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DEPARTMENT OF REVENUE STEPS BACK FROM MADNESS IN TAXING TRUSTS

February 27, 2004

"Revocable trusts" or "living trusts" are a common financial and estate planning device. In these arrangements a taxpayer establishes a trust in which he is trustee and which he can revoke any time. At the death of the taxpayer the assets are disposed of under the trust terms, bypassing probate. The family assets don't become part of the public probate records, and sometimes administative costs of the asset distribution are reduced.

The federal income tax pretty much ignores these "grantor trusts." The grantor hasn't really given up anything, after all -- he can always help himself to the trust assets. The income from the assets is taxed to the grantor as if there were no trust at all.

WHAT ABOUT IOWA?

Iowa had always followed federal rules in taxing trusts. Practitioners were therefore stunned when Department of Revenue examiners strayed from the federal system to deny an Iowa capital gain deduction to taxpayers who held business real estate in their grantor trust.

The capital gain deduction enables taxpayers to avoid Iowa tax on capital gains on the sale of businesses or business real estate if they meet a "10 x 10" requirement - that is, if they have both held the property for 10 years and "materially participated" in the business for 10 years.

A provision of the capital gain deduction law provides that “This capital gain exclusion does not apply to estates and trusts.” Tax practitioners assumed that this rule applied only to non-grantor trusts, which pay taxes on undistributed income. Since grantor trust assets are taxed directly to the owner, it wouldn't make sense for this rule to apply to them.

What makes sense isn't always what gets asserted in a revenue exmination. An examiner told a Mr. and Mrs. Hunter that trusts are trusts, grantor or non-grantor, and the capital gain deduction doesn't apply to trusts. The Hunters paid the tax assessed and filed a protest with the department.

BACK FROM THE BRINK

The Department apparently realized that this examination position would upend many years of settled law and hundreds of estate plans. Iowa would, in effect, have to improvise its own system of taxing trusts. Given the numbingly tedious nature of such a task, the Department stepped back from the brink and permitted the capital gain deduction:

"The Tax Review Unit has decided that the reason given for the assessment was incorrect. In this case, there does not appear to be any justification to distinguish between estates and trusts and other flow-through entities, specifically partnerships, limited liability companies, and S corporations...

In instances where the estate or trust has income taxed directly to the individual, the individual may claim the capital gain deduction if he or she meets the necessary requirements."

And calm was restored to the placid ("dull" is such a harsh word) world of trust taxation.

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