If you've created a trust or are a trustee or beneficiary, you need to pay attention to the IRS' newly revised definition of "income" for trusts.
Traditionally, many trusts have been structured to pay "income" to their beneficiaries. That presents a problem in these days of 1 percent stock dividends and 4 percent bond yields. To attain any kind of income (for distributions to beneficiaries), trustees would have to load up on bonds, sacrificing the higher long-term returns stocks are expected to produce.
Trustees hesitant to use income options
Most states now give trustees some options. Trustees can make income distributions from principal, using an "adjustment" power. Or they can simply pay out, say, 4 percent of trust assets each year (using a "unitrust" election), regardless of whether that 4 percent comes from income or principal.
The problem: Many trustees were reluctant to go along with these state laws. They were afraid of adverse federal tax treatment in these areas. Reason:
1. They feared they'd lose the marital deduction for a surviving spouse.
2. They feared the IRS might consider this income as a taxable gift.
3. Shifting between income and principal might be considered a taxable sale, triggering immediate capital gains.
Good news: New IRS regulations put an end to such fears. The IRS has said it won't hit trusts with any such adverse tax consequences as long as the shift from principal to income meets state law.
Smart moves for trust participants
1. Trust creators: Include 'income flexibility' in trusts. When you establish a trust, give trustees maximum flexibility. Don't lock your trustee into "income-only" provisions.
This is especially vital if you're creating a trust to be your IRA's beneficiary. After your death, if the IRA makes minimum required distributions to the trust, very little "income" can be paid out, in most states. As a result, large amounts will be trapped inside the trust, taxed at steep trust rates.
Also, the new IRS rules add to the appeal of QTIP (qualified terminable property interest) trusts. Such trusts pay distributions to the surviving spouse, defer estate tax until the survivor's death and eventually deliver the trust assets to beneficiaries named by the first spouse to die.
2. Trustees: Distribute income from principal. If you'd like to distribute more income to current beneficiaries, yet still maintain a substantial exposure to equities, see if your state law permits a unitrust election or a power to adjust.
If your state law doesn't offer the flexibility you want, move the trust to a different state. The IRS allows such moves.
3. Trust beneficiaries: Boost your income. If you'd like to receive more income, ask your trustee to choose a higher-payout technique. If the trustee is reluctant, see if the trust provides you with the power to replace the trustee.