Planning with revocable trusts has become increasingly popular in recent years. In many instances, the motives for using a revocable trust are nontax and include avoiding probate, asset protection planning, and managing potential issues relating to the grantor's privacy and incapacity. From a tax perspective, the interplay of the grantor and nongrantor trust rules, coupled with the death of the grantor, creates additional complexity and potential risks for the unwary practitioner. This article will focus on the key tax and reporting areas applicable to revocable trusts and the associated planning and pitfalls that arise at the grantor's death.
Grantor trust characteristics
In a conventional revocable trust structure, the grantor retains the power to revoke the trust and amend its terms. This power to revoke or amend sets several considerations in motion for tax purposes. First, the trust will be considered a grantor trust (e.g., tax transparent) for income tax purposes (Sec. 676). Second, any transfers to the trust will be viewed as incomplete gifts not subject to gift tax (Regs. Sec. 25.2511-2(c)). Third, trust property will be includible in the grantor's estate for estate tax purposes (Sec. 2038).
Operational aspects during revocation period
A revocable trust will remain a grantor trust unless or until the grantor renounces the power to revoke, initiates suitable amendments to the trust during his or her lifetime, decants the trust to a nongrantor trust, or dies. Therefore, all income, gains, losses, deductions, and credits are reportable on the grantor's annual income tax return.
From a tax reporting perspective, grantor trusts have a few options. The general rule provides that grantor trusts must file an abbreviated Form 1041, U.S. Income Tax Return for Estates and Trusts, that includes the trust's name, address, and taxpayer identification number (TIN), along with a separate statement attached to the return summarizing the activities to be reported by the deemed owner. Two reporting alternatives exist that can simplify the process and obviate the need for filing Form 1041.
The first allows the trustee to file the appropriate Form 1099s in lieu of Form 1041 (Regs. Sec. 1.671-4(b)(2)(iii)). From a practical perspective, this method may become unwieldy where a trust has multiple brokerage accounts that include several classes of income and/or a large volume of sale or exchange transactions. It should be noted that where the deemed owner is not the trustee or co-trustee, a grantor trust tax information letter must be provided to the deemed owner.
The second alternative permits the trustee to furnish the grantor's Social Security number (SSN) to third-party payers, provided the trust is treated as being owned by only one person (Regs. Sec. 1.671-4(b)(2)(i)(A)). This option is the simplest and avoids having to file Forms 1099 or Form 1041. Lastly, the two reporting alternatives (Forms 1099 or grantor's SSN) may not be used by a (1) foreign trust, (2) trust with a foreign grantor or that owns assets located outside of the U.S., (3) trust deemed owned by a person whose tax year is other than a calendar year, (4) trust where a grantor or other person is an exempt recipient for information reporting purposes, (5) common trust fund, or (6) qualified Subchapter S trust (QSST).
Death of the grantor
On the death of the grantor, the trust continues uninterrupted, meaning the assets titled in the name of the trust are unaffected (though still subject to the terms of the trust) and will not require probate. However, for income tax purposes, the trust will now be considered a separate taxpayer and will be required to obtain a TIN, even in instances where the trust obtained a separate TIN during the grantor's life (Regs. Sec. 301.6109-1(a)(3)(i)(A)).
Care must be exercised in the trust's transition year when reporting the amount of income, gains, losses, deductions, and credits allocable to the grantor and the trust in the pre- and post-death periods. For example, if the trust provided the grantor's SSN under one of the alternatives stated above, a TIN will need to be provided to third-party payers since the grantor's SSN dies with the grantor. Upon receipt of a TIN, banks and brokers may require the trust to establish new accounts, which could present timing and logistical challenges for the trustee.
A similar issue may arise where the trust obtained a TIN during the grantor's life. Ultimately, the trustee must determine, based on the number of accounts and overall complexity of trust transactions, whether to use the grantor's SSN (if permissible) or a TIN during the grantor's lifetime. Either way, a thorough analysis and reconciliation should be performed to ensure a proper allocation is made to each of the grantor and nongrantor trust periods. Additionally, the tax preparer may need to initiate some tax reporting gymnastics (e.g., nominee and other disclosures) to ensure that correct amounts are reported on each tax return.
