The investment environment over the last year has been tough on everyone, including credit shelter trusts (also called B Trusts or Bypass Trusts). It is up to the trustee of the credit shelter trust (CST) to manage market performance and the tax costs of their investment portfolios while still meeting the requirements of the trust.
The challenges the trustee faces are similar to those of an avid golfer. He or she must be able to strategically maneuver through course-designed and weather-related hazards. If the golfer does not execute each shot effectively, penalty strokes, high scores, and frustration usually follow.
For a trustee, investment hazards can have more serious consequences. The trustee must impartially balance the interests of all beneficiaries by efficiently managing market and tax risks while preserving assets and distributing income. And unlike a round of golf, there is no such thing as a mulligan.
Trust tax costs: Why pay Uncle Sam first?
When taxable income is created by the investments within an irrevocable trust, the trustee has two primary options:
? The income can be held within the trust.
? The income can be distributed (per the terms of the trust) to the income beneficiary.
Taxable income remaining in the trust will be taxed at the trust's applicable ordinary income or capital gain tax rates. The tax rate differential compared to distributing and taxing the income at the individual's tax rates–the highest 35% marginal tax bracket kicks in at $357,701-plus for individuals as opposed to only $11,150 for trusts–may create a tax disadvantage if the income remains inside the trust. (See chart.)
For this reason, many trustees will distribute income even when it is not needed by the beneficiary. In 2007, that amounted to more $65 billion in taxable income for irrevocable trusts. There are two probable sources for this tax cost:
? Investment rebalancing.
? Mutual fund portfolio turnover.
Investment rebalancing
Regular trust portfolio rebalancing is a fundamental regulatory best practice for trustees. When rebalancing is conducted to return the portfolio to its appropriate asset allocation, this sell and buy sequence will generate long or short-term capital gains/losses.
Mutual fund portfolio turnover
The trading habits of a fund manager can also cause taxation for the CST. Each year, a mutual fund will distribute capital gains and dividends to each shareholder. This distributed taxation can be managed through "tax loss harvesting." This process requires realizing actual losses to offset the realized capital gains. This can become complicated and take a significant amount of expertise, which may be difficult for the trustee to manage.
Currently, long-term capital gains, qualified dividends and municipal bond interest receive preferential tax treatment and can play an important role in trust tax efficiency. Trustees may want to complement a diversified, tax-efficient, mutual fund portfolio with an annuity. An annuity is an option to receive tax-deferral, until an income stream begins, along with optional features that may transfer risks through an insurance contract. The trustee needs to review the annuity contract's mortality and expense risk charges and other costs as part of a risk and return cost benefit analysis.
