[With apologies to non-lawyers, this article was written to estate planning attorneys.]
Family farms are my favorite planning niche. It is easy to share the clients’ passion, since I grew up on a farm that was lost to the crises of the early 1980s. Keeping the farm in the family is a common client objective. Some parents want to place heavy-handed restrictions on sale of land, tying the hands of the beneficiaries. I caution against that. But more clients have a mindset of, “after all the challenges we overcame to build this farm, let’s do whatever we can to limit the risks that the next generation might encounter.”
What sort of risks? The top three “predators” tend to be lawsuits, divorces, and catastrophic health crises. A fourth, especially in today’s political climate, is future estate taxes. To achieve such protections I have long been a proponen of leaving assets to beneficiaries in protective trusts. Such a trust is written into the terms of the parent’s living trust, to take effect on the clients’ death. So long as the client is living, it is easily amended and should be regularly updated (to take advantage of new opportunities under the Illinois Trust Code, add new innovations, or adjust to the latest tax law) so that when the trust actually takes effect at the client’s death it will take advantage of the latest and best available drafting.
For the clients who want to restrict and control from the grave, perhaps the off-putting name “spendthrift” trust is appropriate. But for those who want to transfer protected assets and effective control to their successor, a “beneficiary-controlled asset protection” trust is a better moniker.
When leaving the farm to beneficiaries in trust, have you ever heard, “Beneficiaries don’t want their inheritance in trust because the income taxes are higher”? Or, perhaps an objection of a farming heir is, “because we can’t use the inherited land as collateral.” These objections are not well founded. With proper counsel and well-drafted documents, our clients can have their cake and eat it too.
Let’s say client Alice has absolute faith in her farming son Ben and intends to leave him his inheritance outright and free of trust. She has no “control from the grave” desires at all. But she wants to provide any advantages that she can, such as the protections from predators. Thinking that Ben is hard-working and building an estate in his own right and that the country may be headed for reduced estate tax exemptions, she sees that what Ben inherits outright would increase his taxable estate and potentially cause more estate taxes at his death. How might we design her plan so at her death it will give Ben maximum flexible control plus the predator and future tax protections?
Trusteeship and Investment Authority: Under the Illinois Trust Code Ben (the beneficiary) can serve as a trustee. Give him sole authority over investment decisions and administrative functions. These could be virtually unlimited: buy, sell and trade, lease, loan, and borrow, real and personal property, not limited by any Prudent Investor Rule.
Distributions: Ben as a trustee should not have sole authority over distributions. Require that he appoint an independent co-trustee to share equal authority over discretionary distributions of the income and assets of the trust. This distribution co-trustee could be replaced at will by Ben, but no distributions can be made except with the approval of an independent co-trustee. These discretionary distributions should be limited by ascertainable standards of health, education and maintenance.
Future Disposition: Alice doesn’t claim to have a crystal ball and trusts Ben to control the future of the farm. So, she gives him a power to appoint any assets that remain in trust at his death. A general power would be unlimited, but the assets would be included in his taxable estate. So, to keep the trust and all growth out of Ben’s taxable estate, she gives him a very broad limited power to appoint on death to anyone except Ben’s own estate, his creditors or creditors of his estate. She has created a generation-skipping trust.
Once Ben sees how much control he will have of the inheritance in trust, a common question I get is, “In addition to what I inherit, can I add my own land or other assets to this protected trust?” The answer is “No”—Illinois does not give the predator protection to self-funded trusts with retained control and benefits—but the question shows that the benefits of the trust are clear. Ben then asks, “Can I grow the trust?” This points us back to proper estate planning.
When planning, some clients might say “OK, I will give my land to the kids in trusts, but the life insurance and money should go outright and free of trust.” Why? Doing so ties the beneficiaries’ hands! A smart beneficiary doesn’t want it outright and free of trust, because once he gets it that way, it is his own and he cannot put it in the inherited trust. So as planning attorneys, we need to make sure we help each client fully fund their living trust so all possible assets will flow into the protective trusts for their beneficiaries. The more assets in Alice’s trust, the more flexibility Ben will have.
