What happens if you have a will or revocable trust agreement which leaves some or all of your assets at death to a beneficiary who predeceases you? To whom do assets pass at your death, which are earmarked for the deceased beneficiary?
The answer is more complicated than you might imagine, and it can be dependent on a number of factors.
Beneficiary designations in a well-drafted will or revocable trust agreement will anticipate unexpected events, such as the death of a beneficiary prior to the death of the testator or the Grantor of a revocable trust agreement. For example, wills commonly provide that a deceased beneficiary’s share will either lapse at death or will be distributed to other beneficiaries.
North Carolina has an anti-lapse statute, NC Gen. Stat. Section 31-42, which determines what happens to certain property under a will if the intended beneficiary predeceases the testator, and no successor beneficiaries are named for a specific devise.
That statute provides that a beneficiary under a will is deemed to have predeceased the testator unless the beneficiary survives for at least 120 hours after the testator’s death (a deadline set by the NC Uniform Simultaneous Death Act), in which case the predeceased beneficiary’s share will pass as follows:
If the deceased beneficiary is a close relative, i. e, a grandparent of the testator or a descendant of a grandparent, that the descendants of the deceased beneficiary will take the deceased beneficiary’s share, to be divided into further shares as set forth under the North Carolina intestacy laws (the laws which apply when there is no will).
If the beneficiary is not a close relative as described above, the share of the deceased beneficiary will pass as part of the testator’s residuary estate under the will. Most wills drafted by attorneys leave any assets which were not left by specific devise, under a catch-all provision, called the “residuary estate.”
If there is no residuary estate provision in the will, then the deceased beneficiary’s share will pass under the North Carolina intestacy laws, which are often a decedent’s spouse and children first, if any, but they could be more distant kin of the testator if he or she is not married and/or doesn’t have children or grandchildren.
Please note that the anti-lapse statute by its terms is applicable only to wills. Presumably that statute would not apply to revocable trust agreements or to other forms of property ownership or to beneficiary designations.
Examples of other forms of ownership which provide for survivorship include ownership as joint tenants with right of survivorship, accounts with transfer-on-death (TOD) or payable-on-death (POD) provisions, life insurance policies or retirement accounts, payable on death to named beneficiaries, etc. These forms of ownership should provide for successor beneficiaries.
Please be advised that the default provisions of some accounts may be determined by the internal documents of the financial firm, which forms control the disposition of those assets and which are not necessarily identical to the North Carolina intestate succession laws. Often the default beneficiary would be the deceased owner’s estate, in which case the account would ultimately pass under the deceased owner’s will, if any, or under the North Carolina intestacy laws, along with other probate assets, if the decedent had no will.
Perhaps the most important purpose of estate planning is to designate the persons who will receive the decedent’s assets after death.
Consequently, we recommend that you gather your asset ownership and beneficiary designation documents when doing your estate planning, to make sure that they dispose of your assets exactly as you want, and that they make proper provision for the possibility that beneficiaries may predecease you. Your estate planning attorney can name alternate beneficiaries for each devise under your will and for your residuary estate, and can verify the survivorship or beneficiary provisions of assets not passing under your will.
The federal gift tax and estate tax exclusion was doubled from $5 million, indexed for inflation, to $10 million, indexed for inflation, by the Tax Cuts and Jobs Act of 2017, which is currently scheduled to expire in 2026. Including the index for inflation, the total exclusion for 2021 is $11.7 million per person, or $23.4 million per married couple.
Because of the high exclusion under the Tax Cuts and Jobs Act, very few people are currently required to pay federal estate tax.
The Tax Cuts and Jobs Act of 2017 was passed during the Trump administration, and the Biden administration has proposed significant cuts to the exclusion, which many anticipate as going back to the pre-Trump level of $5 million, indexed for inflation, which would be $5.85 million in 2021, if applicable this year, or $11.7 million for a married couple.
Generally, a decedent’s taxable estate is computed by combining the assets constituting his or her taxable estate at death, with the total of his or her lifetime taxable gifts. The decedent’s gross taxable estate is then calculated on that amount, reduced by a credit equal to the date-of-death estate tax exclusion amount. If any federal gift tax has actually been paid by the decedent on any taxable lifetime gifts, then an additional credit is allowed for gift taxes paid.
If a decedent made $1 million in taxable gifts (not including annual exclusion gifts) and thereby used $1 million of his or her lifetime gift tax exclusion to avoid paying gift tax on those gifts, the full $1 million would be added into the decedent’s taxable estate on Form 706, Federal Estate Tax Return, but the decedent’s estate would be entitled to the full amount of the estate tax exclusion on the date of death, unreduced by the gift tax exclusion which had been used during the decedent’s lifetime.
If that decedent’s assets were worth $6.5 million on the date of death, and if he or she had made $1 million in lifetime taxable gifts, then his or her taxable estate would total $7.5 million, and the estate would be entitled to the full estate tax exclusion applicable on the date of death. Under the $11.7 million exclusion in effect in 2021, there would be no estate tax payable at the decedent’s death.
