Possibly obscure trust taxation question

[SecondCor521]

My Mom died last year and some of my parents' assets ended up in a marital bypass/credit shelter trust.

This year the assets in the trust are generating income, and I've figured out that it makes sense to distribute most of that income to my Dad (the current beneficiary) because it'll get taxed preferentially on his return rather than the trust return.

The trust will still owe a small amount of taxes on the income that it retains. I can imagine two relatively easy ways to pay those taxes:

1. Withhold taxes from the distribution to my Dad. If we do this, is this something Vanguard can do? The trust and my Dad's other accounts are both at Vanguard and he can see them in his online login. I got the impression from talking with Vanguard that as far as their concerned, if my Dad wants to take a distribution, he just transfers money online from one account to the other.

2. Pay the taxes next April. I'm slightly worried about an underpayment penalty, but this is the first year that the trust will exist and owe taxes, so I'm hoping/guessing that the government will give us a pass.

 

[SecondCor521]

Never mind. I remembered I had my Dad order checks for the trust account already and we're just going to send in an estimated tax payment in December.

 

[ERD50]

.... I've figured out that it makes sense to distribute most of that income to my Dad (the current beneficiary) because it'll get taxed preferentially on his return rather than the trust return. ...

Why 'most'? Why not distribute ALL the income? As you say, it will just be taxed at the higher tax rates and lower brackets of a trust. With no retained income, I don't think the trust will need to file taxes either - simpler.

Also, if Vanguard charges based on a % of trust assets, that's another ding against holding anything extra in the trust.

-ERD50

 

[SecondCor521]

Good questions.

It is a very small optimization, but it is better to have the trust fill up and pay taxes at the lower tax brackets than distribute it all and have my Dad pay taxes at his higher tax bracket.

The trust will have to file a federal income tax return regardless of whether it distributes none, some, or all of the income because the IRS will be receiving income tax forms (1099's and whatnot) regarding the trust income and will want to know that taxes were paid on that income (either by my Dad or by the trust).

Vanguard charges us nothing for the trust, other than the usual expense ratios on the mutual funds inside of the trust.

 

[Dash man]

Why 'most'? Why not distribute ALL the income? As you say, it will just be taxed at the higher tax rates and lower brackets of a trust. With no retained income, I don't think the trust will need to file taxes either - simpler.



Also, if Vanguard charges based on a % of trust assets, that's another ding against holding anything extra in the trust.



-ERD50

Agreed. And a hefty fee will be charged for filing the trust’s tax return.

 

[ERD50]

Good questions.

It is a very small optimization, but it is better to have the trust fill up and pay taxes at the lower tax brackets than distribute it all and have my Dad pay taxes at his higher tax bracket.
....

Ahhh, OK, I guess if the retained income is small, it would be taxed at 15%, and your Dad as single could easily be higher than that . Single $37,950 is the start of the 25% bracket, estate is 15% up to $2,550.

https://www.putnam.com/literature/pdf/II952.pdf.

But as Dash Man says, check the cost of filing a 1041. I don't think the IRS will be looking for you to file, if income is below some threshold it isn't required, right? Hmmm....

How to Report Irrevocable Trust Income Taxes to the IRS | Finance - Zacks

Form 1041
The trustee must file Form 1041 if the trust has any taxable income for the year or if it has at least $600 in income for the year even if none of it is taxable.

OK, that's a pretty low bar - $600 of any sort of income.

-ERD50

 

[SecondCor521]

Thanks for the double check, I appreciate it.

Trust income will be mostly dividends and MF distributions in the modest five figure range. Now-single Dad looks like he will be taxed at 28%.

At equal tax rates, it becomes a question of where to keep money. Dad doesn't need the income at the moment, and there are potential estate tax concerns, so better to keep it in the trust (which will forever be federal estate tax free).

 

[Dash man]

Thanks for the double check, I appreciate it.

Trust income will be mostly dividends and MF distributions in the modest five figure range. Now-single Dad looks like he will be taxed at 28%.

At equal tax rates, it becomes a question of where to keep money. Dad doesn't need the income at the moment, and there are potential estate tax concerns, so better to keep it in the trust (which will forever be federal estate tax free).

I’m curious how the trust is Federal Estate tax free?

 

[GrayHare]

Certain versions of Turbotax will fill the 1041 form for you. Your state may or may not also require a trust return, and that part is likely not handled by Turbotax.

 

[CaliKid]

I don't know the answer but a lot of bypass trusts state that "all income" shall be distributed. You might double check language.

 

[Dash man]

I don't know the answer but a lot of bypass trusts state that "all income" shall be distributed. You might double check language.

We’ve set up our trusts to distribute all income to avoid Trust taxes and fees charged by the trust administrator to prepare the return.

 

[SecondCor521]

I’m curious how the trust is Federal Estate tax free?

It's a marital bypass or credit shelter trust - I think those are the proper terms, anyway. The assets in it are considered part of my Mom's estate, and since, when she died, her estate was under the federal estate tax limit at the time of her death, there will be no further estate tax due on those assets regardless of how large they may grow.

