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You Did Medicaid Planning, You Created An Irrevocable Trust. Now, Make Sure The Trustee Files A Tax Return (Or Not)

Most irrevocable trusts created for the purpose of protecting assets from the costs of long term care (i.e., the nursing home) must file a Form 1041 (for IRS Federal filing purposes) and a Form IT-205 (for New York State filing purposes) only once — for the year of creation. This is not unusual. There are many types of irrevocable trusts and most of then must file these income tax returns each and every calendar year. However, some irrevocable trusts are grantor trusts and for most grantor trusts, filing Form 1041 (and IT-205) is optional. By the way, most irrevocable “asset protection” trusts are grantor trusts.

So what’s a grantor trust? A grantor type trust has been defined as a trust where a grantor has certain powers in respect of trust property that are tantamount to dominion and control over such property. The Internal Revenue Code (“IRC”) will “look through” the trust form and deem the grantor to be the owner of the trust property and attribute the trust income to the grantor. When a grantor is treated under IRC sections 671-679 as the owner of any portion of a trust, there are included in computing his or her tax liability those items of income, deduction, and credit against tax attributable to or included in that portion. For example, if a grantor or another person is treated as the owner of an entire trust (corpus as well as ordinary income), he takes into account in computing his income tax liability all items of income, deduction, and credit (including capital gains and losses) to which he would have been entitled had the trust not been in existence during the period he is treated as owner. (See 26 CFR 1.671-3).

What power does the grantor have in an asset protection trust that makes the grantor seen by the IRS as having control over trust property? Most asset protection trusts allow the grantor to change the ultimate beneficiaries of the trust. This power alone make the usual asset protection trust a grantor type trust for income tax reporting purposes although there can be other powers that would also make the grantor seem like he or she controls the trust property.

Having established that most asset protection trusts are grantor trusts, the general rule is that all grantor trusts must file a Form 1041, which contains only the trust’s name, address, and tax identification number (TIN) (see Regs. Sec. 1.671-4(a)). The assets owned by the trust are normally titled so that the earnings are initially reported by the payor (i.e., the brokerage firm, etc.) as being taxable to the trust. However, by filing the Form 1041, the trustee is in effect letting the IRS know that the items of income or deductions are instead reportable by the “deemed owner;” the grantor on his or her personal income tax return

The activity that is reportable by the grantor is summarized on a separate statement (a grantor tax information letter), which is attached to the otherwise blank Form 1041 when it is submitted to the IRS. However, there are two alternative reporting methods that allow some grantor trusts to avoid filing a Form 1041.

The first alternative method allows the trustee of the trust to file Forms 1099 in lieu of a Form 1041 (see Regs. Sec. 1.671-4(b)(2)(iii)). Here, the ownership of the assets is listed in the normal way with the payor, so that income is initially reported as taxable to the trust. The taxability of that income is shifted to the deemed owner when the trustee prepares Forms 1099 showing the trust itself as the payor, and the deemed owner as the payee.

The second alternative is a relatively easy way to avoid filing either a Form 1041 or Forms 1099. This involves changing the way the ownership of the trust’s assets is listed with the payor. Specifically, Regs. Sec. 1.671-4(b)(2)(i)(A) is available as long as the grantor trust is treated as owned by only one person. In this scenario, the trustee furnishes to all payors of income (e.g., a brokerage firm, etc.) the following information, so that Forms 1099 or Schedules K-1 (from either a partnership, S corporation, or a trust, as the case may be) are issued using:

The grantor’s name;

The grantor’s taxpayer identification number (i.e., Social Security number); and

The trustee’s address.

Here, the income is reported to the IRS as being taxable directly to the deemed owner; however, the forms are mailed by the payor to the trustee. The goal of this alternative reporting method (from the IRS’s perspective) is to have Forms 1099 and Schedules K-1 issued in a manner that allows the IRS to computer match the income directly against the income shown on the individual’s Form 1040.

Either method works and the trustee of the trust should discuss the above with his or her tax preparer.

Futterman & Lanza, LLP has offices in Smithtown, NY, Valley Stream, NY, Southhampton, NY (by appointment only) and Babylon, NY (by appointment only).

Futterman & Lanza, LLP has clients throughout Suffolk, Nassau, Queens, Brooklyn, Bronx, Richmond, New York, Westchester, and Rockland Counties.

Futterman & Lanza, LLP concentrates its practice to Elder Law, Medicaid Planning, Medicaid Applications, Estate Planning, Probate, Estate Taxes, and Estate Administration.

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