When a Pet owner funds a pet trust, there may be both federal gift and estate tax implications. The brief discussion below will help explain why that is.
Under the current estate and gift tax system, the top federal gift and estate tax rate is 40%; it is imposed on lifetime transfers or transfers at death to the extent they exceed $5.49 million (in 2017). However, every individual is permitted to make certain tax-free transfers because of various gift and estate exclusions.
Everyone has a $5.49 million lifetime gift tax exclusion. This means every individual can transfer up to $5.49 million of cash or property gift tax-free ($10.98 million if he is married and his spouse consents to split the gift). In addition, everyone can make annual tax-free, non-reportable gifts of up $14,000 to an unlimited number of individuals and certain appropriately structured trusts ($28,000 if they are married and their spouse consents to split the gift). This amount, referred to as the annual gift tax exclusion, is indexed for inflation.
Furthermore, at death, everyone has a $5.49 million estate tax exclusion which can shelter $5.49 million in cash or property from estate tax (in 2017). To the extent an individual uses any of his $5.49 million gift tax exclusion, however, his estate tax exclusion will be reduced. This means that if an individual uses all of his $5.49 million gift tax exclusion, he will have no further estate tax exclusions at his death. Having said this, the gift and estate tax exclusions are indexed upward for inflation every year so future opportunities for gift and estate tax savings may be available.
Application to Pet Trusts
How does the above discussion apply to pet trusts? It is simply this: A Pet owner can make tax-free gifts up to $5.49 million to a pet trust to the extent he has not used any of his $5.49 million gift tax exclusion ($10.98 million if he is married). In addition, the Pet owner can structure the pet trust so that he can make annual tax-free gifts of up to $14,000 to it ($28,000 if he is married). The “beneficiary” of the pet trust is the Pet guardian selected to watch after the pet. Thus, generally, for gifts to the pet trust to qualify for the annual gift tax exclusion, the Pet guardian must be notified of the gifts and be permitted to withdraw them for a limited period of time1.
Since statutory pet trusts – i.e., those triggered by a Will and permitted under state law – cannot be funded until the Pet owner’s death, these gift tax rules are only applicable to Stand Alone pet trusts that are created while the Pet owner is alive. Note that if the Pet owner can revoke the trust, his lifetime transfers to it will not be subject to federal gift tax; the trust will be includible in the Pet owner ’s estate when he dies; however, and potentially subject to estate tax. (If the Pet owner can’t revoke the trust, he generally will be considered to have made a “completed” gift and the trust will likely not be includible in his estate.) Finally, if a Pet owner funds a pet trust at his death, those funds will be taxable for federal estate tax purposes unless his taxable estate is less than the $5.49 million estate tax exclusion (the Pet owner’s available estate tax exclusion will be less if he used any of his gift tax exclusion; note also, that his state’s threshold for imposing estate tax may be significantly lower than $5.49 million).
1Crummey v. Commissioner, 397 F. 2d 82 (9th Cir. 1968)
What about Structuring a Pet Trust as a Charitable Remainder Trust2?
Such a trust pays a fixed or variable amount of the trust property at least annually to one or more beneficiaries for life or a term of years, with any remaining property going to charity.
This is because a Statutory Pet Trust – where the trust beneficiary is a pet – does not fit within the definition of a charitable remainder trust because the trust’s required annual payments must be payable to or for the use of a “person,”3 which generally means an individual (not a pet). On the other hand, it is unclear whether a Stand Alone pet trust that has a human beneficiary (i.e., the pet’s pet guardian) and is structured as a charitable remainder trust would be eligible for the charitable estate tax deduction. The Service’s ruling appears to preclude such eligibility by providing that a trust is for the lifetime benefit of a pet (rather than the pet’s pet guardian) if the trust funds are used for the care of a pet.
2IRC § 664
3Treas. Reg. §1.664-2(a)(3) and §1.664-3(a)(3)
In general, when a Pet owner transfers funds and other property to the pet trust – including the pet itself – by gift, bequest, devise, or inheritance, these receipts are not treated as taxable income,4 although they may be subject to gift or estate tax as previously discussed. This means that when the Pet owner gives the pet or funds to the pet trust, they will not be taxable.
However, interest, dividends and other income generated by trust investments are subject to income tax.
The pet trust’s income generally is taxable either to the Pet owner, or to the trust, in the case of a Stand Alone pet trust that a Pet owner creates during his life. If the Pet owner can revoke the trust or is otherwise deemed to own the trust for income tax purposes, all of the trust’s items of income, loss, deduction and credit will be reportable on his income tax return, rather than trust’s return. This type of trust is referred to as a grantor trust and, in effect, allows the Pet owner to make tax-free gifts to the trust by paying its income tax; this way, the trust funds can grow tax-free without being depleted by income tax.
