caregiver’s hands, the assets are exposed to the caregiver’s creditors and they may be transferred to a former spouse on the caregiver’s divorce.

Statutory Pet Trusts

As of August 1, 2007, thirty-eight states and the District of Columbia have enacted statues pertaining to pet trusts, and others have legislation pending. (See Beyer Animal Statutes for a listing of all states’ pet statutes.) These statutes allow virtually any third party designated by the terms of the trust to use the trust funds for the benefit of pets.

Some state statutes specifically limit the terms of a pet trust. For example, some states limit the amount of money an individual can leave in trust for their pet. In those states that have adopted the Uniform Trust Code’s pet trust provisions, the amount of money an individual can leave in trust for a pet cannot exceed the amount required to care for the pet over the term of the trust. The trust must distribute any excess funds to the person(s) or charity(ies) who would have taken had the pet trust terminated.

In making this determination, the level of pet care the owner provided determines the endowment amount required to provide care for the pet. Factors include: the cost of daily care (food, treats, and daycare), veterinary care (yearly teeth cleaning, shots, nail trimming, and emergency care), grooming, boarding, travel expenses, and pet insurance. Additional factors may apply in particular cases. For example, horses are expensive to maintain and require exercise, training, and a large tract of land; some birds and reptiles have very long life expectancies; and care of some pets will require construction of a special habitat on the caregiver’s property.

Traditional Trusts

Even if your state does not have a specific pet trust statute, a pet owner can name a human caregiver as the beneficiary of a trust, require that the distributions to the beneficiary are dependent on the beneficiary caring appropriately for a pet, and require the trustee to ensure that the beneficiary is properly caring for the pet using trust assets. This type of trust may be used without regard to whether the state has a specific pet trust statute.

Funding Pet Care

Many pet owners do not have sufficient funds to properly care for their pets after their disability or death. Life insurance is one way to increase funds available to care for pets after the pet owner’s death.

Trust Terms

In addition to stating that it is the client’s intent to create a trust for the benefit of (or to provide funds adequate for the care of) his or her pet, the trust should specifically name a succession of caregivers/beneficiaries and a separate trustee to ensure that the serving caregiver/beneficiary is properly caring for the pet. The trust should also allow the trustee to reimburse the caregiver/beneficiary for all pet expenses with proper documentation, have access necessary to determine whether the pet is receiving the intended care, and withhold distributions to the caretaker/beneficiary if the pet is not receiving the intended care. If your state statute does not limit the trust terms, the client can include anything that is not illegal or against public policy.

Here are several issues for client consideration:

• Creating a pet panel to offer guidance to the trustee and caregiver/beneficiary, and to remove and replace the trustee and caregiver/beneficiary, if necessary. Consider including a veterinarian to make the final decision regarding euthanization for medical reasons, to ensure that the pet is not euthanized prematurely by the caregiver/beneficiary.
• Paying the caregiver/beneficiary a monthly fee for caring for the pet or allowing the caregiver/beneficiary to live in the client’s home, rent free.
• Awarding a bonus to the caregiver/beneficiary at the end of the pet’s life as a “thank you” for taking care of the pet.
• Determining how the trustee is to distribute the remaining trust funds after the last pet dies.

If the client chooses not to create a pet panel to determine who will be a successor caregiver/beneficiary, the trust should name multiple successor caregivers/beneficiaries (three or more) in case a caregiver/beneficiary is unwilling or unable to serve. As a final back-up, the client should consider requiring the trustee to give the pet to a no-kill animal sanctuary if there are no caregivers/beneficiaries available. This can literally save the pet’s life.

Pet Identification

To prevent the caregiver/beneficiary from replacing a pet that dies to continue receiving trust benefits, the pet owner should specify how the trustee can identify the pet. The client should consider micro-chipping the pet or having DNA samples preserved for verification.

Other

You may encounter pet owners who want their healthy pets euthanized when they become incapacitated or die, thinking “no one can care for my pets as well as I do.” However, many states’ courts have invalidated such euthanasia provisions on the basis that destruction of estate property is against public policy. In these states, encourage clients to consider using no-kill organizations that have the pet’s best interest in mind and will find the next best home for their pets. Again, this is a state-specific question and thus it is critical that advisors know their state’s laws in this area.

