Trust Income and Trust Principal

Wikimedia says this is a rental home, I''ll trust them

Many long-term trusts contain distribution clauses that state that the beneficiary will receive a certain portion of trust income every year, usually 100% and upon certain birthdays, e.g. their 30th birthday, the beneficiary is to receive a fraction of trust principal, e.g. 1/4. Of note, the latter beneficiary may or may not be the same as the former beneficiary. For example, the income beneficiary could be a child and the principal beneficiary could be a grandchild. A natural question that arises is "what is the difference between trust income and trust principal?" The answer to this question is quite simple,  trust income relates to the profits derived from trusts assets and trust principal relates to the asset itself.

For example, assume the trust's sole asset was a rental home with Tommy as trustee and Bobby as the lifetime income beneficiary and Beatrix as the remainder principal beneficiary. Rental income derived from the home would be classified as trust income. The home itself would be classified as trust principal. During Bobby's lifetime, Tommy would distribute to him the income derived from the rental home and when Bobby dies, the home would be distributed to Beatrix outright and free of trust.

The main reason why clients tend to design a trust this way is to benefit multiple generations. For instance, they can make their children the income beneficiary and their grand kids the principal beneficiary.

Still, I am not overly fond of these long-term trusts for a couple of reasons. First, there is an accounting issue that must be addressed. Per California law, each beneficiary is generally entitled to an annual accounting. A trust that last for 30 years would presumably require an accounting on 30 separate occasions. The amount of paperwork that must be documented then would be staggering. Second, income tax rates for trusts are quite steep. If a trust earns roughly $11,000 in income, the trust has reached the top income tax bracket. In contrast, for regular income taxes, a person has to earn hundreds of thousands of dollars before they reach the top income tax bracket. Third, assuming there is real property involved, ongoing maintenance costs would be significant. Numerous parts of a home require substantial expense in order to maintain it, plumbing, the roof, landscaping, heating, cooling, electrical, etc. 

In short, I rarely if ever advise a client to seek a long-term trust as the benefits rarely outweigh the costs. Regardless, it is the client's ultimate decision as to how they want to proceed, I just have to tell them of the risks involved. 

Donate Your House to Charity

Sometimes in life you cannot have your cake and it too. 

The following case addressed a family's attempt to donate their home to a local fire department and the accompanying tax consequences.

Rolfs v Commissioner (7th Cir 2012) 668 F3d 888

The Rolfs purchased a lakefront property on Pine Lake in Chenequa, Wisconsin. The Rolfs were dissatisfied with the existing home and decided to donate the home to the local fire department for training. The fire department, not surprisingly, burned down the house in a subsequent exercise. The Rolfs then claimed a $76,000 charitable deduction on their 1998 tax return for the donated home. Their theory was as follows "[t]he taxpayers argued that the "before-and-after" method should be applied. Their appraiser started with an estimated value of $675,000 for the land and house together, based on comparisons to recent sales of similar properties in the area. Using the same method, he estimated a value of $599,000 for the land alone, without any house on it. He subtracted the latter from the former to estimate $76,000 as the value of the house alone." 

The IRS was dissuaded with this claim and rejected it. The Rolfs then lost on appeal to the Tax Court and appealed again to the circuit court of appeals.

The appellate court affirmed, finding that when donated property is subject to a condition, the condition needs to be accounted for when making the property valuation. In other words, if a donation has strings attached, you need to factor the strings into the valuation equation. In this case, a donated home, given on the condition of subsequent incineration, has practically no value. Trust me on this one.

Furthermore, the appellate court affirmed the finding that the Rolfs received a benefit of $10,000 by donating their home to the fire department. Since the old home would invariably be razed to make way for the new home, this donation essentially benefited the Rolfs aside from the charitable deduction because the fire department performed the necessary destruction of the home. Thus, if the Rolfs' deduction was upheld, the benefit to them would be twofold. First, they would receive a charitable deduction for their donated home. Second, they would avoid having to pay somebody to tear down their home. 

