From time to time prospective clients tell me that they don’t completely understand their estate plan. I empathize since wills, trusts and durable powers of attorney can be confusing. What may appear as straightforward terms take on entirely different meanings under the law. Moreover, each state’s laws are different, so when you migrate from another state to become a Florida resident, unintended consequences might arise in your plan if you don’t update it to Florida law.
Let’s talk about income, for example. Suppose that Mike has an annuity that pays out income over the course of twenty years, but he dies in year 5. The annuity pays to a marital trust for his wife, Betty, and, upon her death, the trust is distributed to his sons from a prior marriage, Stan and Larry.
Assume that, at Mike’s death, the annuity has a basis of $100,000 and the current value is $400,000. So for every distribution, 75% of it is taxable. So, over 15 years each year’s annuity payment approximates $30,000, of which $22,500 is taxable as income.
Under Florida law, however, most of the $30,000 annuity distribution is not “income” to the marital trust, rather it is “principal’ or corpus. This same law is true in many other states, by the way.
What does it mean when the annuity distribution is mostly principle under trust law rather than income? Unless the marital trust authorizes the distribution of principal to Betty following Mike’s death, most of the annuity distribution will remain in the marital trust share undistributed until Betty’s death.
Worse, since under federal income tax law $22,500 of the annuity distribution is taxable, the trust will pay the income tax. Note what’s happening here. State law calls the annuity distribution “principle” but federal tax law deems that same distribution to be taxable income.
When the taxable income is not distributed from the trust to a beneficiary, it is accumulated inside of the trust. Accumulated income is taxed at a very high rate, as under federal tax laws compress the marginal tax rate schedules applicable to irrevocable trusts. Mike’s trust became irrevocable at his death.
In other words, the marital trust, despite the modest amount of taxable income, will likely incur the current highest marginal tax rate, which is equivalent to 37%.
This is not very easy for layman to understand. It’s not that the average client isn’t smart enough; it’s just that when you are dealing in trust and tax law, what may appear simple often isn’t. This is one reason why so many individuals who attempt to construct their own estate plans through web-based programs get themselves into trouble. To create the best estate plan, one must not only understand the complex income and trust tax laws, but also how the various types of assets that are unique to one’s own situation affect the plan’s outcome.
I’m holding a unique interactive workshop on November 7th at the Sanibel Community house at 2:00PM. I’m trying something new in that I’m asking the attendees to bring their current estate planning documents with them. I’ll explain the major elements of a revocable trust, and my law partner and associates will roam the audience and help attendees find the provisions that we’re discussing, answering any questions about their application.
We’ll review the differences between wills and trusts, common trustee issues that every trust should address, and provisions governing the disability of the grantor, and what happens, for example, if you can’t act as the trustee of your own trust because you lost your mental acuity. We’ll also review administrative, tax and distribution provisions.
If you’re interested in attending, you can RSVP through our website estateplanu.org or by calling (239) 322-3831.
© 2018 Craig R. Hersch. Originally published in the Sanibel Island Sun.