If, however, the estate tax exclusion amount is lowered to pre-Tax Cut and Jobs Act levels by the time of a decedent’s death, and if the adjustment for inflation is $1.1 million at that time, the date-of-death exclusion amount would be $6.1 million ($5 million base amount plus $1.1 million adjustment for inflation). If we further assume that the taxable estate totaled $7.5 million under the facts described in the above paragraph, then there would be federal estate tax on the difference between the gross taxable estate of $7.5 million and the date-of-death exclusion of $6.1 million – a difference of $1.4 million, since the lifetime taxable gifts would total less than the date-of-death exclusion.
In contrast, let us suppose that the decedent had made taxable lifetime gifts utilizing his or her full $11.7 million gift tax exclusion prior to his or her death in 2021, instead of the $1 million gifts assumed in our example above, and further suppose that the estate tax exclusion is later lowered to $6.1 million on the date of death. Would the $5.6 million difference between the gift tax exclusion of $11.7 million reported on the decedent’s gift tax returns and the date-of-death estate tax exclusion of $6.1 million, be included in the decedent’s taxable estate?
In November 2019, the IRS published final “Anti-Clawback” Regulations, Regs. Sec. 20.2010-1(c), under which the $5.6 million difference between gift tax exclusion at the time of the gifts and the date-of-death estate tax exclusion would not be “clawed back” into the decedent’s taxable estate. Instead of adding all lifetime taxable gifts to the decedent’s taxable estate on Form 706, the Federal Estate Tax Return, the difference between the higher gift tax exclusion at the time of the gift and the lower estate tax exclusion on the date of the decedent’s death would not be included in the decedent’s taxable estate. Under the above example, $5.6 million of the lifetime gifts (the difference between the $11.7 million gift tax exclusion and the $6.1 million date-of-death exclusion) would not be added into the decedent’s taxable estate. There would be no gift or estate tax on those gifts totaling $5.6 million which had been made under the gift tax exclusion in excess of the date-of-death estate tax exclusion.
The Anti-Clawback Regulations are applicable if the Tax Credit and Jobs Act of 2017 expires in 2026 or if the exclusion is reduced by legislation prior to that deadline.
The Anti-Clawback Regulations are applicable only when the value of total lifetime taxable gifts exceeds the date-of-death exclusion. Taxable gifts totaling less than the date-of-death exclusion amount are added back, in computing the decedent’s taxable estate, but gifts in excess of that amount, up to the gift tax exclusion at the time of the gift, are not included in the decedent’s taxable estate.
Even if the Anti-Clawback Regulations are not applicable, there can be some tax advantages to making lifetime taxable gifts totaling less than the date-of-death estate tax exclusion. For example (1) income earned on gifted assets is taxable to the donee, instead of the donor, and that income is not included on the donor’s federal estate tax return; and (2) post-gift capital appreciation on the gifted property, if any, also is not included on the donor’s estate tax return. However, there would be no advantage under the Anti-Clawback Regulations.
Not many taxpayers can afford to make lifetime gifts which are large enough to take advantage of the Anti-Clawback Regulations, but those few taxpayers who can and do make such gifts could reap large transfer tax benefits for their family.
One possibility is that a person who has a very short life expectancy might make large lifetime gifts to take advantage of the Anti-Clawback Regulations, which they might otherwise not consider because of fear of outliving their assets. With only weeks or months to live, this might not be such a concern. If that person is unable to act for himself or herself at that time, and if that person has a durable power of attorney which expressly permits his or her Agent under the power of attorney to make gifts, then the Agent should consider making those large gifts on behalf of that person.
If you’ve heard of a “three year rule” under which “deathbed” gifts, made within three years prior to a decedent’s death, were disregarded for estate tax purposes, that is not a problem! That rule was the law at one time, but the law has been changed. At the time of the three-year rule, federal gift taxes and federal estate taxes were separate tax systems. Estate taxes were payable only on assets either owned at death or subject to certain powers retained by a decedent. To keep taxpayers from avoiding estate taxes by making gifts shortly before death, Code Section 2035 at that time treated all transfers made within three years of death as “gifts in contemplation of death,” and disallowed those gifts in the calculating a decedent’s taxable estate.
Congress later adopted an integrated gift/estate tax system, whereby all taxable lifetime gifts are added to a decedent’s taxable estate for estate tax purposes, whether or not made within three years prior to death. Consequently, the Anti-Clawback Regulations make no distinction between deathbed gifts or gifts made years earlier, and large deathbed gifts could reap the benefits of the Anti-Clawback Regulations, even if the estate tax exclusion is lowered after the date of the gift and before the death of a decedent.
