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How You or Your Trustee Can Use Trusts to Reduce Taxable Income Now

With the year-end approaching fast, now is the time to consider ways to reduce your 2014 income tax bill. In this issue you will learn:

  •       How you can use charitable trust-based planning to reduce your taxable income; and
  •       If you are the Trustee or beneficiary of an irrevocable, non-grantor trust (such as a Bypass Trust or Dynasty Trust), how you can use distributions, trust reformation, and investment shifting to reduce the trust’s taxable income.

If you would like to learn more about these trust-focused, income-reducing strategies, please call our office at (714) 384-6500 today.

Quick Review of the Federal Income Tax Laws

Significant changes to federal income tax laws went into effect in 2013, including:

  • Raising the top tax bracket from 35% to 39.6%. In 2014, this top rate applies as follows:
    • Married couples filing jointly or qualifying surviving spouses with taxable income above $457,600
    • Heads of households with taxable income above $432,200
    • Married individuals filing separately with taxable income above $228,800
    • Single individuals with taxable income above $406,750
    • Trusts and estates with taxable income above $12,500
  • Increasing the long-term capital gains rate on the top tax bracket from 15% to 20%
  • Applying a 3.8% surtax on the lesser of net investment income or modified adjusted gross income for individual taxpayers earning as follows:
    • Married couples filing jointly or qualifying surviving spouses, $250,000
    • Married individuals filing separately, $125,000
    • Single individuals or heads of households, $200,000
  • Applying a 3.8% surtax on trusts and estates on the lesser of undistributed net investment income or adjusted gross income over $12,500 (in 2014).

This means that the top federal rate is as high as 43.4% for certain taxpayers, with a top combined federal and California rate of 56.7%! Therefore, it is critical to understand how these new laws impact you and what you can do to reduce your income tax liability.

Planning Tip: Since each taxpayer’s circumstances are unique, planning to minimize taxable income is not one-size-fits all, or even most. We are available now to discuss your personal situation and help you explore the options for reducing your income tax bill.

Charitable Trust-Based Tax Reduction Strategies

Charitable Remainder Trusts

While you may be familiar with Charitable Remainder Trusts (CRTs) as an estate planning technique to minimize estate taxes, CRTs are also effective in reducing income taxes under the right circumstances. A CRT is a type of irrevocable trust that pays an annual distribution to one or more individual beneficiaries for a term of years, after which the balance of the trust passes to one or more charitable organizations.

The income tax deduction for contributions to a CRT is limited based on several factors, including your adjusted gross income, your other charitable giving, and what assets you use to fund the CRT. Aside from being able to take a limited income tax deduction over five years for the value of the property transferred into a CRT, a CRT can be used to reduce your income tax bill in the following situations:

Avoiding a Large Capital Gain

If you anticipate recognizing a large capital gain on an appreciated asset, such as the sale of your business, you can transfer the asset into a CRT which then sells it. You will not recognize any capital gain on the sale. In addition, payment of the annual distribution is only taxed when you receive it, which defers the income over a number of years.

Shifting Income to the Next Generation

If you will not need the income from an income-producing asset, you can provide an income stream for your children by transferring the property into a CRT. This shifts the taxable income down to the next generation, who are most likely in a lower income tax bracket.
Planning for Retirement Income. A Net Income with Makeup Charitable Remainder Trust (NIMCRUT) can be used to invest for tax-deferred growth while you are still working and will not need investment income. After you retire, the CRT assets can be invested to replace your lost income.

Planning Tip: You should consider a CRT if you have at least some charitable intent and substantial investable assets that are expected to increase in value and you will not need to rely on the income from these assets. If this describes your situation, please call our office now so that we can help determine if any of these CRT strategies are right for you.

Charitable Lead Trusts

If you have equity in a small business or real estate that is producing a good amount of income, even if you have charitable intent, the idea of the asset ultimately passing to charity may not appeal to you. Rather, you want a charitable deduction but also want the asset to ultimately to go to your children. Under these circumstances a Charitable Lead Trust (CLT) may be the answer.

A CLT can be designed to give an income stream to a charity, reduce your estate and gift tax bill, and preserve the asset for future generations. In one critical respect a CLT is almost the opposite of a CRT. During the term of the CLT, the trust pays an annuity or unitrust amount to the charity. At the end of the trust’s term, the remaining assets can return to the donor or, more commonly, pass to family members. If the assets in the trust grow at a rate that is greater than the government’s assumed growth rate, all of that appreciation passes free from estate or gift tax.

Planning Tip: In the current low-interest-rate environment, the government assumes a very low growth rate for the CLT’s assets. Therefore, it is now much easier for the CLT to outperform these assumptions and pass appreciation tax-free to the donor’s children.

A CLT is a private trust and is subject to normal rules for the income taxation of trusts. A CLT can be a grantor or a non-grantor trust. If the CLT is a grantor trust, the donor will receive an income tax deduction in the year of the CLT’s funding that is equal to the actuarial value of the income interest passing to the charity. However, because it is a grantor trust, future year’s trust income will be taxed to the donor, and thus it is very important to minimize trust income.

Alternatively, if the CLT is not a grantor trust, the donor does not receive an income tax deduction on creation of the trust, but the trust will take a charitable deduction every year for the amount that it pays out to charity.

Planning Tip: A grantor CLT can be advantageous if you need a large up-front deduction; for example, in a year in which you have a significant spike in income.

How to Avoid the Income Tax Squeeze on Trusts

As mentioned above, irrevocable, non-grantor trusts (such as Bypass Trusts and Dynasty Trusts) are subject to highly compressed income tax brackets (in 2014, the top 39.6% tax rate kicks in at only $12,500 of trust income). In addition, trusts in the top tax bracket are subject to the 20% long-term capital gains rate and the 3.8% surtax.

As part of their fiduciary responsibilities, Trustees of this type of trust must carefully consider ways to reduce the trust’s taxable income. After taking into consideration the terms of the trust agreement, the ongoing needs and tax status of the trust beneficiaries, and applicable state law, income-reducing strategies Trustees should consider include:

  • Distributing income to beneficiaries so that the income is taxed in the beneficiaries’ lower   bracket
  • Making in-kind distributions of low basis assets to beneficiaries
  • Invoking the 65-day rule and distributing trust income to beneficiaries by March 6, 2015, which will   allow the trust to deduct the income as a 2014 distribution
  • Exploring options to permit capital gains to pass to beneficiaries, such as reforming or decanting   the trust to broaden the Trustee’s discretion to allocate between income and principal
  • Shifting investments to minimize taxable income and gains
  • Merging or terminating small, uneconomic trusts


Planning Tip: Trustees must weigh the tax benefits of making distributions and changes to the trust’s provisions against the grantor’s intent, the ongoing requests of the current beneficiaries, and what will be left for the remainder beneficiaries. If you are the Trustee or beneficiary of an irrevocable, non-grantor trust, we can analyze your trust’s 2014 tax liability and help evaluate the options for minimizing the trust’s taxes.

Final Advice for Individuals and Trustees

Planning to reduce income taxes is a balancing act. The needs of the individual taxpayer or trust beneficiary must carefully be weighed against the overall tax savings. In addition, income, gains, losses, and tax brackets must be reviewed annually since the expenses of the individual or beneficiary will change from year to year. We are available now to answer your income-tax planning questions and help determine whether these or other strategies are the right strategies for you to reduce your income tax bill. Please call us at (714) 384-6500 to schedule an appointment.

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