On the bright side, the donation saved the Rolfs the trouble of finding a company to apply a wrecking ball to their home. Hence the latter benefit remained intact despite the court's ruling, the home destruction by the fire department, while the former benefit, the charitable deduction, was disallowed.

Trust Taxation

Trusts, like any other entity, must pay income taxes for the revenue it generates during the year. One key distinction between trusts and other taxpayers is the fact that trust tax brackets are very compressed. The following graphs illustrates such as it depicts the trust tax brackets for 2010: 

Federal

              

Taxable Income	Tax Rate
$0 - $2300	15%
$2300 - $5350	$345 plus 25% of amount over $2300
$5350 - $8200	$1107.50 plus 28% of amount over $5350
$8200 - $11,200	$1905.50 plus 33% of amount over $8200
over $11,200	$2895.50 plus 35% of amount over $11,200

California

Taxable Income	Tax Rate
$0 to $7124	1.25 %
$7124 to $16,890	$89.05 plus 2.25 % of amount over $7124
$16,890 to $26,657	$308.79 plus 4.25 % of amount over $16,890
$26,657 to $37,005	$723.89 plus 6.25 % of amount over $26,657
$37,005 to $46,766	$1370.64 plus 8.25 % of amount over $37,005
over $46,766	$2175.92 plus 9.55 % of amount over $46,766

It should be noted that federal and California trust taxation varies each year so by no means do the above two graphs represent the 2011 trust tax brackets. Instead, the graphs represent how quickly a trust reaches the top income tax bracket. For example, a person in 2010 does not reach the top income tax bracket until they earn $373,650. Whereas, a trust reaches the top income tax bracket by earning a mere $11,200. Clearly this is a large discrepancy. 

Property Taxes and Capital Gains

The notable Campbell, CA water tower down the street from my office

When somebody inherits real property and sells it thereafter, two important legal issues commonly arise, property taxes and capital gains. Property taxes in California are governed by Prop 13. Basically Prop 13 says that real property may be levied a 1% tax on the assessed value each year and the assessed value may be raised by no more than 2% annually. Capital gains is the tax imposed on a person when an asset is sold for a gain, namely the sale price exceeds the cost-basis. The following example illustrates how these legal topics relate to inheriting and then selling real property in California. 

The following individuals are fictitious characters invented through the limited powers of my imagination.

In 2008, Bobby Beneficiary, a resident of Mendocino, CA was informed by his Uncle George that his mother Ma Bell passed away and left her home in Campbell, CA to him through her will. Bobby's father Pa Bell had predeceased his mother. Ma and Pa Bell bought the home in 1980 for $10,000. Later in 2008, the will was probated and title to the Campbell home was transferred to Bobby from his late mother. Bobby was concerned that he will have to pay property taxes for the current value of the home, $600,000. However, Bobby was told by the probate attorney that this transfer qualifies for the parent-child exclusion and no re-assessment for property taxes will occur. Rev & T C § 63.1. Thus, Bobby was able to maintain the very low assessed value of the home, $10,000, for as long as he desires. This was particularly important for Bobby because he would rather not be forced to sell the property. Instead, Bobby would prefer to sell the property during a seller's market.

A few years later, in 2011, Bobby decides that the time is right to sell the Campbell home. Bobby was able to delay the selling of the home because property taxes were quite affordable given the low assessed value of the home. During the summer of 2011, Bobby finds a purchaser of the home and the parties agree to a purchase price of $650,000. Following the sale, Bobby becomes concerned over the enormous tax burden he will face next year when he files his taxes. The reason for Bobby's concern is that he has received shoddy accounting information over the years. Bobby has been deceived into believing, through viewing many late-night infomercials, that his basis in the property is $10,000. Hence, he erroneously believes that he will have a gain of roughly $640,000 (650,000-10,000). Yet in reality when Bobby inherited the property from his mother he received a new cost-basis in the property. When a person inherits property, the cost-basis is generally the date of death value of the asset.  IRC §1014(a); Rev & T C §18031. Here, the value of the Campbell home was $600,000 on Ma's date of death. Thus, Bobby's capital gains would in actuality be much smaller than he originally believed. That is, his capital gains would be $50,000 (650,000-600,000). Ultimately, Bobby's ability to inherit property from his mother, known as stepped-up basis, reaps enormous tax savings for him.

