Trying to figure out the meaning of this sentence

[AppleLaw]

Jurisdiction

Missouri

This is about a revocable living trust for a family member that is deceased. I'm hoping for some feedback about what this Article section is trying to say, it's very unclear to me.

I understand this is a bit out of context without the whole document, but a primary Article of the document says up front that "the Trustee shall pay any and all taxes owing by the Grantor..."

The part I'm trying to understand is in bold letters, I think the rest is benign for us. What does it mean? Since the trust should have settled any & all taxes, how does income tax basis come into play? Might it be about the different tax brackets the beneficiaries are in? I don't see why that would matter either.

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The trustees shall be permitted to retain nonincome producing assets unless a beneficiary makes demand that any such asset be converted to an income producing asset. No such demand shall be permitted if an event has occurred requiring or permitting distribution of the nonincome producing asset to a beneficiary. The trustees shall be permitted in the Trustee's discretion to make distributions in cash or in specific property, real or personal, or in undivided interests therein, or partly in cash and partly in such property. The Trustee may make such distributions without regard to the income tax basis of specific property allocated to any beneficiary, and shall have no responsibility to adjust for differences in income tax basis among beneficiaries. Any distribution made under this Trust Agreement, other than a gift of specific property other than money, may be satisfied from any property the Trustee may allocate for that purpose, and no asset need be divided pro rata. Except as otherwise specifically set forth herein, in allocating assets to satisfy any distribution, the Trustee shall be assign to each such asset its value as of the date of distribution. The Trustee shall be permitted to allocate items between income and principal as the Trustee deems appropriate in the Trustee's discretion.

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[adjusterjack]

I'm not a lawyer, I didn't play one on TV, but I stayed at a Holiday Inn once.

Here's an example of what I think that sentence is saying.

Bob, the deceased, left a home worth $250,000 to Jim and a home worth $250,000 to Joe. The income tax basis is the value of the properties at the time of Bob's death. Both get an equal amount of cash from the estate.

Jim is going to live in his home as his primary residence. If he lives there for at least 2 years and sells the home for a gain of $250,000 or less, he will pay no income tax on the gain.

Joe is going to rent out his home and isn't likely to keep the home forever. When he sells he will pay capital gains income tax on whatever the gain is, less applicable adjustments. Depending on how much and when, the tax could be substantial.

Joe says to Sam, the trustee, "I want a bigger cut of the cash because I will pay a lot in taxes."

That sentence allows Sam to tell Joe to pound sand.

 

[Tax Counsel]

In plain English, that sentence is saying that the trustee may, when distributing trust assets, ignore what the beneficiary will have left should the beneficiary sell the property. Basis is the term in federal tax law that tracks the owner's cost in the asset. The basic formula for determining the capital gain or loss of an asset when sold is:
gross sales price - expenses of sale - adjusted basis = capital gain

That gain is added to other captial gains you had in the year and reduced by the capital losses in that year. The net gain or loss then goes to the front of your income tax return in which all the various items are added together to get your adjusted gross income (AGI). The AGI is an important figure because a lot of provisions in the Internal Revenue Code (IRC) use AGI as a measuring stick for things like whether you made too much money to be eligible to claim a particular benefit, whether your income is low enough to qualify for a particular deduction or credit, etc.

The capital gain formula I put in the above formula shows how important basis is to the tax out come. The higher the basis is, the lower the capital gain is.

I think an example will best illustrate the issue that comes up In the context of estate asset distributions. Suppose Amy dies and has two surviving children, Brenda and Charlie. Amy has two assets, both worth $1 million. She put both of those assets into her revocable living trust. One of those assets is a stock account she bought through her broker. The other is a §401(k) plan from her employer that is also worth $1 million. Those are the values at the time Amy dies. Amy's trust directs that Brenda and Charlie are each to get 50% of the value of the assets. At Amy's death, the trust becomes an irrevocable trust. However, it will function very much like a will, and importantly, that's how tax law will look at it.

Brenda comes to the trustee wanting her share, and she wants the stock. On the face of it, that shouldn't be a problem because both assets are worth $1 million. The trustee can give her either of the assets and still comply with the will. But then Charlie objects, saying he wants the stock, too. Why do they both want the stock over the § 401(k) plan?