Conclusion

Many clients are oblivious to the issues surrounding the care of their pets after their disability or death. By raising this issue with clients, the planning team can differentiate itself and provide value in an area that is significant to many clients, while also creating additional revenue for multiple team members.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 2, Issue 11

Before 2007, a non-spouse beneficiary of a qualified plan was stuck taking distributions under the terms of the plan, which typically required full distribution within five or fewer years of the participant’s death. The Pension Protection Act of 2006 (PPA 2006) authorized non-spouse beneficiaries (before it was only surviving spouses) to roll over to an Inherited IRA.

This issue of our newsletter looks at a very recent pronouncement from the IRS that finally makes this PPA 2006 provision useable and, therefore, is very beneficial to clients and all wealth planning professionals who understand its implications.

Apparent Good News in PPA 2006

PPA 2006 provides that, effective January 1, 2007, a non-spouse qualified plan beneficiary may be permitted to roll over to an Inherited IRA after the plan participant’s death.

The January 2007 IRS Roadblock

Unfortunately, the IRS focused on the “may” and quickly issued guidance that virtually eliminated the planning opportunity that PPA 2006 seemed to provide. In its January 29, 2007 Notice 2007-7, the IRS declared that a plan was not required to offer non-spouse rollovers, saying it was optional with the plan provider whether to adopt a plan amendment permitting non-spouse rollovers. Therefore, absent a voluntary plan amendment, a non-spouse was stuck using the plan’s payout period. And major plan providers did not offer such amendments to their prototype plans.

The October 2007 IRS Roadblock Removal In late October the IRS issued its 2007 Interim and Discretionary Amendments, as follows:

“Section 402(c)(11) [Discretionary]: PPA ’06 . . . added Section 402(c)(11) to allow nonspouse beneficiaries to roll over distributions from a qualified plan to an individual retirement plan. Nonspouse beneficiary rollovers are an optional plan provision for 2007. See, Notice 2007-7. Pursuant to an impending technical correction, nonspouse beneficiary rollovers will be required for plan years beginning on or after January 1, 2008.” (Emphasis added.)

This amendment appears to be in anticipation of a Congressional change to PPA 2006 to make it mandatory that qualified plans permit non-spouse rollovers. The full text of the IRS document is at www.irs.gov/retirement/article/0,,id=173372,00.html.

What Does All This Mean for Your Clients?

Beginning January 1, 2008, non-spouse beneficiaries finally will be able to take advantage of the PPA 2006 provisions and roll over from a qualified plan into an Inherited IRA. In the Inherited IRA, the non-spouse beneficiary can use his or her own life expectancy to determine annual required minimum distributions (RMDs). This can significantly reduce the amount that the beneficiary must withdraw each year, thereby deferring income tax and allowing the account balance to continue to grow income tax free.

Implementation of a non-spouse rollover raises numerous pitfalls for the unwary. These pitfalls are identified in the Planning Tips that follow.

Planning Opportunities

The IRS’s change of position means that additional planning options are now available for non-spouse beneficiaries of qualified plans. These options include those listed below, which were outlined in greater detail in a prior issue of The Wealth Counselor:

• Name a Retirement Trust as beneficiary to ensure the longest term payout possible, while also ensuring consistent account management – in the manner desired by the client using the client’s advisors – oftentimes over generations.
• Give the accounts to charity at death and replace with insurance owned by a Wealth Replacement Trust.
• Take the money out during lifetime and buy an immediate annuity to provide a guaranteed annual income, to pay the income tax, and to pay for Insurance owned by a Wealth Replacement Trust.
• Take the money out during lifetime and pay the income tax, then gift the remaining cash through an Irrevocable Life Insurance Trust or other Irrevocable Trust.
• Name a Charitable Remainder Trust as beneficiary with a lifetime payout to a surviving spouse; the remaining assets passing to charity at the death of the spouse.
• Give up to $100,000 from IRAs directly to charity before December 31, 2007.

Asset Management Opportunities

Experience teaches that beneficiaries often frustrate the stretch-out plans of the decedent and squander their opportunity for tax-free growth by withdrawing far more than the required minimum distributions. However, if the participant names a trust as beneficiary of the qualified plan, PPA 2006 provides that the trustee of that trust may roll over from the qualified plan into an Inherited IRA for the benefit of the trust beneficiary. Clients who name a trust as beneficiary of their qualified plan account can thereby protect the assets from creditors (including loss in a beneficiary’s divorce) and the beneficiary from the temptation to be a spendthrift.