Another tip: If a husband and wife want to make large lifetime gifts to their children and/or grandchildren – to take advantage of the Anti-Clawback Regulations – but they are not able to make large enough gifts to utilize both spouses’ full exclusions – they should not make joint gifts, which would be deemed to be one-half each. It would be more tax-efficient for the gifts to be from one spouse only, to enable the gifts by that spouse to utilize his or her gift and estate tax exclusion as much as possible, without splitting the gifts with the other spouse.
For married taxpayers with total assets of several million dollars or more, it is important to consider whether the estate tax exclusion of the first spouse to die should be utilized to minimize federal estate taxes upon the death of the surviving spouse.
Anything which a decedent leaves outright to his or her surviving spouse will qualify for the deceased spouse’s estate tax marital deduction and will pass to the spouse, tax-free. However, that property will become part of the surviving spouse’s taxable estate and will therefore be subject to potential transfer tax (gift tax/estate tax) for the surviving spouse, unless a portability election is made on a federal estate tax return for the deceased spouse.
A portability election is made in Part 6 of the deceased spouse’s federal estate tax return, unless the surviving spouse intentionally opts out of portability under Section A of Part 6.
Until 2011 the only way to take advantage of the estate tax exclusion of the first spouse to die was to leave assets in a manner which would not qualify for the deceased spouse’s marital deduction and thereby would use the deceased spouse’s estate tax exclusion, instead of his or her marital deduction, to avoid or reduce estate tax at the first death. That is, using the exclusion at the first spouse’s death was a “use it or lose it” proposition. If the first spouse to die did not provide for a portion of his or her estate to be set aside in a manner which did not qualify for the marital deduction, then his or her estate tax exclusion would be lost forever and could not later be used to reduce federal estate taxes at the death of the surviving spouse.
Let us assume that a deceased spouse in 2010 had a taxable estate of $6 million, and that the estate tax exclusion was $3.5 million at that time. Estate taxes at the first death could have been completely avoided if the deceased spouse left at least $2.5 million to the surviving spouse in a manner which qualified for the estate tax marital deduction, in which case up to $3.5 million in value could be set aside at the first death which would not be subject to estate tax at the surviving spouse’s death. Thus, only $2.5 million would become part of the taxable estate of the surviving spouse.
Often the first priority of a deceased spouse is to provide for the surviving spouse, in which case the $3.5 million share (under the above fact situation) which was intended not to qualify for the estate tax marital deduction was often left in trust for the surviving spouse’s lifetime benefit, but the terms of the trust would keep the assets from being included in the taxable estate of the surviving spouse. The undistributed trust assets would remain outside the surviving spouse’s taxable estate and would pass to the secondary beneficiaries after the surviving spouse’s death, free of estate tax.
Prior to 2011, when the law was changed, a common method used to minimize estate taxes at the surviving spouse’s death, was a “shelter credit” trust created by the deceased spouse, sometimes called a “family” trust (which is a friendlier-sounding name). A trust funded at the first spouse’s death, could make income and/or discretionary principal distributions to or for the benefit of the surviving spouse for life, but upon the death of the surviving spouse, the trust assets would pass on to the remainder beneficiaries, often the deceased spouse’s children and grandchildren, free of federal estate tax.
Starting in 2011, however, a different set of rules became applicable. After that date it became possible for the deceased spouse’s unused exclusion at the time of his or her death to be preserved, even if assets were left outright to the surviving spouse. If the deceased spouse’s exclusion was preserved, the exclusion could be used for gifts subsequently made by the surviving spouse, or on the surviving spouse’s estate tax return.
If you have estate planning documents which were executed before 2011 which include a shelter credit trust (a “family trust”) for the surviving spouse, you are advised to review these documents with your estate planning attorney, to see that such a trust is still appropriate for you, especially with the higher threshold for estate taxes likely to be available at your death.
The federal and gift tax exclusion has been increased substantially since 2011 on two occasions, first to $5 million indexed for inflation, then to $10 million indexed for inflation. The latter was under The Tax Cuts and Jobs Act of 2017, which is scheduled to expire in 2026, but which could be reduced at an earlier date by act of Congress.
If a deceased spouse does not utilize the opportunity in his or her estate planning documents to preserve some or all of his or her estate tax exclusion, the surviving spouse now has the option of filing a federal estate tax return and electing the portability option to preserve the Deceased Spousal Unused Exclusion (DSUE) on that return, which allows the surviving spouse to apply the deceased spouse’s DSUE against any gift and estate tax liability of the surviving spouse, including future lifetime gifts and transfers upon the death of the surviving spouse.
In order to take advantage of the portability of the deceased spouse’s DSUE, the personal representative of the deceased spouse’s estate must file a federal estate tax return (Form 706) in a timely manner, on which the DSUE is computed, and must elect to claim a DSUE portability election. That election may be made in Part 6 of the federal estate tax return. Once made, that election is irrevocable.
Estate tax returns are due nine months after the date of death, but a six-month extension is available, if requested on or before the original due date of the return.