Nevertheless, if the pet trust is not a grantor trust or ceases to be one when the Pet owner dies, it will be a separate taxable entity and will pay tax on its own income.
Generally, the trust income tax rates are imposed at graduated rates that mirror those of individuals. However, unlike individual taxpayers who typically do not pay income tax at the highest marginal rate until their income exceeds $418,400, or $470,700 for married couples filing joint tax returns,5 trust income is subject to income tax at the highest marginal rate when it exceeds $12,5006 ; this is a clear disadvantage to holding funds in trust, and illustrates why a grantor trust may be attractive if the Pet owner is not in the top federal income tax bracket. Some commentators believe that a pet trust is subject to a more favorable tax rate (i.e., married filing separately), but based upon this author’s analysis of Rev. Rul. 76-486, it appears that pet trusts are subject to the same income tax rates applicable to all other trusts.7
Nevertheless, a pet trust is not taxable on trust income (other than capital gain) to the extent it is distributed to the pet’s Pet guardian in the case of a traditional pet trust; instead, the distribution is deductible by the trust and taxable to the pet guardian.
When all is said and done, either the Trustee or the Pet guardian pays the income tax on the trust’s income depending on whether trust income is accumulated or distributed each year. If the Pet owner intends to compensate the Pet guardian for any income tax liability associated with trust distributions, this will need to be taken into account when distributions are made.
What if the pet, rather than a pet guardian, is the trust beneficiary, such as with a Statutory pet trust? Because the IRS does not recognize a pet as a trust beneficiary, the pet cannot be taxable on trust distributions that it receives. In addition, the pet’s Pet guardian cannot be charged with the tax liability because the Pet guardian serves only as an agent of the pet and does not consume the distributions for his own benefit (similar to a court-appointed guardian of a minor or incapacitated person). This could have created a lucrative tax loophole because no one (neither the pet nor its pet guardian) would have been subject to income tax on the trust income paid to or for the benefit of the pet. The IRS quickly recognized the problem, and in Rev. Rul. 76-486,8 held that an enforceable pet trust established under a state statute is taxable on all of its income, regardless of whether any distributions are made for the benefit of the pet beneficiary.
What are the tax ramifications if the pet is considered an asset of a Stand Alone pet trust, rather than a trust beneficiary indirectly through the pet guardian? In this case, perhaps an argument could be made that expenditures for the pet’s care are deductible as trust administration expenses because they are incurred in the “normal” business of administering a trust designed to take care of a pet. After all, trustee fees and professional fees – including those for attorneys, accountants, and tax return preparers – incurred in administering the trust are deductible. However, when a pet is not an income-producing asset and the expenditures incurred for the pet’s care are not inextricably related to the normal business of administering a trust (not just a pet trust), they should not be deductible.9 Sometimes, a pet is an income-producing asset and in that case, the expenditures incurred for the pet’s care are inextricably related to the normal business of administering a trust (not just a pet trust), and then they could be deductible. 10
4I.R.C. § 102
5This threshold, which is inflation adjusted, applies to top income tax brackets for 2017 beginning at 418,400 for single and $470,700 for married taxpayers filing jointly in 2017.
6This threshold, which is inflation adjusted annually, applies in 2017.
7Commentators appear to believe this because Rev. Rul. 76-486 provides that a Pet Trust is subject to the tax rates imposed by IRC §1(d) which are the tax rates for married individuals filing separately. At the time of the Ruling, IRC §641, which specifies the tax rates applicable to estate and trusts, referenced IRC §1(d). As a result, the tax rates for married individuals filing separately, applied to all estates and trusts, not just Pet Trusts. However, IRC § 641 was subsequently amended for tax years beginning after December 31, 1976 by replacing the reference to IRC §1(d) with § 1(e), with the effect that estates and trusts (including pet trusts) are no longer subject to the more favorable rates applicable to married individuals filing separately but are now subject their own more compressed tax rates.
81976-2 C.B. 192.
9IRC §212 allows a deduction for ordinary and necessary expenses incurred: (a) for the production of income; (b) for the management, conservation, or maintenance of property held for the production of income; or (c) in connection with the determination, collection, or refund of any tax. The accompanying regulations also state that a trustee may deduct expenses incurred “in connection with the performance of the duties of administration.”
10 IRC §212 allows a deduction for ordinary and necessary expenses incurred: (a) for the production of income; (b) for the management, conservation, or maintenance of property held for the production of income; or (c) in connection with the determination, collection, or refund of any tax. The accompanying regulations also state that a trustee may deduct expenses incurred “in connection with the performance of the duties of administration.”