Conclusion

The IRS now requires that all qualified plans permit non-spouse rollovers for plan years beginning on or after January 1, 2008. This “about face” means that all non-spouse beneficiaries will be able to roll over from qualified plans to Inherited IRAs rather than be stuck with shorter payout under the plan provisions. This will permit the planning team to implement the right strategy to meet the client’s unique planning objectives.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

Volume 2, Issue 10

The last issue of our newsletter examined trusts and the asset protection benefits provided to trust makers and their beneficiaries through the utilization of ongoing trusts. This issue of our newsletter addresses related and important questions about the taxation of trusts, which are important to all wealth planning professionals.

Trusts are Separate Taxpayers

All trusts are separate taxpayers. Unless disregarded under the exception for grantor trusts discussed below, each trust has its own tax year and tax accounting method. Trusts also receive income and pay expenses. Net income is taxed either to the trust or to the beneficiaries, depending upon the trust terms, local law and, in the cases of complex trusts (defined below), whether the trust distributed the income.

A trust’s distributable net income (DNI) determines the amount of the distribution the trust can deduct, and the amount the beneficiary must report as income. Thus, DNI acts as a ceiling on the amount of the deduction a trust can take for distributions to beneficiaries. DNI also acts as a ceiling on the amount of the distribution that the beneficiary must account for on his or her income tax return.

An explanation of the DNI calculation is beyond the scope of this newsletter. However, it is important to note that this is an area where the client’s wealth planning team must work together to ensure that the income taxation flows as the client desires. For example, as a general rule, capital gains will be subject to taxation at the trust level except in the year the trust terminates. However, if the client so desires and if it is permissible under state law, the lawyer can draft the trust agreement so that it defines trust income to include capital gains, thereby passing the capital gains tax liability to the beneficiary.

Simple vs. Complex Trusts

The Internal Revenue Code defines a simple trust as a trust that:

1. By its terms must distribute all of its income (meaning fiduciary accounting income) currently;
2. Makes no principal distributions; and
3. Makes no distributions to charity.

The regulations to the Internal Revenue Code define a complex trust as a trust that is not a simple trust; in other words, a trust that:

1. Is allowed by its terms to accumulate income;
2. Makes discretionary distributions of income or mandatory or discretionary distributions of principal; or
3. Makes distributions to charity.

Grantor Trusts

The Internal Revenue Code defines a grantor trust as a trust in which the trust maker has one or more of the powers specifically described in Sections 673 to 677. A trust can also be a grantor trust as to a beneficiary where the beneficiary has one or more of these same powers if the beneficiary also has or had the power over the trust principal described in Section 678. To the extent a trust is a grantor trust, it functions as a conduit; in other words, all of the income, deductions, credits, etc., flow through to the trust maker or beneficiary and are subject to tax on their own personal tax return, regardless of whether the trustee makes distributions from the trust. The general rules governing the income taxation of trusts and their beneficiaries do not apply to grantor trusts due to application of these rules.

It is now clear that with a grantor trust, the grantor’s payment of the trust income tax does not constitute a gift to the trust beneficiaries. Thus, for those clients who are willing to pay this tax, grantor trusts are also excellent vehicles to leverage gifts to beneficiaries.

Grantor Trusts and Life Insurance

Grantor trusts also can be very useful in the context of transfers of life insurance. When transferring life insurance (for example, from the insured to avoid estate tax inclusion or to a “new” irrevocable life insurance trust), consider selling the policy for full and adequate consideration to a trust that is a grantor trust as to the insured. As long as the sale is for the policy’s full fair market value, such a transfer will avoid the three-year estate tax inclusion rule, and it will not invoke the transfer-for value rules.

Compressed Income Tax Brackets for Trusts

A frequent objection to the accumulation of trust income is the fact that trusts pay federal income tax according to a compressed rate schedule. In other words, trusts pay the maximum federal income tax rate of 35% at only approximately $10,500 of income per year in 2007, compared to approximately $350,000 for single taxpayers, heads of household, or those married filing jointly.

On its face, it appears that it may be costly from an income tax perspective to accumulate trust income. However, the critical questions are, what type of income is it and, if interest or rent income, will accumulation result in additional tax? In other words, what are the relative tax rates of the beneficiaries?

Furthermore, trust makers can give a trustee the ability not only to distribute directly to a beneficiary (which is not good for asset protection), but also the discretion to make distributions on behalf of a beneficiary such as to pay rent, medical expenses, tuition, credit card bills, etc.

Conclusion

A working knowledge of the taxation of trust income is important for the client’s entire wealth planning team. By working together, the team can often minimize the overall tax impact and help ensure that our plan meets the client’s unique planning objectives.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.