As you can see, inheriting property from somebody enjoys the best of both worlds, retention of old assessed value for property tax purposes and a stepped-up basis for the asset to reduce capital gains.

Stepped-Up Basis

Whenever a person sells an asset, whether personal or real, the person needs to determine cost basis of the item to ascertain whether or not the sale results in a taxable gain. For example, John purchases 118 Green Street in CA for $100,000 in 1985. The cost basis would be $100,000. If, generally speaking, John ever sold the property for greater than $100,000 such sale would result in a taxable gain.

One of the prime benefits of acquiring real property through inheritance is the application of "stepped-up basis." The result of stepped-up basis is that a person who inherits real property receives a new cost basis which is pegged to the fair market value of the asset at the date of the decedent's death. IRC §1014(a); Rev & T C §18031. Yes, that is how it is written in tax terminology. For example, from above, John purchases 118 Green Street for $100,000 in 1985. Due to real estate appreciation (just go with it), John's home gradually increases in price to $700,000 in 2012. John then dies in a tragic hot air balloon accident in 2012 in Morgan Hill, CA. John's heirs would be entitled to claim $700,000 as the cost basis of the home. Subsequently, when John's heirs sell the home, the starting point for a taxable gain would be $700,000, whereas the starting point for John would be $100,000. Though capital gains tax is much lower than regular income tax (see Mitt Romney tax return for 2010), it still is roughly 25% combined for federal and state, that is California. When you multiply that by 600,000, the result is a rather large number. Thus, it is quite clear that stepped-up basis affords heirs an enormous tax savings because they are not liable for the appreciation that has accumulated over the years. Rather, the heirs can take advantage of the new date of death value of the asset. The common result is that heirs of real property often pay little to nothing in capital gains taxes if they sell the inherited property shortly after receiving it. 

Trustee of a Living Trust

Central Trust Company
Altoona, PA

The term "trustee" is used in many different legal fields. For example, in bankruptcy a trustee is appointed for administering the bankruptcy estate, in the case of a foreclosure the trustee is responsible for handling the property's foreclosure and in the case of a trust, a trustee is required in order to administer the trust. The following are some questions that delve into the topic of a trustee of a trust, whether irrevocable or revocable. 

1. What is a trustee?

A trustee is the legal owner of trust property who administers the trust estate in accordance with the trust's directions. Prob C § 16000. For example, if a trust owns a home and the trustee is John Smith, title to the property would be held, loosely stated, as "John Smith, trustee of the Smith Trust."

2. Who can be a trustee?

A trustee can be a person or natural person. 

In regards to a natural person, such an individual needs to be an adult because minors cannot enter into contracts to sell property.  Wallace v Riley (1937) 23 CA2d 654. 

In terms of a person, a corporation can serve as trustee. Prob C § 300. However, before you list some large financial institution as the trustee, please be aware that corporate trustees require large estates, typically in the millions of dollars, before it undertakes representation as trustee.

  

3. Can I pick myself as trustee?

Yes and this is quite common. Many couples appoint themselves as trustees and name their children as successor trustees.

4. What duties does a trustee?

To list all the duties of a trustee would be a bit much for this post. Please click on this link for a full explanation. Suffice to say there are plenty. 

5. How is a trustee compensated?

Trustee compensation is not a matter of right for the trustee. Thus, the trustee may be entitled to no compensation if so provided by the trust document.