Sometimes a personal representative fails to file a federal estate tax return claiming the portability election in a timely manner. If so, Rev. Proc. 2017-34 provides a fairly simple procedure for relief in certain circumstances. If the personal representative, after the return’s due date, wants to file an estate tax return to claim portability, he or she may be allowed to do so under that Revenue Procedure, but only if all the following requirements are met: (1) The decedent must have died after 12/31/2010, and must have been a U.S. citizen who was survived by his or her spouse; (2) The personal representative must not have been required to file a federal estate tax return (other than to claim portability); (3) An estate tax return must not have been filed before the filing date for the return; and (4) The personal representative must include the following statement at the top of Form 706: FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER SECTION 2010(a)(5)(A).
This method of filing for relief is available only if filed within two years from the date of death, and only if all the requirements listed above have been met. If those requirements have not been met, the personal representative may request a private letter ruling from the IRS, which is more cumbersome and expensive procedure, but which may provide relief.
Please note that the DSUE does not apply to generation-skipping-tax. The deceased spouse’s GST exemption is lost if not used by the deceased spouse.
Also please note that, although the exemption for gift and estate tax for the surviving spouse is indexed for inflation, the DSUE amount for the deceased spouse’s exclusion is frozen as of the deceased spouse’s date of death, and is not indexed for inflation which occurs after the deceased spouse’s death.
If the surviving spouse makes taxable lifetime gifts after the death of the first spouse to die, and if a portability election has been made after the first spouse’s death, the DSUE of the deceased spouse is first applied to those gifts, before the surviving spouse’s gift tax exclusion is used.
On page 1 of Form 709, U.S. Gift Tax Return, Item #19 asks whether the surviving spouse has applied for a DSUE exemption from a predeceased spouse to a gift or gifts reported on the surviving spouse’s gift tax returns; if so, the surviving spouse is instructed to complete Schedule C on the Form 709.
If a surviving spouse has more than one deceased spouse who made DSUE elections, the exemption of the last predeceased spouse at the time of the gift shall be applied first, if available. That is, the DSUE of more than one predeceased spouse, if applicable, may be applied in succession, starting with the most recently-deceased spouse.
There is a limit on the total DSUE amount which can be applied for a surviving spouse, however. The total DSUE amount claimed by a surviving spouse or by his or her estate cannot exceed the overall exclusion set out for gifts or estates for a single individual.
There are a number of factors which should be considered when determining whether or not to use portability at the first spouse’s death, both in pre-death planning and after the death of the first spouse to die, including: (a) the size of the combined estates of both spouses; (b) the age of the surviving spouse; (c) the surviving spouse’s ability to manage assets, and his or her spending habits and needs; (d) protecting the eventual inheritances of the children and grandchildren; (e) other likely inheritances by the surviving spouse; and (f) the possibility of remarriage by the surviving spouse.
If considering whether to make a portability election after the first spouse’s death, the safest approach – based on the theory that one never knows what will happen – would be to have the surviving spouse make a portability election, no matter what the circumstances, but the cost of preparing an estate tax return and making the election is often impractical, given the financial situation of the surviving spouse. Each case and each family financial situation is different, so we recommend that you review your circumstances with an experienced estate planning attorney, both while both spouses are living and again after the death of the predeceased spouse, to decide what’s best for you.
What do you do if someone wrote a will, but the will cannot be found after the testator’s death?
Will that person’s estate pass to his or her heirs according to the North Carolina intestacy laws, which are applicable when a person dies without a will?
No. It is possible in North Carolina to probate either a lost will or a will which has been inadvertently destroyed without the testator having the intent to revoke the will.
In North Carolina the Clerk of Superior Court has jurisdiction to probate a lost or destroyed Will. The North Carolina General Statutes do not provide a special procedure to be followed, but the right to probate a lost will is established by case law. See In re Hedgepeth, 150 N.C 245 (1909), concerning the probate of a Will in common form, i.e. the informal procedure under which most wills are probated. Also see In re Will of Herring 19 N.C. App. 357 (1975) where a lost will was probated in solemn form, which is a formal and binding procedure.
There are no printed forms furnished by the clerk’s office for the probate of a lost or destroyed will, so we recommend that an application for probate be drafted by an attorney.
There is no case law or statutory law concerning who may apply for probate of a lost or destroyed Will, but the persons who may apply for the probate of an existing will include the executor named in the will or, if the named executor fails to apply for probate within 60 days after the date of death, any person interested in the estate – whether under the will or under the intestate succession laws – may apply.
The person propounding the lost or destroyed will for probate must provide evidence of the following:
The death and domicile of the testator. This is usually done by a sworn statement that the testator has died, accompanied by a certified copy of the death certificate and a sworn statement that the testator was a resident of the county at death.
Evidence that the will was properly executed. A photocopy of the will would provide evidence, if available, but if not available, this can be proven by affidavits from subscribing witnesses, if living and available. The Clerk of Court determines whether the evidence is sufficient.