Interplay with the decedent's final return, fiduciary income tax, and Form 706
Upon the death of the grantor, grantor trust status terminates, and all pre-death trust activity must be reported on the grantor's final income tax return. As mentioned earlier, the once-revocable grantor trust will now be considered a separate taxpayer, with its own income tax reporting responsibility. Sec. 644(a) states that the tax year of any trust (other than trusts exempt from tax and charitable trusts) must be the calendar year.
Depending on the language and directives embodied in the trust document, the trust may be considered a simple trust (one required to distribute all its income annually and which does not also distribute corpus or principal) or a complex trust. Concurrently, the deceased grantor's estate will come into existence and also be considered a separate taxpayer for income tax purposes. The estate will have its own tax reporting responsibility and be required to obtain a TIN.
An often overlooked yet important distinguishing factor applicable to an estate is its ability to elect a fiscal year other than a calendar year. Electing a fiscal year end may afford the estate or beneficiaries a tax-deferral opportunity and provide the executor with additional time to organize the estate's affairs. This can be especially advantageous when the decedent dies during the latter part of the calendar year.
To reduce the number of separate income tax returns that may be required after the death of the grantor, the trustee of a former revocable trust and the estate's executor may consider a Sec. 645 election to treat certain revocable trusts as part of the estate. A trust will be considered a qualified revocable trust (QRT) if it was treated under Sec. 676 as owned by the decedent of the estate by reason of a power in the grantor. The election, which is irrevocable, is made by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate, no later than the time prescribed for filing the return for the first tax year of the estate, including extensions, or, where no probate estate exists, the due date of the QRT's income tax return, including extensions. A Sec. 645 election makes available a number of income tax advantages that would not otherwise be available in a separate trust tax filing, including:
- Use of a fiscal year;
- A larger exemption amount ($600 versus $300 for a simple trust versus $100 for all other trusts);
- No requirement to make estimated tax payments until after the second tax year following the decedent's death;
- Deducting medical expenses paid by the trust on the decedent's final income tax return;
- A potentially longer time frame for owning S corporation stock (period of administration versus two-year period for former revocable trusts);
- Claiming a charitable deduction for amounts permanently set aside for charitable purposes but not yet paid;
- Ability to deduct losses for in-kind pecuniary bequests otherwise nondeductible under the related-party rules for trusts; and
- Two-year waiver of the active participation requirement under the passive activity rules.
A Sec. 645 election will remain in force for (1) two years if no estate tax return is required to be filed, or (2) the earlier of the date the trust and estate have distributed all of their assets or the day before the later of (a) two years following the date of the decedent's death or (b) six months after determination of the estate's final estate tax liability, if an estate tax return is required to be filed (Reg. Sec. 1.645-1(f)). During the election period, income and deductions are reported on a combined basis, but distributable net income must be computed separately for the estate and trust. Upon termination of the election, the electing trust component is deemed to have been distributed to a new trust. The new trust will be required to report on a calendar year, which may cause beneficiaries to receive two Schedule K-1s, Beneficiary's Share of Income, Deductions, Credits, etc., in instances where the co-electing estate files on a fiscal year.
If Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, is required, the assets held in the revocable trust should be aggregated and reported on Schedule G, Transfers During Decedent's Life, rather than listed separately (e.g., stocks and bonds, real estate, mortgages, notes, cash, etc.). Additionally, the Part 4, General Information, questions dealing with lifetime transfers (Q12) and the establishment of trusts (Q13) should be answered "yes." A verified copy of the written trust instrument should also be attached.
Practitioners should know the tax implications when a grantor dies
In summary, the use of revocable trusts has become increasing widespread in recent years. In many instances, the grantor, trustee, and executor have focused their attention on the nontax advantages of using revocable trusts, particularly in jurisdictions where probate is costly and protracted. Practitioners must be aware of the tax issues and nuances that will ensue upon the death of the grantor, so they can provide before-the-fact, valued-added advice to their clients.
— Charles A. Barragato, Ph.D., CPA, CFE, is a partner in Private Client Services with BDO USA, in Melville, N.Y. To comment on this article or suggest an idea for another article, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.