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Here’s the question I’ll try to answer in this post:
What happens to a grantor trust when the grantor dies
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I myself, am a Grantor in a Grantor Trust in my home state of Florida. It was created as part of my own personal estate planning. I did alot of research as part of my own estate planning and that is what I’m sharing today.
So now let’s talk about death. The grantor trust status terminates with the death of the grantor. The trust instrument must be reviewed to determine what happens to the trust property after the death of the grantor.
Obviously, if the trust terminates and the property is paid outright to its individual beneficiaries, issues of ongoing trust income taxation become irrelevant. No need to read further.
In my case, the trust will continue after my death. After my death, the trust now becomes a “new” taxpayer. The trustee should obtain a new taxpayer identification number (unless there was one obtained before, which is good practice) for the trust.
Consider the issue of income tax basis for the trust assets. If the powers over the trust retained by the grantor were administrative only, although the grantor remained taxable on the trust income until death, the trust principal would not be included in the grantor’s estate. The gift to the trust would be considered complete as of the date of the transfer of the trust assets to the trust by the grantor. Accordingly, in such a situation, the grantor’s basis in the properties transferred to the trust during the grantor’s
lifetime carries over to the donees/ beneficiaries of the trust. [IRC § 1015]
Alternatively, it is possible that the grantor’s retained interest in the trust that caused the grantor trust status to be established for income tax purposes is a sufficiently broad interest (such as the power to revoke the trust) that the retention of this interest also requires inclusion of the trust property in the grantor’s estate for federal estate tax purposes. [IRC §§ 2036 and 2038] Where this is the case, the inclusion of the trust property in the grantor’s estate results in an income tax basis to the grantor’s heirs equal to the fair market value of the trust property as of the date of the grantor’s death. [IRC § 1014]
Application of this rule could result in a basis to the heirs either stepped up or stepped down from the grantor’s original cost basis in the property.
When the grantor of a grantor trust dies, and the grantor trust status terminates, the trust itself is often the vehicle to be used to wind up the decedent’s affairs and distribute his or her assets to the intended heirs.
The Taxpayer Relief Act of 1997 introduced Code Section 645 which permitted an election to be made for income tax purposes to enable a Qualified Revocable Trust to be treated and taxed as part of the decedent’s estate, not as a separate trust.
With the substantial federal estate tax exclusion available in 2020 ($11.58 million, indexed for inflation) and the opportunity for estates of married decedents to elect portability of the exclusion, the vast majority of decedent’s estates will not be taxable and not be required to file Form 706 (except for portability purposes) so there will not be a federal estate tax proceeding.
Nevertheless, the income tax benefits of the QRT election, even for two years, suggest that making the election is a worthwhile decision in the majority of cases. When a Section 645 election is made for a QRT, the trustee is not required to file Form 1041 for the short taxable year of the QRT beginning with the decedent’s date of death and ending December 31 of that year. [Reg. § 1.645-1(d)]
Form 1041 must be filed for the short taxable year of the trust beginning with the decedent’s date of death if a Section 645 election will not be made for the trust. If the Section 645 election is made, the electing trust and related estate are treated as constituting separate shares of the estate under Code Section 663(c) for purposes of computing DNI and applying the distribution provisions of Code Sections 661 and 662. If there is a distribution from the related estate to the QRT (or vice versa) the distribution reduces the distributing share’s DNI and increases the gross income of the receiving share. [Reg. § 1.645-1(e)]
Once the QRT election is made, only one Form 1041 need be filed in the name of the estate, rather than separate returns for the trust and for the estate. During the election period, the trust has to participate in only one annual fiduciary income tax return filing for the combined trust and estate under the name and identifying number of the estate. The executor of the related estate is responsible for filing Form 1041 for the estate and for all electing trusts. All items of income, deduction and credit for the estate and all electing trusts are combined on the single Form 1041. One $600 annual income tax exemption is allowed.
Perhaps the most important and desirable features of the Section 645 election are that once the election has been made, an electing trust may utilize a number of advantages previously limited to estates. An electing trust may select a fiscal year rather than a calendar year. The electing trust may claim an annual exemption of $600, be possibly (depending on the activities of the decedent) entitled to deduct up to $25,000 in real estate passive losses, [IRC § 469(i)] and may deduct amounts paid or permanently set aside for charity. The electing trust may hold S Corporation stock in accordance with the broader rules allowing estates generally, but not all trusts, to be S Corporation shareholders. [IRC § 1361(b)(1)(B) and (c)(2)] The provisions of Code Section 6654(l)(2)(A) relating to the two-year exception to an estate’s obligation to make
estimated tax payments will apply to each electing trust for which a Section 645 election has been made. [Reg. § 1.645-1(e)]
An electing trust will be treated as a trust and not as an estate for purposes of the retirement plan required minimum distribution rules of Code Section 401(a)(9). [Reg. § 1.645-1(e)] This provision assures the trust of greater flexibility in determining the designated plan beneficiary
and greater deferral, if desired, of the payment of required minimum distributions, and does not subject the trust to the unfavorable rules that result when an estate is named a retirement plan beneficiary.
When the election period terminates, the combined estate and QRT terminate, and are deemed to distribute their assets to a new trust to which Code Sections 661 and 662 apply. The deemed distribution entitles the distributing entity to an income distribution deduction (if any income is distributable) per Code Section 661, and the new trust must include the income distribution in income as required by Code Section 662.