The contents of the will. Usually a copy of the will, if available, is admitted into evidence, but if a copy is not available, the contents may be proven by the testimony of witnesses (not necessarily by subscribing witnesses on a witnessed will).
A statement that the will was lost or was destroyed without the testator’s intent to revoke the will. The application may describe the circumstances that resulted in the loss or destruction of the will, such as a fire or a move by the testator to another house, or perhaps to a home for the elderly.
The evidence must be sufficient to overcome a presumption that the will was revoked. Sometimes a will may be given to someone else for safekeeping, but that person later loses the will.
Evidence that there was a diligent search performed for the original Will, in places where it would be likely to be found. We recommend that the propounder describe the places searched and the description of the search.
If the testator had a safe deposit box at his or her bank – that would be an important place to look. If the name of the attorney or law firm that drafted the will is known, their office should be checked. Also, wills are occasionally filed for safekeeping with the office of the Clerk of Superior Court of the county where the testator resided at the time the will was written. Searches should include the testator’s valuable papers, copies of tax returns, or sometimes special places, such as a family Bible.
With a probate in common form, the evidence will often be filed with the application, and the Clerk will rule on the evidence informally. Normally, if the propounder submits sufficient evidence, the Clerk will admit the will to probate. However, some Clerks will require a hearing.
A caveat or will contest may be filed for a lost or destroyed will, following statutory procedures. A caveat proceeding is heard in Superior Court and not before the Clerk. If a will has already been admitted to probate in common form, the matter will be transferred to Superior Court to determine whether the will was properly the testator’s will – even is the caveat is not filed until after the probate in common form.
A probate in solemn form is a procedure in which the clerk issues summonses to all persons interested in the estate and holds a hearing. A probate in solemn form will be binding and will not be appealable if no will caveat is filed before or during the hearing. That is, if someone wants to challenge the validity of a will submitted for probate in solemn form, they must either file a caveat before the probate hearing or raise the issue at the hearing, because the probate will otherwise be final and binding. If the caveat is filed in a timely manner, however, the matter will be transferred to Superior Court to determine whether the Will is valid, without a ruling by the Clerk.
Consequently North Carolina law provides that a Will may be probated which has been lost or inadvertently destroyed.
Qualified Disclaimers can be useful tools to alter the way property passes at death, and are often used as a method to reduce transfer taxes, such federal estate tax or gift tax.
Simply stated, a qualified disclaimer is a refusal to accept a gift, bequest, devise or beneficiary designation, done in a manner which meets certain statutory requirements.
Disclaimers may be made of lifetime gifts, but that is extremely rare, and this article will focus on transfers after a transferor’s death.
A qualified disclaimer after a transferor’s death must be in writing, it must clearly identify the property which is being disclaimed, and it must be signed by the person making the disclaimer, or his or her legal representative. The written disclaimer must be delivered to the transferor’s legal representative, such as the executor of an estate, and in North Carolina to the probate court, within nine months after the transferor’s death, with the exception of a disclaimer by a minor disclaimant, which may be made within nine months after the minor disclaimant’s twenty-first birthday.
Property cannot be disclaimed after it has first been accepted by an individual. For example, if an individual accepts stock dividends, he or she cannot later disclaim the shares of stock which paid those dividends.
The disclaimed property passes as though the disclaimant had predeceased the transferor. If there is a will, it passes to the successor devisees or beneficiaries under the will, after it has been disclaimed by the primary devisee or beneficiary. If there is no will, the property must pass to the secondary heirs under state law, who would have inherited the disclaimed property if the disclaimant had predeceased the decendent.
The person making the disclaimer cannot direct that a disclaimed devise or inheritance be passed to someone else, other than the person or persons who would have received the property if the disclaimant had predeceased the transferor. For example, a will leaves property to the transferor’s brother if he survives the transferor, and if he does not survive the transferor, the will leaves the property to the transferor’s sister. The disclaimant cannot disclaim the property and direct that is passes to his or her children, instead of to the sister.
The disclaimed property passes to the successors without any tax consequences to the person making the disclaimer, provided that the disclaimer is “qualified.” That is, the qualified disclaimer is not subject to gift tax, which would have been applicable if the person making the disclaimer had accepted the property and subsequently made a gift of that property to the transferees.
Generally, a disclaimant cannot disclaim property to a trust that names the disclaimant as a beneficiary of the trust or gives the disclaimant the power to direct the further disposition of the disclaimed property. For example, if the disclaimant is also the trustee of the trust to which the disclaimed property passes because of a disclaimer, and, as Trustee, has the discretionary power to direct its further disposition then the disclaimer would not be qualified unless the disclaimant also disclaimed his discretionary power.
There is an exception for a spouse, who can be a beneficiary of a trust, but the spouse cannot have the power to further direct the disposition of the trust property after the disclaimer, unless the spouse also disclaims his or her right to direct such disposition.