If they promptly sell the stock, they'll have to pay tax on the gain in the stock. The key number they need to figure out the gain is the basis. The IRC states that assets owned by a decedent at the time of her death has a basis equal to its fair market value on the date of death. With a revocable living trust, Amy is viewed by the tax law as the owner of the trust assets until she dies. Thus, the stock portfolio has a basis of $1 million. Selling the stock for $1 million results in no gain because the sales price equals the basis. Thus, if Brenda is successful in getting the stock, she can sell it right away and come out of it with $1 million.

The §401(k) account result is very different. The typical 401(k) plan has no basis and is not treated as a capital asset. So if that's what Charlie gets, he can take an immediate distribution of the § 401(k) account, which is $1 million. But unfortunately for Charlie, that $1 million is not reduced by any basis, so his taxable income from the the distribution is the entire $1 million. Adding insult to injury, that income is ordinary income, not capital gain. So it gets hit with the higher income tax rates for ordinary income. I'll make the example simple and assume that the entire $1 million is taxed at the highest rate of 37%. That means Charlie pays the IRS $370,000 in income tax for the §401(k) distribution, leaving him with $630,000.

The bottom line is that both assets have a pre tax value of $1 million, but very different after tax values. The sibling who gets the stock account gets to walk away with $1 million in his/her pocket after taxes, while the other walks away with only $630,000. Not hard to see why Brenda and Charlie both want the stock account, not the §401(k) account.

This brings us to the importance of the trust provision you highlighted in your question. The trustee may disregard the basis and make the distributions based on market value rather than after tax value.

This is why, when doing estate planning, you want to consult an estate planning attorney who is also a tax attorney or consult both an estate planning attorney and tax attorney. The exact language of the will is important. Amy may have wanted her kids to walk away with the same amount of money after tax. If she did,then she wants her will to clearly express that. There are several ways that could have been in this case. But in your case, the grantor of the trust opted to let the trustee make distributions without regard to basis. That's how you can wind up with results like my example above. Because each person's estate is different and their plans are different, there may be an infinite number of ways the distribution might work out. Without expert planning, the person making the estate plan may inadvertently end up making choices that aren't really how they wanted things to end up.

State taxes and state law play an important role in the planning, too. For example, my state has no estate or inheritance taxes, a flat income tax rate, and a simple, inexpensive probate process that works at least as well as using a revocable living trust. In my state, and nearly all others, Amy could have just made beneficiary designations with the investment broker and §401(k) trustee that each kid gets half, i.e. they each get half the stock account and half the §401(k) account. That's avoids probate and trust fees, the kids can just go to the financial institutions, and get their half, and when all the dust settles they each come out the same after tax (not taking into account the other income they each have). That's as equal as she could have made it, and it would save a lot of fees, too. So in my state, it's simple compared to some other states, but it's still possible to mess things up if you're not careful.

 

[Tax Counsel]

Here's an example of what I think that sentence is saying.

That's not what the sentence is getting at. With a will or a revocable living trust (which is by far the most common trust used in estate planning), only the circumstances at death are going to matter. Hence it's the basis at the time of death that matters, not what the beneficiaries will do with it later. There is no way the trustee will know when the distribution is made shortly after death if one of them will hold on to the house they get and make it a qualified personal residence. It would be impossible for the trustee to be sure he got the distribution equal after tax if he had to project out to all the different things that might happen and try to pick the right one. He'd be throwing darts at a dart board while blindfolded. That one distributee is smarter at finance and tax after he/she gets their share doesn't matter and isn't taken into accout. Instead, estate planners and tax lawyers look at it through the lens of what would each walk alway with if they immediately sold the assets after the distribution. That provides a concrete number to work with to decide how the assets are to be divided.

 

[AppleLaw]

@Tax Counsel

First, I have to say thank you for the time you put into that reply. You hit the nail on the head with your example. Very helpful!

In this case the trustee kept a Roth for themself and designated a taxable to me. Both of those accounts named the trust as the beneficiary, and the Grantor would have intended for the outcome to be equal between us.

A catch is that the account designated to me has been in an inherited IRA that remains in the trust. The trust says that distributions were to be made free from trust, so that seems to be a failure by the trustee. The account continues to be in their control, so the distribution seems incomplete. Might this mean the tax liability remains with the trust?