On the flip side, the assets got a step up in basis to the date of her death but my understanding is that when they are eventually distributed to her children there will not be a further step up in basis then. So any capital gains taxes her kids might ultimately pay will be based on prices from 2016.

 

[SecondCor521]

Certain versions of Turbotax will fill the 1041 form for you. Your state may or may not also require a trust return, and that part is likely not handled by Turbotax.

My Dad has a CPA do his taxes, and my expectation is that he will have the CPA do the 1041 also. His CPA is pricey compared to Turbotax, but he likes knowing they're done right and he can easily afford it.

His taxes are getting simple enough to where I could probably do them, but I'm not sure he would feel comfortable with that.

I don't know the answer but a lot of bypass trusts state that "all income" shall be distributed. You might double check language.

Yeah, I already did. The trust language says that distributions are at the discretion of the Trustee, who is my Dad.

 

[meierlde]

Certain versions of Turbotax will fill the 1041 form for you. Your state may or may not also require a trust return, and that part is likely not handled by Turbotax.

Turbotax business does 1041s for trusts as well as partnerships and estates.
The trust then sends a K-1 to the beneficiary with for the income transfered (as does an estate).

Note that preparer fees are deductable on form 1041 as well. So at a minimum you want to withhold the preparer fee from the
beneficiary so it can be deducted.

 

[Dash man]

It's a marital bypass or credit shelter trust - I think those are the proper terms, anyway. The assets in it are considered part of my Mom's estate, and since, when she died, her estate was under the federal estate tax limit at the time of her death, there will be no further estate tax due on those assets regardless of how large they may grow.



On the flip side, the assets got a step up in basis to the date of her death but my understanding is that when they are eventually distributed to her children there will not be a further step up in basis then. So any capital gains taxes her kids might ultimately pay will be based on prices from 2016.

We also have a credit shelter trust provision in our revocable trusts. Our attorney told us the only way to avoid estate taxes was to keep the value of the estate under the Federal limits by gifting, spending or removing assets from the estate. and our trusts are designed to combine our exemptions when the first of us passes. But you said the trust value was under the limit when your mom died, so that’s why there’s no estate tax. It’s not because of the type of trust.
Our trusts will be split into several trusts for our descendants after any taxes are paid (if needed), and other beneficiaries will receive funds directly distributed to them.

 

[SecondCor521]

Note that preparer fees are deductable on form 1041 as well. So at a minimum you want to withhold the preparer fee from the
beneficiary so it can be deducted.

Right. I've made a note to have him pay the preparer fees for the trust taxes via a check from the trust. Thanks.

 

[SecondCor521]

We also have a credit shelter trust provision in our revocable trusts. Our attorney told us the only way to avoid estate taxes was to keep the value of the estate under the Federal limits by gifting, spending or removing assets from the estate. and our trusts are designed to combine our exemptions when the first of us passes. But you said the trust value was under the limit when your mom died, so that’s why there’s no estate tax. It’s not because of the type of trust.
Our trusts will be split into several trusts for our descendants after any taxes are paid (if needed), and other beneficiaries will receive funds directly distributed to them.

Emphasis added...Right, I was just mentioning the type of trust as a preamble, and I thought relevant piece of information, to the salient point.

But what I wrote was that my Mom's estate size was under the federal limit when she died. The size of my Mom's estate and the size of the trust ended up to be two different numbers.

Without getting into too much private detail, my parents live/d in a community property state and without this trust it would have been more likely that one or both of them would have paid federal estate taxes. The amount to which this trust was funded was a carefully crafted trade off between multiple factors.

The trust in question was funded *after* my Mom's death as a combined result of her will, a separate marital trust document, a marriage settlement agreement, TEDRA, and the community property laws in their state.

You have the overall picture right, though - the intent was to avoid "wasting" the first person's federal estate tax exemption amount while preserving the assets for the use of the remaining spouse if needed, then passing the assets to the kids after the second spouse's death. Sounds like your plans are doing a similar sort of thing.

 

[Dash man]

Emphasis added...Right, I was just mentioning the type of trust as a preamble, and I thought relevant piece of information, to the salient point.

But what I wrote was that my Mom's estate size was under the federal limit when she died. The size of my Mom's estate and the size of the trust ended up to be two different numbers.

Without getting into too much private detail, my parents live/d in a community property state and without this trust it would have been more likely that one or both of them would have paid federal estate taxes. The amount to which this trust was funded was a carefully crafted trade off between multiple factors.

The trust in question was funded *after* my Mom's death as a combined result of her will, a separate marital trust document, a marriage settlement agreement, TEDRA, and the community property laws in their state.

You have the overall picture right, though - the intent was to avoid "wasting" the first person's federal estate tax exemption amount while preserving the assets for the use of the remaining spouse if needed, then passing the assets to the kids after the second spouse's death. Sounds like your plans are doing a similar sort of thing.

Yes, same goal. We’re not a community property state, but each have a child from a previous marriage that creates its own difficulties under Pennsylvania law.