However, a trustee is almost always compensated in reality. Few people are willing to assume a position with all the risks without a reward. The following are various methods used to calculate a trustee's compensation if allowed:

• The trustee is compensated in accordance with a set formula. For example, it is common for a trustee to be compensated 1% of the value of the trust estate annually;
• In the case of a corporate trustee, it has a published fee schedule;
• The trustee is paid a fixed amount per year;
• The trustee is entitled to "reasonable compensation." Probate Code §15681

6. Is trustee compensation considered taxable income?

Yes, income received from acting as a trustee is considered taxable income. Pay your taxes!

7. Can a person refuse the selection as trustee?

Yes, and a person has the right to decline trusteeship even after assuming the position. Prob C § 15640.

8. Can a trustee be removed?

Yes, a trustee can be removed (1) in accordance with the trust instrument (2) by the court on its own motion, or  (3) on petition of a settlor, cotrustee, or beneficiary under Probate Code Section 17200.  Prob C § 15642(a).

9.  Can there be more than one trustee?

Yes, California law permits a trust to have more than one trustee administer it.

10. Does a trustee have to be bonded (see insured)?

No, a trustee need not be bonded unless the trust document requires a bond or a court orders a bond on a finding that the beneficiaries' interests must be protected. Prob C §15602(a)(2). 

11. What are some examples of what not to do as a trustee?

As taken from a prior post:

The trust drafter instructed the trustee, Bank of America, to not allow the trust bank account to exceed the maximum Federal Deposit Insurance Corporation amount. For whatever reason, Bank of America permitted the account to exceed the threshold amount. In particular, the FDIC amount was $10,000 (think 1960s) but the account balance at one time was $49,000. Consequently, Bank of America was held to have breached its fiduciary duty to follow the terms of the trust. Prob C §16000; Estate of Gilmaker (1962) 57 C2d 627.

The trustee was engaged in a real estate dispute with one of the beneficiaries. Since the beneficiary had a combative litigation style, the costs were substantial. In order to cushion the blow of litigation, the trustee decided to sue the beneficiary for elder abuse (the trustee represented an elderly couple), which permitted the recovery of attorney fees. Ultimately, the trustee obtained a judgment against the beneficiary for roughly $700,000 in civil court. The problem was that the trustee incurred fees totaling roughly $1.3 million in the process of obtaining that judgment. Furthermore, the beneficiary filed for bankruptcy subsequent to the judgment. Whoops. The court held that the trustee breached his duty to prudently enforce claims against the trust, since no prudent person would spend $1.3 million to try to collect $700,000. Prob C § 16010; Schwartz v. Labow (2008) 164 CA4th 417.     

12. Can a trustee seek judicial guidance when administering the trust?

Yes, a trustee can petition to appropriate court to seek assistance for the following. Prob C §17200.

• Determining questions of construction of a trust instrument;
• Determining the existence or nonexistence of any immunity, power, privilege, duty, or right;
• Determining the validity of a trust provision;
• Ascertaining beneficiaries and determining to whom property shall pass on termination of the trust, to the extent not specified in the instrument;
• Settling accounts and passing on the trustee's acts, including the exercise of discretionary powers;
• Instructing the trustee;
• Compelling the trustee to submit a report or account to the beneficiary under specified circumstances;
• Granting powers to the trustee;
• Fixing or allowing payment of the trustee's compensation or reviewing its reasonableness;
• Appointing or removing a trustee;
• Accepting the resignation of a trustee;
• Compelling redress of a breach of the trust;
• Modifying or terminating the trust;
• Combining or dividing trusts;
• Amending the trust to qualify a decedent's estate for the federal estate tax charitable deduction;
• Transferring a trust or trust property between jurisdictions;
• Transferring a supervised testamentary trust between counties;
• Removing a testamentary trust from court supervision;

13. Can a trustee terminate a trust?

Yes, a trustee can terminate a trust in certain instances. For example, if the trust's principal dips below $40,000, the trustee has the power to terminate the trust. Prob C § 15408(b).

14. Can a trustee be sued?

Yes. 

