Tax laws are written to deal with the things that we do — that is, our lives. Over time, the tax system has increasingly encroached on the varied activities and decisions that make up our lives.
A trust allows one person (the grantor) to make a transfer (property) to someone (the trustee) who will hold legal title on behalf of someone else (the beneficiary) based on the wishes (terms) of the grantor.
Trusts are used for many purposes. We often think they are used for a minor child or some other party who lacks the capacity to deal with the property. But that just scratches the surface of potential uses.
The length of my column forces me to narrow the focus. So, let’s start with “Mom,” a healthy and intelligent 75-year-old widow.
Mom is retired with three adult children and a bunch of grandchildren. Mom, while not rich, is doing fine financially.
She has a pension, Social Security, Medicare, a mortgage-free house, a late-model car and $800,000 of savings.
Mom will not be subject to the estate tax. Her savings will probably stay intact, and grow, because her pension and Social Security satisfy her living needs.
Mom has unfettered control over her life and her assets. A trust seems not only unnecessary to her, but also undesirable. She does not need someone to make decisions for her.
Even so, there is a trust for Mom. It is often called a “revocable living trust.” Mom will be the grantor. Her house and savings will be the property. She will be her own trustee!
Mom will also be the beneficiary. And the terms? Mom, as trustee, will do whatever the heck she wants to with the trust property for her benefit. And if she doesn’t like the trust — she’ll just end it.
Seems like busy work for a lawyer. But there is a point. First, the trust terms will explain what is done with her property after her death. And who will take over as trustee after her death.
Second, the terms will allow for a co-trustee or a successor trustee to be named. By Mom. And not just when she dies.
Mom could name a co-trustee when she is 88 years old and tiring of handling her assets. Or even when she starts to feel that her capacity to handle the assets is starting to slip.
A successor could take over if Mom does lose capacity to deal with her assets. With a co-trustee or a successor, Mom can continue as the sole beneficiary.
Remember, tax is life. So, there is a tax angle to all of this. Trusts file their own tax returns. Trusts pay tax. The trust rate structure hits the highest rate faster than any other taxpayer.
Well, that sounds nasty. Think about the trust we first created for our healthy, 75-year-old Mom. The Mom with full capacity to handle her assets.
That Mom had full control over the trust assets and was the only beneficiary. She could terminate the trust at will.
The tax law recognizes that such a trust is indistinguishable from its grantor. Hence it is called a “grantor trust.” No trust income tax return is filed.
What if an 88-year-old Mom starts to lose her mental capacity and names Daughter as co-trustee? No tax issue if Mom is “starting” to lose capacity. By inference, she still has capacity.
Let’s say that (now) 90-year-old Mom has lost capacity. Daughter handles all aspects of the trust. Is a trust return required?
Yes. Mom cannot revoke or change the terms of the trust. Is that your final answer? Perhaps not if you are the return preparer.
Perhaps all income (and allowed medical deductions) continues to be reported on Mom’s return. Why complicate things until Mom passes away?
Tax is life. Life is difficult. Hence, tax is difficult. A trust is no longer a grantor trust when the grantor is incapacitated.
Tax preparers don’t judge capacity. Who does? A doctor. Is that your final answer? You are probably wrong. Capacity to execute legal decisions is a legal judgment.
Don’t call a doctor. Call a lawyer. But, until that happens, and it may not, the tax return preparer keeps reporting a grantor trust. I doubt there’s anyone to stop him.
Jim Hamill is director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.