In the event a trust has been taxed for income tax purposes as a grantor trust, but does not meet the requirements to be treated as a Qualified Revocable Trust, the Code Section 645 election is not available. In such a situation, the trust document must be consulted to determine whether the trust will continue as a “standard” simple or complex trust following the death of the grantor, or whether the trust will terminate and distributions of the trust property will be payable to the trust beneficiaries.
Efficient Tax Planning with Foreign Grantor Trusts
Foreign Grantor Trust Planning If the requirements of Section 672(f) are satisfied, there are substantial opportunities for efficient tax planning for U.S. beneficiaries.
Since all income is considered taxable income of the foreign grantor, U.S. beneficiaries can receive distributions free of tax.
The foreign grantor is only taxed on Effectively Connected Income (ECI) or U.S. source Fixed, Determinable, Annual, or Periodical (FDAP) income. Therefore, the trust can invest in the U.S., generate capital gains (excluding Foreign Investment in Real Property Tax Act (FIRPTA) gains) and interest income, as well as non-U.S. income, without incurring an income tax burden in the U.S. If properly structured, it can be free from U.S. transfer tax.
Exit Tax and Grantor Tax
Grantor Trusts
All assets of a grantor trust, for which the covered expatriate is treated as the owner, are subject to the exit tax.
The Joint Committee on Taxation’s commentary on the HEART Act expressly states this rule, although the statutory language, which refers to “all property of a covered expatriate,” makes this requirement far from clear.
Despite this rule, the application of the exit tax to grantor trusts must often be coordinated with the possible “outbound migration” of the trust, which may result in gain recognition. Under § 684, the outbound migration of a U.S. trust triggers gain (but not loss) recognition in the trust’s assets, if the trust is not a grantor trust subsequent to the migration.
As the grantor trust status is limited in its application to non-U.S. persons, trusts other than revocable trusts will cease to be grantor trusts upon the grantor’s expatriation in many circumstances.
If gain is recognized as a result of the outbound migration, that gain is taken into consideration prior to the application of the exit tax, ensuring the gain is taxed only once.
3 Ways FGTs Can Be a Great Tax Tool
Before becoming a U.S. resident, a taxpayer has the ability to make irrevocable gifts to non-U.S. individuals in trust under the following conditions:
- The trust document explicitly states that it is not allowed to have U.S. beneficiaries.
- The trust is not considered a U.S. grantor trust.
By doing this, the taxpayer can potentially avoid U.S. income taxes on future income generated by the gifted assets. Additionally, they may also avoid subsequent U.S. gift and estate taxes on the transfer of those assets. This is simply because the individual, who is now a U.S. resident, no longer possesses the income-producing assets for U.S. tax purposes.
As a word of caution, nonresidents who establish foreign grantor trusts that have (or could have) a U.S. beneficiary are liable for U.S. income tax on the foreign trust’s income if the nonresidents become U.S. taxpayers within five years of transferring property to the trust (Regs. Sec. 1.679-5(a)).
Therefore, a nonresident alien planning to immigrate to the United States should create and fund the foreign trusts at least five years prior to becoming a U.S. person to avoid being taxed on trust income.
Tax Implications of Residing in the US with UK Pensions
The IRC applies to U.S. citizens and residents, encompassing lawful permanent residents and those meeting the substantial presence test (section 7701(b)(3)). Distributions from UK-based defined contribution pension plans to UK citizens in the U.S. aren’t taxed for income earned before U.S. status. However, defined benefit pension plan interest is subject to taxation as immediate gross income.
The grantor trust rules (sections 671-679) delineate trust property ownership for tax purposes. Notably, section 673 designates the grantor as the owner if retaining interest, while sections 674, 677(a), and 678(a)(1) define ownership based on factors like disposition powers. In cases of U.S. property transfer to a foreign trust with a U.S. beneficiary within five years, section 679(a) treats the U.S. person as the owner.
Gross income from a UK pension is generally reported on a U.S. tax return, but provisions in the 2001 U.K.-U.S. income tax treaty can modify this. Treaty Article 4 defines residency and includes exceptions for cases of dual residency. U.S. nationals are citizens, while UK nationals comprise British citizens with the right of abode.
Treaties include savings clauses allowing citizen taxation despite the treaty. Article 17 exempts pension income from double taxation. Article 18 taxes pension income when received.
Summary:
- UK pension interest for U.S. citizens/residents is largely taxed by the U.S.
- Contributions and pre-U.S. accrued income generally evade U.S. tax.
- UK pension income becomes taxable upon U.S. distribution.
- Around 25% of a UK-based defined contribution pension plan balance may be tax-free.
Let’s Talk About Pre-Expatriation Trusts
Pre-Expatriation Trusts
Potential covered expatriates should be advised to utilize all of their remaining unified credit before expatriating.
Once a covered expatriate becomes a non-U.S. citizen and non-U.S. domiciliary, the unified credit is no longer available for either § 2801 tax purposes or standard estate and gift taxation, except for the potential availability of a $13,000 estate tax credit.
The most efficient utilization of this credit is likely through transfers to a “pre-expatriation” trust, which can be structured as a standard irrevocable gifting trust.
Careful consideration should be given to whether the trust should be structured as a grantor or non-grantor trust. Additionally, it should be considered whether expatriation will cause the trust to become a non-U.S. trust, thereby triggering § 684 gain and potential throwback tax in future years.
