Category: Income Tax

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Estate Planning Estate Tax Gift Tax Income Tax Litigation

A Promise Is a Promise: The Enforceability of Charitable Pledges under New York Law

Haley B. Bybee —

Charitable contributions are often utilized in estate planning to assist a client not only in supporting his or her favorite charities but also to reduce tax liabilities both during life and at death. However, before clients agree to make any charitable contributions, they should understand that the agreements between themselves and charitable organizations, such as pledge agreements, can be binding.

Historically, New York courts have favored enforcing charitable pledges as a matter of public policy and in doing so, courts have relied on three common law contract law theories: (1) unilateral contract, (2) bilateral contract, and (3) promissory estoppel.[1]

Courts have most frequently relied on the theory of unilateral contract to enforce charitable pledges.[2] Under that theory, a charitable pledge or promise to make a future gift constitutes a unilateral offer, and “when accepted by the donee charity by the incurring of liability or detriment . . . [the offer] ripens into a binding contractual obligation of the donor and [is] enforceable against him.”[3] There have been numerous cases in which a donor’s promise to make a charitable contribution has been enforced on this ground.

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Estate Planning Income Tax

What Makes a Trust Foreign or Domestic—And Why Does It Matter?

Sean R. Weissbart —

Sean Weissbart's headshot photo

The United States is one of two countries in the world that imposes a tax on the worldwide income of its citizens. (The other is the East African country of Eritrea, which imposes a two percent tax on its citizens living abroad, far less than the top rate for U.S. income tax of 37 percent.)

Of course, trusts do not have citizenship like individuals, but trusts that are classified as domestic trusts for U.S. income tax purposes “suffer” the same fate: U.S. income tax is imposed on the worldwide income of the trust even if its income is earned from sources outside the United States or the Settlor and beneficiaries reside outside the United States.

So, what makes a trust a domestic trust and would it be better to avoid this classification? Paradoxically, a trust must meet two tests to be considered a domestic trust, and if it fails either of these tests, it will be classified as a foreign trust.

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Capital Gains Tax Estate Planning Income Tax State Tax

NFTs: A Tale of Two Classifications

Sara K. Osinski —

On March 21, 2023, the Department of the Treasury and the Internal Revenue Service (“IRS)” released Notice 2023-27, announcing their intent to provide guidance on classifying certain non-fungible tokens (“NFTs”) as “collectibles,” which could subject owners of NFTs to higher long-term capital gains tax.

Digital assets, such as NFTs and cryptocurrencies, are currently generally classified as “property.” Therefore, under current law, gains from the sale or exchange of NFTs are taxed based on how long such NFT was held by the owner. For instance, if the owner sells an NFT he or she has held onto for one year or less, then the sale of such NFT would be subject to short-term capital gains tax. Short-term capital gains are taxed at the ordinary income rates, and the federal[1] ordinary income tax rates currently range from 10 percent to 37 percent depending on the taxpayer’s taxable income. On the other hand, if the owner sells an NFT he or she has held on to for more than one year, the sale of such NFT would be subject to federal long-term capital gains tax. Long-term capital gains are subject to federal tax at a rate of zero percent, 15 percent, or 20 percent depending on the taxpayer’s taxable income.

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Estate Planning Income Tax Spousal Rights

Beware of the SLAT Divorce Trap

Andrew M. Logan —

The Spousal Lifetime Access Trust, or SLAT, has become one of the most popular estate planning strategies employed by married couples. It is an irrevocable trust created by one spouse (the “grantor”) for the benefit of the other spouse and, usually, other family members. Like many irrevocable trusts, the assets transferred to a SLAT, along with any appreciation generated after the transfer, should be removed from the grantor’s and beneficiary-spouse’s estate for estate tax purposes. One of the unique benefits of a SLAT is that it allows the grantor to retain indirect access to the trust’s assets through distributions to the beneficiary-spouse. SLATs seemingly provide a way for grantors to “have their cake and eat it too,” but there may be unanticipated tax consequences to the grantor if the marriage to the beneficiary-spouse ends in divorce.

Because the grantor’s spouse is a beneficiary, a SLAT is usually taxed as a so-called “grantor trust” for income tax purposes. This means that the grantor is responsible for paying the SLAT’s income and capital gains taxes, even though the SLAT’s assets have been removed from the grantor’s estate for estate tax purposes. Under current law, the grantor’s payment of the SLAT’s income tax liabilities is in effect an additional tax-free gift to the SLAT each year. These payments allow the assets of the SLAT to grow without being depleted by the payment of income taxes.

As long as the grantor and the beneficiary-spouse are married, they will both be able to reap the benefits of the SLAT.[1] However, if they divorce, the grantor will not only lose indirect access to the SLAT’s assets, but will also remain liable for its income taxes if the beneficiary-spouse remains a beneficiary of the SLAT following the divorce.[2] Section 672(e) of the Internal Revenue Code , the so-called “spousal unity rule,” provides that the grantor is treated as holding any power or interest held by the grantor’s spouse at the time the power or interest was created, even if that individual subsequently ceases to be the grantor’s spouse.

