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Practice Management

Changes to income and estate taxes as well as the 3.8% Medicare surcharge on investments require advisors to rethink the tax implications of their advice.

This Practice Management article is intended for financial advisors only (registered representatives of broker dealers or associated persons of Registered Investment Advisors).

Advisors always need to weigh the tax implications of their investment advice. This is never easy, but it can be devilishly difficult when trying to figure out all the implications of the recent "fiscal cliff" tax deal, including higher income tax rates, a 3.8% Medicare tax on passive investments, and changes in the estate tax rules.

Conventional wisdom once held that high-growth assets should be held in a bypass trust, since the trust's assets would grow outside the estate. Now, however, with higher capital gains taxes and portability, the opposite approach might be true. An argument can be made that bonds should be held in the bypass trust and equities should be held in the name of the surviving spouse. That way, the stocks' appreciation will get a step-up in basis on the surviving spouse's death.

If Rates Rise
All this sounds good, but in the current investment environment, the yield curve for bonds is rather flat. An upward movement in interest rates seems almost inevitable; for long-term bonds, this could lead to extreme volatility.

In addition, despite possible tax-planning advantages, the idea of having any portfolio invested 100% in any asset class would probably run afoul of prudent investor laws and open a fiduciary to substantial surcharge risk. Unless a will or living trust that creates a bypass trust expressly authorizes an undiversified portfolio, a trustee must be cautious in trying to maximize tax benefits.

Even if the will creating the trust permits the trustee to vary from prudent investor rules, the language in many documents won't provide professional trustees with sufficient comfort to do so. Getting beneficiaries to sign off on the investment policy statement approving the tax-advantaged strategy might not assuage concerns for all trustees.

There is a related issue to be wary of: In the current investment environment, wealth managers have been turning to fixed-income substitutes such as real estate investment trusts (REITs); master limited partnerships in oil, gas, or pipelines; or sovereign debt funds (since Brazilian bonds, for instance, pay more than U.S. bonds). It could then be these substitutes held in the bypass trust.

But the trustee again faces a host of issues. Fiduciaries owe loyalty to all beneficiaries, not simply the surviving spouse. And the language used in many wills to create bypass trusts may not suffice to provide comfort to a fiduciary investing only in these asset classes. While a family trustee may simply do it, a third-party trustee may be wary of a lawsuit if things don't pan out as intended.

Using an IRA
Because of a couple of tax changes—the maximum capital gains tax rate being raised to 20% (from 15%) and the new 3.8% Medicare surtax on investment income above certain thresholds—as well as the impact of state taxes, some advisors may want to shift allocations between taxable accounts and nontaxable accounts such as IRAs.

So, as an advisor, where do you put corporate bonds? One possibility is in an IRA, in order to avoid current higher income tax rates. But what if the IRA holds only bonds and then bonds crash?

If this results in greater relative growth in nontaxable versus taxable accounts, then for clients who have designated different beneficiaries for their retirement accounts and in their wills, the modified investment allocations may affect the amounts that IRA beneficiaries would receive. That is a significant development that advisors must consider. Merely maximizing return and tax benefits is not enough if such actions affect different beneficiaries' inheritances significantly.

Grantor Trust Impact
Grantor trust status has been a favored estate-tax planning technique for years, and many of the trusts set up in 2012 were this type of trust. All the income earned by the trust is taxable for the grantor—usually the client setting up the trust. Grantor trust status reduces the grantor's estate by using it to pay income tax on assets growing inside the grantor trust—which are outside his or her estate for estate-tax purposes.

If the trust's grantor is in the highest income tax bracket, the tax bite will be painful. And if the federal estate tax is no longer a risk for the client, as a result of the new $5.25 million inflation-adjusted federal estate-tax exemption, the client may not be getting the anticipated tax benefit.

One option is to turn off grantor trust status—but that is permanent and has some negative aspects. Grantor trust status lets the client sell assets to the trust; this could be useful for asset protection or other reasons. It also lets the client swap or buy appreciated assets from the trust to put into his or her own estate, to get a step-up on death. On the other hand, getting rid of grantor trust status may make it feasible to distribute income, shifting it to beneficiaries in lower tax brackets, such as children or grandchildren.

If the decision is made to turn off grantor trust status, the exact terms of the trust must be reviewed. In many trusts, it may be possible for a person, perhaps someone designated as a trust protector, to simply turn off grantor trust status. In other trusts, it may be possible for the people given the specific rights that trigger grantor trust status to relinquish those rights.

If no other option is feasible, it might be possible to roll the existing trust into a nearly identical new trust that is designed not to be a grantor trust. This process is called decanting.

Mitigating Tax Problems
But it is not always optimal to sacrifice grantor trust status permanently. It will be up to the financial advisor to mitigate the negative income tax result. This might be achieved by any combination of the following:

  • Modify asset-location decisions to favor investments generating cash flow in an individual client's name to cover income tax costs, or non-income-producing assets (such as growth stocks) in the trust, to lessen the income tax burdens added by the trust.
  • Favor tax-advantaged investments, such as tax-exempt bonds and insurance products inside the trust. If life insurance is to be used, be certain that the trust is suitable for holding the insurance since it may not have been designed with that purpose in mind.
  • Harvest gains and losses more aggressively and coordinate planning to reduce the income tax burden.

There are yet other options for dealing with clients who are frustrated about the income tax burden on earnings retained in an irrevocable grantor trust.

Some grantor trusts, though not all, include tax-reimbursement clauses. If such a clause is included, however, it must be exercised judiciously; if it is used on a regular basis, the IRS might argue that the use shows an implied agreement between the trustee and the grantor to benefit the grantor. Also, for this strategy to be effective, the trust must be based in a state where that provision won't negate the goal of keeping trust assets out of the reach of creditors and the grantor's estate.

In addition, if the grantor's spouse is a beneficiary of the trust, a change that increases permissible distributions to the spouse might resolve a couple's cash flow concerns.

Taken together, the new estate and income tax changes, along with the explosion in the number of grantor trusts created in recent years, greatly complicate the investment allocation and location decisions that wealth managers and planners must make. As with so many tax changes, efforts at simplification have the opposite result.

Martin M. Shenkman, CPA, PFS, JD, is a Financial Planning contributing writer and an estate planner in Paramus, New Jersey. He runs, a free legal website.



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