It is possible to disclaim partial interests in property, but not interests which cannot be severed into separate shares at the time of the disclaimer. For example, a person may disclaim 1,000 out of a total 2,000 shares of stock in an estate, but he or she cannot accept the dividends for life and disclaim the “remainder interest” in those shares after his or her death. In that case, a “vertical” disclaimer of half the shares will work, but a “horizontal” disclaimer would not work.
If the disclaimant is the trustee of the trust into which property is disclaimed, but as trustee is given the authority to make distributions among several beneficiaries, then the disclaimant must also disclaim his or her fiduciary power to direct the disposition among those beneficiaries.
Generally, a person cannot disclaim property in order to become qualified for Federal Title XIX assistance, such as Medicaid. The person must disclose all of his or her property to qualify or to remain qualified, including any property the person has disclaimed or wishes to disclaim.
Disclaimers are very technical in nature and you should not try to disclaim property without the assistance of a qualified attorney.
Charitable Remainder Trusts can be useful tools to avoid or to postpone capital gains tax on the sale of appreciated assets, for someone who wants to make a charitable gift after the termination of the trust. A person (the trust “grantor”) creates a trust which pays a stream of distributions each year to one or more beneficiaries (the “income beneficiary”) for life or for a term of years, after which the trust terminates and the remaining trust assets are distributed to a tax-exempt organization or organizations (the “remainder beneficiary”). Since the remainder beneficiary is a charitable organization, any capital gains which are retained in the trust are not subject to capital gains tax.
There are two types of charitable remainder trusts, called Charitable Remainder Annuity Trusts or CRATs and Charitable Remainder Unitrusts or CRUTs. A CRAT pays fixed distributions to the income beneficiary based on the original value of the trust assets, whereas a CRUT adjusts the distributions each year to reflect any increases or decreases in the value of the trust assets.
Example: $1,000,000 in assets are transferred to a charitable remainder annuity trust, or CRAT. The Grantor is to receive 5% of that value, or $50,000, per year, until the trust terminates. The income beneficiary frequently is a married couple and the trust term may be for their joint lifetimes and for the lifetime of the survivor. If the trust is funded with appreciated assets, no capital gains tax will be payable upon the sale of those assets. If the assets are worth $1,000,000 at the time of the gift and if they are sold for that amount, assuming that they were originally acquired for $100,000, the trust would not pay income tax on the $900,000 capital gain when the assets are sold. In addition to avoiding capital gains tax at that time, the grantor gets a charitable deduction on his or her income tax return for the value of the charitable remainder interest, calculated by Treasury actuarial tables applicable when the contribution to the trust is made. When the trust terminates – often after the death of the second spouse to die, the remaining trust assets are paid to a tax-exempt organization or organizations (the “charitable remainder beneficiary”) as set forth in the trust agreement.
A charitable remainder “unitrust” or CRUT is similar to an annuity trust, except that the distributions are adjusted annually, to reflect any increase or decrease in the value of the trust assets. If a 5% Unitrust was originally funded with $1,000,000 in assets, but grows in value to $1,100,000, the unitrust distributions for the following year would be 5% of the new value, or $55,000. This is different from a CRAT or annuity trust, for which the distributions would remain the same, even if the value of the trust assets increases or decreases.
Please note that the distributions from a CRT to the income beneficiary are taxable, to the extent that (a) the trust has taxable income, including capital gains, and/or (b) the trust had , in previous years, taxable income which has not been distributed to the income beneficiary. The trust cannot avoid income tax by investing in tax-free bonds until all taxable income has first been distributed, which makes this strategy impractical.
The general rule is that a CRAT or CRUT is required to distribute at least 5% annually, but there are exceptions for certain types of unitrusts. For example a “net income” CRUT (sometimes called a NICRUT) is not required to distribute more than its net income, and a “net income” CRUT with makeup provisions” (sometimes called a NIMCRUT) may make up income arrearages from past years (i.e., from years in which the trust was allowed to distribute less than the unitrust percentage), until the excess distributions have caught up with those arrearages. Thus a 5% NIMCRUT which earns only 1% in a given year would distribute only 1% currently and would accrue a 4% arrearage, which may be distributed only from excess income in subsequent years, i.e., income in excess of the 5% unitrust percentage. If 7% income is earned in a subsequent calendar year, the 2% overage for that year in excess of 5% may be distributed to the income beneficiary as a make-up distribution.
There are certain types of investments which enable the trustee to have some control over the realization of taxable income of a trust, in which case the trustee may minimize taxable income in one year and maximize taxable income in another year.
Occasionally someone creates a CRT which he or she later desires to exit. Circumstances can change over time, and sometimes there is an unanticipated major life event, which causes a change of mind. The trust itself is irrevocable, but there are alternatives which permit an income beneficiary of a CRT to obtain a more suitable result.