After getting every possible dollar in at the beginning, are there ways to grow the trust? If income distributions are discretionary, undistributed funds could be re-invested within the trust. That is especially significant since it is designed for generation skipping. What does the born-and-bred farm inheritor want to do? The largest asset in his inherited trust is land and Ben’s whole livelihood is geared toward acquiring more land. As trustee of his inherited trust, he can use any cash inheritance he received in the trust to buy more land. Ben will want to invest at least some of the trust income that way, too.
Here we run into the first objection: “But trusts pay higher income taxes if they don’t distribute the income.” Every myth has a kernel of truth.
Because of the compressed tax brackets on trusts the traditional approach has been to simply require all net income to be distributed from the trust. If the income is all distributed to the beneficiary, the trust takes a distributable net income deduction, pays no tax, issues a K-1 showing that the beneficiary got the income, and the beneficiary reports it as personal income in his tax bracket. If operated this way the trust creates no higher taxation than if the inheritance had come outright and free of trust.
A bit more finesse in trust management, however can actually reduce taxes. Ben should plan to take full advantage of the marginal brackets. Under the compressed brackets, the first $100 is exempt from tax; the next $2,650 is taxed by the feds in the 10% bracket, the next $6,900 in the 24% bracket, the next $3,500 at 35%, and everything after that at 37% plus Net Investment Income (Affordable Care Act) tax of 3.8%. In Illinois the trust will pay 4.95% income tax and we also add 1.5% Personal Property Replacement Tax to whatever is taxed to the trust.
What bracket is Ben going to be in? Probably 12%, 22% or 24% federal brackets. With the 65-day-rule, he can determine in January and February exactly what his personal rate for the prior year will be, then distribute by about March 5 from the trust any amount of income it takes to get the trust tax rate down to not more than his own. He should be able to leave at least $2,750, maybe $9,650 in the trust and pay a little less tax than if it were distributed. Not by much, but probably enough to pay for the tax preparation…which means having the benefits of the asset protection trust just became free.
Ben was hoping to buy more land in the trust. The $2,750 or $9,650, less taxes paid, isn’t going to go far toward land purchases if he still has to distribute all income above those levels.
This is where recent innovations in drafting come into play. Design the trust so that income can be reinvested within the trust but taxed as though it was distributed to the beneficiary. Give Ben the power to “vest in himself” some portion of the trust income. This is authorized by Section 678(a) of the so-called Grantor Trust Rules, which says the following:
“A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which…such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself[.]”
A power to vest is really nothing more than a defined right to withdraw. It makes sense that if a person has unfettered personal control of certain income, the IRS would declare it taxable to him. Ben will be treated as the owner of those items of income, deductions, and credits against tax of the trust that are attributable to that portion of the trust that he can withdraw. Those items will be reported on Ben’s own 1040, not on the trust’s 1041, and will be taxed at Ben’s tax rate. The trust income that he can withdraw will be deemed—in the same way that the income of a client’s revocable living trust is deemed to be his own personal income—to belong to Ben. No distribution is required and no K-1 is issued for this portion of the income. According to the instructions for preparing a 1041,
“If only part of the trust is a grantor type trust, the portion of the income, deductions, etc., that is allocable to the non-grantor part of the trust is reported on Form 1041, under normal reporting rules. The amounts that are allocable directly to the grantor are shown only on an attachment to the form. Don’t use Schedule K-1 (Form 1041) as the attachment.” (emphasis added)
In this instance, the beneficiary who has the right to withdraw is the “grantor” for purposes of that instruction. Even that is logical: the person with a right to withdraw and doesn’t exercise it could be said to have granted the funds to the trust. The right to withdraw can be written to reach all of the trust income but my preferred approach is to give Ben the right to withdraw only the trust income that would otherwise be taxed at the top bracket. This way, after the trust takes all its normal deductions and the net income is determined, the first $13,150 will be reported in the 1041 and taxed on normal complex trust principles: to the trust if not distributed, to Ben if it is distributed. Then all income above that amount will be described on an attachment to the 1041 stating that it is being reported by Ben on his own 1040. Retaining that excess (over $13,150) in the trust or distributing it to Ben has no impact, and any distribution of that excess income to him should not be reported on a K-1.