Just like any other entity, the trustee can be sued. Moreover, the trustee is the appropriate party to sue, rather than the trust itself. Prob C §16249(a).

15. Can the trustee act as the trust's attorney?

No, a trustee may not represent the trust in court, or propria persona for those Latin-inclined. Ziegler v Nickel (1998) 64 CA4th 545. This means that a trustee would need to hire an attorney to represent the trust in a court case. 

Estate Planning Fees

A common question from a homeowner who is interested in writing a revocable trust, is what are the costs and obligations, other than attorney fees, involved with the process? The following are
some topics raised by that question.
 
Property taxes
 
Whenever there is a “change in ownership”, the property taxes for that particular parcel of land will be re-assessed to its current the fair market value. Rev & T C §60. For example, if Bobby purchased from Sam a home for $500,000 in San Jose in 2007, Bobby’s property taxes would be based off of that $500,000 figure. Now assume that Bobby had purchased the property for $40,000 from Sam in 1979. In 2011, Bobby decides he wants to write a trust to avoid probate. However, Bobby is hesitant to write a trust and fund it with his home. He is worried that the Santa Clara County Assessor will try to re-assess his property taxes to its 2011 fair market value and in turn raise his property taxes. Fortunately for Bobby, California law is very specific in saying that a home transfer to a revocable trust is not considered a “change in ownership.” Rev & T C § 62(d)(2). Thus, the fear of re-assessment for property taxes when funding a revocable trust with a home is unwarranted.

Documentary transfer tax

In the case of a real property transaction, the transfer of a home from seller to buyer for example, there is the inclusion of a fee known as the documentary transfer tax. Rev & T C § 11911. The deed, the document which denotes the identity of the seller and buyer, must show the amount of the documentary transfer tax due. Rev & T C §11932. For reference, the tax rate is $0.55 per $500 of value (0.11 percent) sold. Rev & T C §11911.

Since a trust needs to be properly funded, whereby a trust transfer deed will need to be drafted, the documentary transfer tax becomes an issue, albeit only superficially. The reason for the superficiality is that California law states that a transfer of a home to a revocable trust is exempt from the fee imposed by the documentary transfer tax because there is no consideration tendered. Rev & T C §11930. Therefore, the documentary transfer tax is not an issue when a homeowner funds his or her trust when their home.
 
Income tax returns
 
Most revocable trusts are known as “Grantor Trusts” in IRS language. IRC §§671, 676. This means during the time that the trust is revocable, the settlor, the person who wrote the revocable
trust, is not required to file an additional tax return for the revocable trust. Hence, the creation of a revocable trust will not result in the settlor having to file more paperwork with the IRS and
California Franchise Tax Board.
 
Gift taxes
 
The inapplicability of gift tax in regards to creating a revocable trust bears mentioning to erase any confusion. There is no gift tax if you transfer property from yourself to a revocable trust that you created. A revocable trust is not a separate legal entity. Goldberg v. Frye (1990) 217 CA3d 1258. Hence, if you transfer property to your revocable trust it would be as if you handed an item from
your left-hand to your right-hand. Thus, there is no gift tax in the revocable trust creation equation because there is no third-party involved.
 
Recording Fees
 
Once a person has executed a trust transfer deed, it needs to be recorded in order to give proper notice to third-parties that the buyer is now the owner of the property. However, whereas there are exemptions with the previously mentioned fees and taxes, there is no such exemption for recording a deed. Each county has their own schedule of fees to record a document. For example, to record a deed in Santa Clara County, it is $15 for the first page and $3 for each additional page. The deed may be presented personally to the clerk-recorder or you can mail it in.
 
Notary Fees
 
It should be mentioned that a notarized signature is not required to execute a revocable trust. In that, there is no California law that says that a signature has to be notarized when executing a revocable trust. However, out of custom, a signature is notarized when executing a revocable trust.

A California notary may charge up $10 per signature when executing a revocable trust. Govt C § 8211. Often times, the attorney drafting the trust doubles as a notary and the fee is waived.