Despite permanent spousal portability in the federal estate tax after resolution of the "fiscal cliff," credit shelter trust planning in New Jersey will likely remain popular due to the lack of portability in the state estate tax. While little publicized, both the recent American Taxpayer Relief Act (ATRA) and the Affordable Care Act (ACA) greatly increased the taxes on all trusts taxed under Internal Revenue Code (IRC) Subchapter J. ATRA increased the trust tax rate for income above an inflation adjusted $11,950 threshold to 39.6 percent for ordinary income, and 20 percent for capital gains and qualified dividends. The ACA implemented IRC 1411, which imposes a 3.8 percent surtax on trust investment income above the same threshold. Both of these provisions increase the income tax cost of credit shelter trust planning.
Fortunately, there are two ways to reduce the tax bite of these new ACA/ATRA taxes in New Jersey credit shelter trusts. The first involves applying IRC 678, and the second involves modifying trust Distributable Net Income (DNI).
IRC 678 is a little known (and poorly understood) code section that allows a trust beneficiary to be the "tax owner" of trust income and deductions, removing the trust from punitive Subchapter J tax rates. It reads:
A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which:
(1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or
(2) such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner thereof.
Under IRC 2041 and 2514, a surviving spouse obviously cannot retain the right to vest all corpus in herself, in a credit shelter trust. The alternative is to get into IRC 678 by giving the spouse the right to vest in herself the income generated from corpus. Due to varying definitions of the word "income," requiring a surviving spouse trustee to distribute all trust income to herself annually will not suffice. Under the terms of a credit shelter trust instrument, "income" generally means accounting income under the Uniform Principal and Income Act (UPIA). "Income" in IRC 678(a)(1), on the other hand, means taxable income. Taxable income includes capital gains income, which under the UPIA is accounting corpus. As a result, a mandatory income interest doesn’t give the spouse the right to vest all of the taxable income in herself. The trust then has only a "partial" IRC 678 status, where capital gains and deductions paid from accounting corpus are taxed within Subchapter J, and all other taxable income and deductions paid from accounting income are taxed under IRC 678. See, e.g., Goldsby v. Commissioner, T.C. Memo 2006-274.
If the trust were instead drafted to override the UPIA and include capital gains in the definition of accounting "income," "full" IRC 678 status would be achieved, but the surviving spouse would be left with an undesirable general power of appointment over trust corpus under IRC 2041 and 2514.
What if a surviving spouse trustee was given the right to vest in herself all corpus, subject however to an ascertainable standard such as "health, education, maintenance and support" (HEMS)? This would solve the aforementioned IRC 2041 and 2514 problems, as both sections explicitly exclude powers subject to an ascertainable standard. However, while authorities differ, it appears that ascertainable standards also exclude such a power from IRC 678.
In U.S. v. De Bonchamps, 278 F.2d 127 (9th Cir. 1960), a life tenant had the right to vest in herself the corpus of the estate in question for her "needs, maintenance and comfort." The court held that IRC 678 did not apply because her power to invade corpus was too limited. De Bonchamps, however, involved a life tenant and not a trustee/beneficiary. The court noted that a life tenant does not have the power to deprive a remainderman of an asset except by using it to exhaustion. A surviving spouse trustee/beneficiary, on the other hand, does have the right to distribute to herself an asset to the exclusion of remainder beneficiaries without exhausting said asset. It’s unclear if this distinction matters under IRC 678.
Complicating things further, in Private Letter Ruling (PLR) 8211057, a beneficiary acting as sole trustee had the power to distribute assets to himself for his "support, welfare and maintenance." With very little explanation, the PLR held that the beneficiary was treated as the tax owner of the trust under IRC 678. With regard to this PLR, many commentators have argued that the addition of "welfare" to the ascertainable standards of "support" and "maintenance" converted the otherwise ascertainable standard to being unascertainable. See, e.g., A Beneficiary as Trust Owner: Decoding Section 678, 35 ACTEC Journal 106. Under this reasoning, IRC 678 would not have applied to a pure HEMS standard. The PLR itself never discusses whether an ascertainable standard affects IRC 678 at all, let alone whether "welfare" is an ascertainable standard. Unfortunately, due to the renewed interest after ACA/ATRA, the IRS recently added IRC 678 to the list of topics for which it will not issue any more private letter rulings.
