The investment environment over the last year has been tough on everyone, including credit shelter trusts (also called B Trusts or Bypass Trusts). It is up to the trustee of the credit shelter trust (CST) to manage market performance and the tax costs of their investment portfolios while still meeting the requirements of the trust.
The challenges the trustee faces are similar to those of an avid golfer. He or she must be able to strategically maneuver through course-designed and weather-related hazards. If the golfer does not execute each shot effectively, penalty strokes, high scores, and frustration usually follow.
For a trustee, investment hazards can have more serious consequences. The trustee must impartially balance the interests of all beneficiaries by efficiently managing market and tax risks while preserving assets and distributing income. And unlike a round of golf, there is no such thing as a mulligan.
Trust tax costs: Why pay Uncle Sam first?
When taxable income is created by the investments within an irrevocable trust, the trustee has two primary options:
? The income can be held within the trust.
? The income can be distributed (per the terms of the trust) to the income beneficiary.
Taxable income remaining in the trust will be taxed at the trust’s applicable ordinary income or capital gain tax rates. The tax rate differential compared to distributing and taxing the income at the individual’s tax rates–the highest 35% marginal tax bracket kicks in at $357,701-plus for individuals as opposed to only $11,150 for trusts–may create a tax disadvantage if the income remains inside the trust. (See chart.)
For this reason, many trustees will distribute income even when it is not needed by the beneficiary. In 2007, that amounted to more $65 billion in taxable income for irrevocable trusts. There are two probable sources for this tax cost:
? Investment rebalancing.
? Mutual fund portfolio turnover.
Regular trust portfolio rebalancing is a fundamental regulatory best practice for trustees. When rebalancing is conducted to return the portfolio to its appropriate asset allocation, this sell and buy sequence will generate long or short-term capital gains/losses.
Mutual fund portfolio turnover
The trading habits of a fund manager can also cause taxation for the CST. Each year, a mutual fund will distribute capital gains and dividends to each shareholder. This distributed taxation can be managed through “tax loss harvesting.” This process requires realizing actual losses to offset the realized capital gains. This can become complicated and take a significant amount of expertise, which may be difficult for the trustee to manage.
Currently, long-term capital gains, qualified dividends and municipal bond interest receive preferential tax treatment and can play an important role in trust tax efficiency. Trustees may want to complement a diversified, tax-efficient, mutual fund portfolio with an annuity. An annuity is an option to receive tax-deferral, until an income stream begins, along with optional features that may transfer risks through an insurance contract. The trustee needs to review the annuity contract’s mortality and expense risk charges and other costs as part of a risk and return cost benefit analysis.
Trust-owned annuity taxation: Controlling tax transaction costs
Given an expected increase in tax rates in coming years, controlling income will become even more essential. One strategy is to use an eligible trust-owned annuity to defer ordinary income taxes. This allows the trustee to have full control over the annuity portion of the trust portfolio.
A variable annuity investment allows for potential accumulation while controlling taxation. Rebalancing can be facilitated automatically and without immediate taxation. Underlying portfolio turnover is done without taxable distributions so that taxation only occurs when distributions are needed and distributed to the beneficiary(s) of the trust.
However, for a trust-owned annuity to be eligible for income tax-deferral, every trust beneficiary must be an individual. If any trust beneficiary is a non-natural entity, such as a charity, corporation, partnership, or estate, the annuity earning will be subject to current federal and state ordinary income tax. If the annuity does qualify for tax deferral, the IRS 10% penalty may apply to distributions prior to the annuitant attaining age 59 1/2 .
Trust-owned annuity riders: Market risk and income
Annuities offer additional guarantees (at extra cost) that can help protect against two risks a trustee must plan for: income beneficiary longevity risk; and un-diversifiable market risk.
Withdrawal benefit for life
This optional living benefit rider can provide a steady stream of income for the lifetime of the income beneficiary. The longevity risk is transferred to the insurance company while the undistributed annuity assets remain invested. It is important to choose a withdrawal benefit that allows for exclusion ratio treatment for two reasons:
(1) The treatment maximizes the tax efficiency of the annuity distributions.
(2) The payments more closely align with certain income accounting provisions of the Uniform Principal and Income Act (UPAIA). The UPAIA may restrict a trustee from distributing all intended income from standard earnings-first annuity withdrawals to the income beneficiary.
A guaranteed death benefit can provide market protection to the trust’s remainder beneficiaries with the income beneficiary as annuitant. If the income beneficiary dies, a guaranteed lump sum death benefit is paid to the trust regardless of the annuity value at that time.
The deferred gains would be subject to trust ordinary income taxation, but in most cases the trust will terminate and distribute trust assets to the remainder beneficiaries. Assuming this is done in the same calendar year, the deferred annuity earnings should pass through the trust and be taxable at the remainder beneficiary’s ordinary income tax bracket.
It’s time to consider a trust-owned annuity
As a financial professional, your job is to work with trustees and their legal and tax advisors to identify whether an annuity is an appropriate complement to the existing trust asset allocation. Fixed annuities should be considered for part of the conservative portion of the trust portfolio. Variable annuities combine diversified investment options, rebalancing features and optional living or death benefits for a portion of the equity component of the trust portfolio.
Wright Edler is vice president and division sales manager for ING U.S. Annuities, based in West Chester, Penn. He can be emailed at Wright.Edler@us.ing.com.