Avoid Income Tax Disasters on Early Trust Terminations

By Ed Morrow

U.S. Bank Private Wealth Management

Ten new IRS rulings highlight critically important income tax ramifications surrounding early trust terminations.  These terminations are often referred to as a commutation, wherein each beneficiary receives a percentage reflecting the value of their respective interests.

This is especially true regarding termination of bypass trusts perceived to no longer be needed for estate tax purposes, thousands of which have probably been terminated in recent years without consideration or warning of the potential income tax disaster. These commutations might be a complete catastrophe that produces a much worse result than had the parties done nothing at all — or taken a different path.

In one of these rulings (IRS PLRs 2019-32001 to 2019-32010), a settlor established an irrevocable trust for his son and his son’s descendants. The trust paid the son all net income, with no discretion for additional principal, and the remainder to his descendants’ bloodline outright. The parties agreed to terminate the trust early, according to the actuarial value of the interests of the son, his four children and eight grandchildren, and went to court to approve the settlement agreement and terminate the trust accordingly. This was permitted under state law, provided no material purpose of the trust was frustrated. The court agreed and approved the settlement, contingent on the IRS granting a private letter ruling.

The IRS did grant favorable rulings regarding gift and goods and services (GST) taxes, but threw in an extra surprise on the income tax ruling. The IRS deemed the trust termination to be a taxable sale by the son and great-grandchildren to the grandchildren, triggering capital gains tax. But it gets worse as the son was deemed to have a $0 basis and had to pay long-term capital gains tax on the entire amount received.

This creates a huge income tax event, potentially worse than if the trustees had sold all of the trust assets. Even more troublesome, the son’s estate is dramatically increased by the amount received net of tax – even though he didn’t need the income – and may be taxed at 40%. Worse still, he will receive fair market value basis assets or cash that will only receive a step up at his death for any appreciation occurring after the transaction, if any. This is a heavy price to pay to get out of a trust, like cutting off an arm to cure the itch from a mosquito bite. 

There are no dollar amounts in the various private letter rulings, but imagine you and your family have a trust established by your parent similar to the one in these rulings, with $10 million of assets and a basis in these assets of $5 million. The actuarial value of your interest is $4 million, your children’s interest is $5.5 million and your grandchildren’s interest is $0.5 million (40%; 55%; 5% – this would vary based on the ages of the beneficiaries.) The $5 million of basis would be divided by the same percentage under the uniform basis rules: $2 million, $2.75 million and $250,000, respectively. On a commutation, you would pay long-term capital gains tax (20% + 3.8% net investment income tax) on $4 million (under these IRS rulings, you cannot use your share of $2 million basis). Your grandchildren would pay long-term capital gains tax on $500,000, but are permitted to use their $250,000 share of uniform basis to offset gain, incurring $250,000 of long-term capital gain. Your children would pay tax on the $4.5 million of total assets going to you and the grandchildren to “buy out” their share, minus the $2.25 million of basis attributed to those assets. Thus, the total gain triggered among the family is as high as $6.5 million ($4 million for you + $250,000 for grandchildren +$2.25 million for your children). Ouch! If we assume a 23.8% tax rate (not including any state income tax if they live out of state) on this $6.5 million, that’s a $1,547,000 price tag to terminate the trusts. Even if the trust were invested 100% in cash, there would still be a nasty tax bill ($4 million times 23.8% = $952,000). This tax could have largely been lessened or avoided by waiting until death, releasing an interest, or amending the trust, selling to a third party or taking another path that would not cause such a horrific taxable event. 

In short, these rulings point out significant income tax dangers to early terminations of trusts. Courts are not always going to approve these (such as the recent Florida case of Horgan v. Cosden,) but even in cases where they would, beneficiaries should consider alternatives such as extraordinary distributions, loans, releases/gifts or other lesser amendments before proceeding with an early termination that may trigger phantom gains. There are several potential solutions around these issues.