If IRC 678 is to be invoked while avoiding estate inclusion, the "partial" IRC 678 status referenced above is likely the best that can be done. This partial status carries the significant drawbacks of capital gains income remaining taxed under Subchapter J, and all trust income being distributed back into the surviving spouse’s taxable estate each year, even if unneeded for her support.
For those practitioners unwilling to wade into IRC 678, there is another option. Even if a credit shelter trust remains taxed under Subchapter J, it can still avoid punitive tax rates on income other than capital gains by distributing such income as DNI to the surviving spouse to the extent it exceeds the inflation adjusted $11,950 ACA/ATRA threshold.
Dealing with capital gains income is more complex. By default, capital gains income is not part of DNI under Treas. Reg. 1.643(a) 3(a), and is therefore taxed to the trust even if distributed. Under Treas. Reg. 1.643(a) 3(b)(2), however, if under the governing trust instrument capital gains are consistently treated as part of a beneficiary’s distribution on the trust’s "books, records and tax returns," they can be included in DNI. As evidence of the required consistency, practitioners should consider drafting corpus distribution ordering rules within the trust instrument. The exact "order" chosen may vary dependent upon the estimated taxable income of the beneficiaries, but an example of one such set of ordering rules is as follows: 1) from net short-term capital gain which is IRC 1411(c) "net investment income"; 2) from any other taxable income (other than long-term capital gain) allocated to corpus which is IRC 1411(c) "net investment income"; 3) from any net short-term capital gain which is not IRC 1411(c) "net investment income"; 4) from net long-term capital gain which is IRC 1411(c) "net investment income"; 5) from net long-term capital gain which is not IRC 1411(c) "net investment income"; 6) from any taxable income allocated to corpus not previously listed; and 7) from amounts of corpus not considered to be taxable income. The exact order chosen often won’t matter much, so long as accounting corpus that is taxable income is always distributed before accounting corpus that is not taxable income.
In addition to corpus ordering rules, practitioners should consider drafting a direction to an independent trustee to distribute DNI if, in his sole discretion, it creates beneficial tax mitigation. The drafter may wish to absolve a trustee from any liability for exercise or nonexercise of this tax driven distribution power.
However, in a typical credit shelter trust, where the surviving spouse rather than an independent party is trustee, such a tax driven distribution power could create a problem under IRC 2041, 2514 and possibly Treas. Reg. 25.2518 2(e)(2), unless the surviving spouse’s power to distribute to herself is either mandatory or limited to HEMS.
A mandatory withdrawal over all taxable income would make this DNI discussion moot, as it brings us back into IRC 678 as discussed earlier.
This distribution power, then, must be restricted by HEMS when held by a surviving spouse as trustee. It may be the case that in most years, the amount of taxable income after the distribution deduction for HEMS will be less than the $11,950 inflation indexed ACA/ATRA threshold. To plan for other years where the amount of taxable income after the distribution deduction for HEMS does exceed the ACA/ATRA threshold, the trust could grant the surviving spouse the power to hire and fire a special co trustee to assist her. Said special co trustee could be a CPA, attorney, friend or family member who is not "related or subordinate" to her within the meaning of IRC 672(c).
In the event the surviving spouse needs to distribute more taxable income than HEMS allows, she could appoint the special co trustee to make the remainder of the tax driven distribution on a fully discretionary basis unbound by HEMS. To avoid estate inclusion, the surviving spouse cannot have any control or input over the independent co trustee’s distributions. However, she can be granted indirect control through a power to hire and fire the independent co trustee at will. Under the reasoning of Rev. Rul. 95 58, most practitioners believe the independent co trustee’s discretionary powers should not be attributed to her despite this hire/fire power, so long as the independent co trustee is required to be outside of the "related and subordinate" definition.
While neither distributing DNI nor relying on IRC 678 is optimal, choosing one is certainly preferable than the alternative of proceeding without a credit shelter trust and wasting the first spouse’s $675,000 New Jersey Estate Tax exemption. •