Let us suppose that the spouse of the trust grantor unexpectedly dies and later the grantor remarries and wants to make the new spouse an income beneficiary. Since the original trust was irrevocable, it cannot be changed to substitute the new spouse as a replacement beneficiary. In that case the grantor may want to exit the original trust in a manner permitted by law and to enter into a new trust agreement under which the new spouse is an income beneficiary.
There are several alternative methods for exiting an existing charitable remainder trust:
Temination of a CRT. One option is for the trustee simply to terminate the trust, in which case the trust assets must be divided between the charitable beneficiary and the income beneficiary strictly according to Treasury actuarial tables, following procedures established by the IRS. Care must be taken to avoid “self-dealing” under Code Section 4941, which could subject the trust to severe penalties.
Sale of income interest. Another option would be for the income beneficiary to sell the income interestin the trust to a third-party buyer. An important benefit from this alternative is that it frequently results in getting more money to the income beneficiary than would be received in a straightforward trust termination. Please note that the income interest in a CRT is considered a capital asset for income tax purposes, and if the sale of that capital asset results in a higher price than the actuarial value of that asset under the Treasury actuarial tables, there would be a taxable capital gain for the income beneficiary.
The original CRT would continue to exist under this alternative, under the same terms and conditions, but with a different income beneficiary – but please be aware that if the original term of the trust was measured by the life of the original income beneficiary, there would be no change in the term of the trust and the original income beneficiary’s life would continue to be the measure for the remaining term of the trust.
The proceeds received by the income beneficiary from the sale of the income interest could be contributed to a new charitable remainder trust if the Grantor so desired, with income tax benefits applicable to a new CRT, but the new trust would be scaled down in size as compared to the original trust unless additional assets were added to the new trust. The new trust could have different beneficiaries than the original trust, such as a spouse by a second marriage or other family members.
CRT Rollover. A third option could be a charitable remainder trust “rollover,” where the income beneficiary rolls over his or her income interest to a new CRT. Initially, the new CRT would have no assets other than the right to receive unitrust distributions from the old trust, which would continue to exist. However, an important benefit of this alternative is that the income interest from the old trust can be sold by the new CRT to a third-party buyer, and if the sale price is higher than its actuarial value under the Treasury tables, there will be no capital gains tax on the sale of that income interest, as long as the gain is retained by the trust. The proceeds of sale could be invested by the new CRT differently than the assets of the old trust, which investment strategy may be more appropriate for the new trust. The income beneficiary from the old trust would be the grantor of the new CRT and would get income tax benefits applicable upon the creation of a new CRT. New beneficiaries could be named for the new trust.
The original CRT would continue to exist and the charitable beneficiary would still receive the remainder distribution on termination of the trust under the original terms of the trust. Please note that if remaining term of the old trust was based on the measuring life of the original income beneficiary, that same person’s life would continue to be the measuring term for the old trust, even if that person is no longer receiving the unitrust distributions from the old CRT.
Distribution to charitable beneficiary. Lastly, an income beneficiary who no longer needs or wants the income distributions from the CRT may want to terminate his or her trust by giving the income interest to a charitable remainder beneficiary. If that is done, then the charitable remainder beneficiary would own both the income interest and the remainder interest, and the trust could be terminated. A beneficiary who gives his or her income interest to a charitable organization will get a charitable deduction for giving that income interest to charity, based on the value of the income interest under the Treasury actuarial tables at the time the trust is terminated.
Charitable remainder trusts often last for one or more decades. Although the original reasons for creating the trust were presumably valid at the time the trust was created, circumstances can change over time. Whatever the reason for the exiting a CRT, the procedure is complicated and in some states may even require court action. You need to consult with an experienced professional to discuss your situation and to determine the best option available for you.
Prior to the adoption of The SECURE Act of 2019, the required minimum required distributions (RMDs) for retirement accounts were based strictly on the actuarial life expectancy of the beneficiary. If the beneficiary of the retirement account was a trust, the distributions from the retirement account to the trust were based on the age of the trust’s “identifiable primary beneficiary.” If there were several identifiable beneficiaries, the RMD was based on the life expectancy of the oldest identifiable beneficiary.
The SECURE Act of 2019 changed the required minimum distributions (RMD) for retirement account beneficiaries (including identifiable beneficiaries of trusts) other than spouses, including adult children or grandchildren. The RMD has been changed from their actuarial life expectancy to 10 years (maximum), subject to exceptions. An exception is still available for beneficiaries who are “disabled” as defined by Internal Revenue Code Section 72(m)(7) or “chronically-ill” as described by Code Section 7702B(c)(2), with limited exceptions. The RMD for trusts on behalf of those beneficiaries is still based on the actuarial life expectancy of the identifiable primary beneficiary, and is not subject to the 10-year maximum payout applicable to most beneficiaries.
The Secure Act of 2019 virtually eliminated the “Stretch IRA” strategy to reduce IRA distributions by naming very young beneficiaries, but some of those benefits still exist for disabled or chronically-ill beneficiaries.
