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Trusts, Fees, and TAXES

ILast month the U. S. Supreme Court ruled that investment management expenses incurred by a trust are not as tax deductible as some believed they used to be.  We refer to the case as “Rudkin” because it involved a trust set up under the will of a Mr. Henry A. Rudkin.  In a unanimous opinion written by Chief Justice John Roberts, the court ruled that investment advisory fees paid by a trust cannot be deducted in full for income tax purposes.  Trustees can only now deduct investment management costs to the extent they exceed 2% of the trust’s adjusted gross income (AGI).

I am bringing this to your attention because trusts are becoming increasingly common in claims resolution.  The one you are likely to encounter most often in personal injury cases is called a “supplemental needs trust” and it is designed to preserve a settling claimant’s eligibility for government benefits.  A properly arranged supplemental needs trust allows the claimant to segregate the proceeds of their settlement in a dedicated fund for their own benefit without suffering any interruption in their public assistance benefits.  This new ruling makes such trusts more expensive for the beneficiary because it restricts how much of the trust’s financial advisory fees can be deducted against the income generated by the trust. 

The Rudkin case illustrates just how expensive this can be for certain beneficiaries.In 2000, the Rudkin trustee hired an outside firm to provide advice on investing the trust’s assets.  The trust paid the financial planning firm $22,241 in advisory fees and had originally claimed all those fees as deductions on the trust’s income tax return.  The IRS contested full deduction of these fees, contending that current law limits the deduction of such fees to 2% of the trust’s adjusted gross income.  Properly calculated in this way, the IRS said the trust owed an additional $ 4,448 in taxes.  The trustees fought this interpretation all the way up to the highest court in the land but lost.

As a result of this ruling, most trust companies will now have to change the way they bill their clients.  Currently, few itemize their investment fees and expenses, instead bundling them into a single larger fee for all services.  Under the new rules, if the trust charges a single bundled fee, the taxpayer would have to try to figure out how much of that fee is deductible, thus increasing costs further through additional income tax preparation costs.

Since there’s no challenging “the Supremes”on this issue, what alternatives do trust beneficiaries have?  One natural source of relief is to do what many claimants already do: simply don’t take the entire settlement proceeds in cash (allocated to the trust).  Instead, if the claimant sets up a thoughtfully “integrated” settlement – part structured settlement/part trust – they can materially reduce the impact this ruling has on their future income. 

By allocating a portion of their settlement proceeds to a classic structured settlement but having the future structure payments made directly to the trust, they successfully shelter this portion of their assets from such non-deductible trust expenses altogether.  The idea is to keep the balance of cash in the trust as low as practical (consistent with their needs) to minimize taxes paid by the trust.  This approach not only reduces overall fees but, since all investment income from a properly established structure is tax-free, it maximizes net returns to the beneficiary . Supplemental needs trusts and structured settlements work beautifully together in this way; the Rudkin ruling makes thoughtful integration of these two techniques even more beneficial. 

Financial planners we speak with are regularly astonished - and dismayed - to learn how often some claimants are “advised” to waive their right to a Section 104-qualified structured settlement and funnel all settlement proceeds straight into a taxable trust.  The reasons given vary from “we can do better than a structure” to “this will allow you to keep control of your money” or my favorite “with all the deductions we will build in (italics added) you will keep control of your money and still never pay any income taxes”.   If this latter statement was ever true (it wasn’t) it’s certainly dead now.

As I wrote earlier, trusts can serve a critically valuable role in the claim settlement arena.  However, from the standpoint of prudence, allocating all funds to solo trusts rarely compares favorably to trusts integrated with qualified structured settlements.  Side by side comparisons prove this time and again.

Unfortunately, as important as this consideration is, few in most claimants’ immediate circle of advisors possess the skills required to even attempt such a comparison.  Not only does the analyst have to consider the appropriate global asset allocation strategy for the claimant, they also need to familiarize themselves with the claimant’s life care plan to know what kind of future cash flows they need to ensure proper care.  Lastly, when considering the structure and trust options, they must take into account all the fees and expenses that will be charged against the trust - no simple task as few people know how to “unbundle” them .  Yet even if the claimant was lucky enough to retain a qualified and unbiased financial expert, they may still have to hire an accountant to determine the tax deductibility of the trust’s investment advisory fees and expenses. 

In the end, an analysis of Rudkin simply highlights the remarkable financial value that structured settlements offer claimants.  It is not my purpose here to bash trusts if they are used properly, but I come alive anytime someone wants to exclude consideration of a qualified Section 104 structure in favor of a taxable — and now more expensive — trust.  

Do you have a case where a thoughtfully integrated trust/structured settlement approach may be beneficial?  Call Frank C. Kilcoyne, CSSC at 800-544-5533, I am here to help.

See Knight v. C.I.R., 128 S.Ct. 782, 76 USLW 4048, 101 A.F.T.R.2d 2008-544, 2008-1 USTC P 50,132, 08 Cal. Daily Op. Serv. 550, 2008 Daily Journal D.A.R. 633 (U.S. Jan 16, 2008) (NO. 06-1286)

Subject to certain restrictions

After calculation of the future fixed payments, structured settlements involve no further charges.

Often the primary reason to “bundle” them in the first place.