Consider the following example. In 2020, George created a SLAT for the benefit of his then spouse, Sally, which provided for discretionary income and principal distributions to Sally during her lifetime. In 2023, George and Sally divorced and the trust agreement provides that Sally will continue to be a permissible beneficiary of the SLAT even after a divorce. Accordingly, following the divorce, the SLAT will likely remain a grantor trust as to George because the spousal unity rule only looks at when Sally’s interest in the trust was created, and not at the time of the George and Sally’s divorce. This means that George will continue to be responsible for paying the taxes[3] on the SLAT’s assets, even though he no longer has indirect access to the trust property.[4] Fortunately for couples who are contemplating creating a new SLAT, the effects of the “divorce trap” can be mitigated with proper planning and structuring. For couples with existing SLATs, they should carefully review the trust terms to confirm what happens in the event of divorce. It may be possible to address the “divorce trap” issues in a post-nuptial agreement and/or a trust modification or decanting.

[1] Of course, if the beneficiary-spouse predeceases the grantor, the grantor would then lose his or her indirect access to the trust property.

[2] The trust agreement will typically address the beneficiary-spouse’s interest in the SLAT following a divorce. The trust agreement may provide that the beneficiary-spouse will continue to be a beneficiary following a divorce or will cease to be a beneficiary. The spousal unity rule is only implicated if the beneficiary-spouse continues to be a beneficiary following the divorce.

[3] In a number of states, the trust agreement can include a provision authorizing an independent trustee, in the independent trustee’s discretion, to make distributions to the grantor to reimburse the grantor for the income tax liabilities of the SLAT. If this reimbursement provision is structured correctly, it should not result in the assets of the SLAT being includable in the grantor’s estate for estate tax purposes.

[4] Prior to the Tax Cuts and Jobs Act of 2017, following a divorce from a spouse who continued to be a beneficiary of a SLAT, if distributions were made to the former spouse, the SLAT’s taxable income, up to the amount of distributable net income, could have been carried out to the spouse, potentially reducing the income to be reported on the grantor’s personal income tax returns. However, following the 2017 Act, this is no longer the case, and the grantor must carry the full amount of the SLAT’s income tax liabilities on his or her personal returns, regardless of whether distributions are made to the former spouse.

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Estate Planning Estate Tax Exemption Capture Planning Gift Tax Income Tax

Irrevocable Trusts: Who Is the Taxpayer?

Kyle G. Durante —

In establishing and funding an irrevocable trust, a common question is who is responsible for the income tax liabilities associated with the trust? Many individuals assume that the trust is a separate and independent taxpayer, requiring the trustees to file income tax returns for the trust. However, that is not always the case.

Irrevocable trusts are either classified as “grantor trusts” or “non-grantor trusts.” When an irrevocable trust is classified as a grantor trust, the trust is treated as identical to the settlor or the donor, requiring the settlor to report all matters of income and deduction with respect to the trust on his or her own individual income tax returns. When an irrevocable trust is classified as a non-grantor trust, the trust is deemed to be a separate taxpayer, requiring the trustees to file annual income tax returns for the trust (known as fiduciary income tax returns) reporting all matters of income and deduction with respect to the trust.

Generally, whether an irrevocable trust will be classified as a grantor or non-grantor trust depends on certain powers that may have been retained by the settlor with respect to the trust, who are the beneficiaries of the trust, and certain provisions in the trust. For instance, if the settlor retained the power of substitution (also known as a swap power), if the trustees have the power to use trust income to pay premiums on a life insurance policy insuring the life of the settlor or if the settlor’s spouse is a permissible beneficiary of the income of the trust, the irrevocable trust will be deemed to be a grantor trust. As a general rule, although not always the case, an irrevocable life insurance trust (holding a life insurance policy insuring the life of the settlor) or a spousal lifetime access trust (“SLAT”) will almost always be deemed a grantor trust during the settlor’s lifetime.

At first blush, a grantor trust may be seen as a harmful result given that the settlor is transferring property to an irrevocable trust (of which the settlor is generally not a beneficiary and no longer has access to the property) but the settlor remains liable for the income tax bill. However, establishing an irrevocable trust as a grantor trust can have significant transfer tax benefits. By establishing a grantor trust, each year the settlor will report and pay any associated income tax liabilities with respect to the trust. Under current law, the payment of tax liabilities that would otherwise be paid by the trust is, in essence, a tax-free gift to the trust each year. As such, the payment of the trust’s tax liabilities by the settlor will permit the settlor to further deplete the assets in his or her own name (that will be subject to estate tax at his or her death) without using any of the settlor’s gift/estate tax exemption.

With respect to grantor trusts, of course, once the settlor dies, the trust will generally cease to be a grantor trust and convert to a non-grantor trust. It may also, however, be possible to convert the trust from a grantor trust to a non-grantor trust, and vice versa, during the settlor’s lifetime, if that would be desirable.

Irrevocable trusts are further subclassified under the Internal Revenue Code as either foreign or domestic trusts. As a general rule, domestic trusts are subject to U.S. income tax on their world-wide income, while foreign trusts are subject to U.S. income tax on only their U.S.-sourced income. The implications of each such classification and the tests to determine such classifications will be addressed in an upcoming cross-border estate planning series.