Distributions from a retirement account result in taxable income to the beneficiary or beneficiaries who receive the distributions. When a distribution is payable to a trust, the trust receives the taxable income, but the income tax liability for the distribution is passed on to the beneficiaries to whom the trust further distributes the income. Trusts are taxable entities and they file fiduciary income tax returns each year and pay income tax on any undistributed income. However, if distributions to beneficiaries are made during the year (or early in the following year, if the trust so elects on its timely-filed fiduciary income tax return), the trust can claim a “distribution deduction” on its fiduciary income tax return. That is, the trust can deduct from its taxable income the amount distributed to trust beneficiaries, and the trust issues a Schedule K-1 to the trust beneficiaries, reporting the distribution as taxable income to them. The tax laws discourage trust income from being accumulated in a trust by taxing undistributed trust income at much higher rates than the rates applicable to individuals.
The terms of some trusts require that the trusts distribute all their income to trust beneficiaries each year. These trusts are often called “simple trusts,” but insofar as retirement benefits are concerned, this type of trust can be categorized as a “Conduit Trust.”
A Conduit Trust is sometimes called a “see-through” trust, since the retirement distributions are taxable to the trust beneficiaries who end up receiving the distributions, and are not taxable to the trust.
Most of the time, overall income taxes are` reduced if a trust distributes retirement account income to the beneficiaries of a trust – because of the high tax rates applicable to trusts. However, minimizing taxes may not be the only consideration.
If the beneficiary of the IRA is a trust for a special needs beneficiary who is an “identifiable primary beneficiary,” any distributions of retirement account income from the trust to the trust beneficiary might result in too much income for the beneficiary, thereby disqualifying the beneficiary from means-tested governmental benefits, such as Medicaid.
An Accumulation Trust is an alternative to a Conduit Trust. The Accumulation Trust can be named as a beneficiary of retirement account benefits for an identifiable primary beneficiary, instead of a Conduit Trust. If the retirement income is not required to be distributed to the identifiable primary beneficiary and it may instead be retained by the trust, then the retirement account income would not cause the beneficiary to lose means-tested benefits, such as Medicaid. See Reg. Section 1.401(a)(9)-5, Q & A-7(c)(3), Example 1.
Consequently, an Accumulation Trust may be appropriate where the identifiable primary beneficiary of a trust is a special needs individual. The Accumulation Trust allows the trustee to receive the RMD from the retirement account, but does not require the trustee to distribute the RMD to the special needs beneficiary each year, thereby preserving the eligibility of the special needs beneficiary for needs-based government benefits. Instead of distributing the benefits to the beneficiary every year, which is a requirement of a Conduit Trust, the trustee of an Accumulation Trust can retain retirement benefits within the trust for future distributions to the special needs beneficiary or to the remainder beneficiaries of the special needs trust.
An Accumulation Trust which accumulates retirement distributions within the trust and does not distribute those benefits to the beneficiary must pay income tax on the accumulated income at trust tax rates, which are much higher than individual rates. However, even highly-taxed retirement account income which is accumulated within a special needs trust might be preferable to having the trust beneficiary declared ineligible for means-tested benefits, such as Medicare.
That is, if a Special Needs Trust is required to distribute to beneficiaries the required minimum distribution (RMD) from retirement accounts, the distributions would reduce the trust’s taxable income on the trust’s fiduciary income tax return, but would increase the beneficiary’s income. If the trust is an Accumulation Trust and is not required to distribute the income to the special needs beneficiary, the undistributed income is taxable to the trust itself, and it is not deemed to be taxable income of the trust beneficiary; since the income is retained by the trust, it is not considered to be the beneficiary’s income and does not disqualify the beneficiary from means-tested government benefits.
To be a valid Accumulation Trust, (a) the trust must be a valid trust under state law, (b) the trust must be irrevocable, (c) the beneficiaries must be identifiable and (d) certain documentation must be provided to the plan administrator.
As a result, even though the RMD may be taxable to the Accumulation Trust in high income tax brackets, The SECURE Act of 2019 may permit smaller RMDs from a retirement account to a trust for a disabled or chronically-ill beneficiary, in which case the amount required to be distributed to the trust will often be a smaller amount than would be applicable if the beneficiary were not disabled or chronically ill. That is, the tax detriment caused by the high fiduciary income tax rates, may be partially offset by a lower RMD from the retirement account to the trust.
If you currently have named a trust for the benefit of a disabled or chronically-ill trust beneficiary as beneficiary of your retirement account, you should review the terms of the trust with a qualified attorney, to make sure that the trust is not a Conduit Trust, which could render the trust beneficiary ineligible for means-tested government benefits, such as Medicaid.
If you have a retirement account or accounts from which you want to accumulate retirement income in trust for the possible needs of a disabled or chronically-ill beneficiary, you should consider having the retirement account payable to an Accumulation Trust for that beneficiary, instead of a Conduit Trust, which must be paid out at least annually to the beneficiary.