There are plenty of issues to deal with in drafting your §678 “power to vest” clause beyond this article and they have been written elsewhere. But for Ben, the practical effect is brilliant. Say the trust has $80,000 in net income. The first $13,150 will be subject to complex trust treatment, and Ben is deemed to be the taxpayer for the remaining $66,850. Ben will personally pay the tax on that $66,850, plus any part of the first $13,150 the trustees (Ben and his independent co-trustee) distribute to him. The Trustees distribute $10,400 and take the distribution deduction off the $13,150, leaving the trust to pay tax on only $2,750 at the 10% federal rate. Overall result? The trust retains $69,600 and pays $436 state and federal tax on only $2,750, for net increase (positive cash flow) of $69,164. Outside the trust Ben uses the $10,400 he received to pay the tax on $77,250 at his personal rate.
What does Ben want to do with this accumulation of income? Invest in more land. This gets back to the issue of collateral. Since Ben can retain positive cash flow in the trust without incurring any higher taxes than if he had no trust involved, the trust itself now is a viable borrower. He takes any cash inheritance that he received in the trust to make a down payment, then pledges the inherited land in the trust as additional collateral and borrows as much as he can comfortably service with net annual positive cash flow of $69,164.
Which brings us to the most significant income tax saving opportunity provided by Ben’s asset protection trust. What sort of income is this trust realizing, and how would it be different than if there were no trust? Ben is a farmer. Had he inherited the land outright, all money he would make farming his own land would be self-employment income subject to ordinary income tax and S.E. tax. But since Ben inherited his land in trust but farms as a sole proprietor, he must rent the land from the trust.
The rent paid to his inherited trust will reduce his self-employment income. The trust receives it as rental income.
Let’s say he inherited 400 acres, the reasonable rental value is $225 per acre, and real estate taxes are $25 per acre. His self-employment income that is subject to S.E. tax of 15.3% is reduced by $80,000 (the real estate taxes would have been paid either way). Even if all that rental income is distributed to Ben as beneficiary of the trust, the interaction of Ben as farmer with the trust as landlord saved him $12,240 in S.E. tax. I have had beneficiaries see this and promptly increase the rate of rent they pay to their inherited trust!
Let’s tie it back together with the buying of additional land. With the trust buying the land so it will remain protected from predators and will stay outside of his taxable estate, Ben has the $69,164 that stayed in the trust to pay mortgage payments. Had no trust been established for him, he would have $12,240 less after taxes to pour back into land purchases, and everything—the 400 acres and cash he inherited, and all the land he buys with income reinvested within the trust—would be exposed to predators and inside his taxable estate.
What if Ben decides farming just isn’t for him? Remember, Alice could have placed restrictions on him, but chose not to. So as the trustee with sole authority over investments, he could convert it all to cash and reinvest in any way he wants. From that point forward he still has the right to withdraw the income that exceeds $13,150 per year, and he and his cotrustee can distribute the rest of the income and principal as needed for maintenance: to maintain a comfortable standard of living. If anything is left at his death, he has the power to direct where remaining assets will go.
So I ask you, did Alice do anything but favors for Ben by leaving his inheritance—land, cash, everything—in an irrevocable trust?
Original edition of this article published in the newsletter of the Illinois State Bar Association’s (ISBA) Section on Agricultural Law, March 2021, Vol. 30 No.5
Then it was re-published in the newsletter of the Illinois State Bar Association’s (ISBA) Section on Trust & Estates, May 2021, vol. 67, no. 11
©2021 Curt W. Ferguson, all rights reserved