What is a Trust?
A living trust is a legal arrangement used in estate planning that provides for the management and distribution of your property when you die. The trust is usually evidenced by a written document called a “Declaration of Trust” or “Trust Agreement,” whereby one person, called the “trustor” or “grantor,” transfers property to another person, called the “trustee,” who holds the property for the benefit of another person, called the “beneficiary.” The obligation of the trustee is to conserve and protect assets transferred to the trust, and to collect income and distribute or accumulate it as prescribed in the trust instrument. The typical living trust is revocable and amendable by the grantor during his or her lifetime. During his or her lifetime, the grantor is also the trustee and beneficiary. As trustee, the grantor can manage and control the trust property; as beneficiary, the grantor receives all of the benefits of the trust assets. Upon the death of the grantor, a “successor trustee” (child, friend, bank, etc.) takes over as trustee and follows the trustor’s instructions, which are set forth in the trust, concerning the distribution of property and the payment of taxes and expenses.
Use in Avoiding Probate
Although living trusts have been around for centuries, the general public has only recently caught on to the use of trusts as a way to avoid the time and significant cost of probate upon the death of the grantor. Probate is a court-supervised procedure for collecting your assets when you die, paying debts and taxes, and distributing the property to your beneficiaries (either according to the instructions you set forth in your will or as determined by state law if you die without a will). Living trusts avoid the court procedure otherwise required to transfer assets to your beneficiaries at death. In addition, a properly formed and administered trust can provide tax planning flexibility for the beneficiaries, and save estate taxes on your estate when you die.
The Grantor Trust Rules
In the typical living trust, as the grantor of the trust, you are treated as the owner, and you are taxed on the income from the trust assets. Generally, as a grantor, the only way you can avoid taxation on the income from the trust (and avoid including trust property in your gross estate) is to give up control and benefits of the assets that you assign to the trust, and give up the right to revoke or amend the trust. Code Sec. 677(a). The trust would then be characterized as an irrevocable trust. The trustee would manage the trust, and the income from the trust would be taxed to the trust if accumulated in the trust, or to the beneficiaries if distributed to the beneficiaries.
Retaining a right to revoke, amend or manage the trust only with the approval and consent of an adverse party (a person with a beneficial interest in the trust) will not cause you to be taxed on the trust income. However, giving power to manage and control trust assets to your spouse or a non-adverse party will cause the trust income to be taxed to you, as if you remained the owner of the property, under the “grantor trust rules” of the Internal Revenue Code. (Code §671 through 677).
You will also be treated as the owner of the trust if trust income is or may be used to pay debts of you or your family. Reg. §1.677(a)-1(d). In addition, although Code Sec. 677(b) provides that you will not be taxed if trust income may be used for support of someone you are legally obligated to support, you will be taxed if income is actually used for that purpose.
An irrevocable trust is an arrangement in which the grantor departs with ownership and control of property. Usually this involves a gift of the property to the trust. The trust then stands as a separate taxable entity and pays tax on its accumulated income. Trusts typically receive a deduction for income that is distributed on a current basis. Because the grantor must permanently depart with the ownership and control of the property being transferred to an irrevocable trust, such a device has limited appeal to most taxpayers.
Irrevocable trusts, however, are useful in life insurance planning. For instance, a properly structured irrevocable life insurance trust can avoid probate costs and fees, and estate taxes on the insurance proceeds paid to the trust upon the grantor’s death. Irrevocable trusts are also useful in providing children, especially those over age 14, with a fund for education or other specific planning purposes. Again, the trust is usually funded with “after-tax” dollars through a gift. The annual gift tax exclusion (an exclusion for gifts of $10,000 or less per year per donee) does not apply to gifts of a future interest (such as a gift to a trust), so the so-called “Crummy” trust provisions must be properly applied to make the gift a “present” interest. Drafting such clauses requires expertise.
A grantor’s use of irrevocable trusts to avoid taxation of income, and to provide for accumulation of income to provide for beneficiaries at a later date, has been limited under the current tax system. The Revenue Reconciliation Act (RRA) of 1993 has made trusts subject to faster tax rate escalation than individual taxpayers. For example, trusts are taxed at 39.6 percent on taxable income in excess of $7,650. For filers of joint returns, the 39.6 percent rate does not begin until taxable income is $256,500.
Ironically, the impact of RRA changes will not severely impact trusts whose grantors or beneficiaries are already in the 39.6 percent bracket; they will affect the smaller estates of middle and upper-middle income taxpayers, whose grantors and beneficiaries are in lower tax brackets.
To avoid being taxed at the higher rates, trust income can be reduced by increasing distributions to beneficiaries, reducing the amount of taxable income produced by the trust assets, or having the trust invest in assets that produce capital gain (maximum tax rate is only 28 percent) rather than ordinary income.
Since a trust is taxed as a separate entity on accumulated income, it is sometimes desirable to create as many trusts as possible for purposes of accumulating income at the lower tax brackets. However, two or more trusts will be treated as one trust if the trusts have substantially the same grantor and primary beneficiaries, and federal tax avoidance is the principal purpose of the trusts. Code §643(f).
Although limited in recent years, income splitting among family members through family trust arrangements remains a valid way of reducing overall family income tax. Although an assignment of income from one family member to another is not sufficient, an outright transfer of income-producing property can achieve income splitting. If the family member to be benefited lacks the ability to manage the assets, you can use a trust. If the beneficiary is a minor, you may consider the creation of a custodial account under the applicable state’s Gifts to Minors Act or the Uniform Transfers to Minors Act.
The use of irrevocable trusts in sophisticated tax planning involves a multitude of complex tax rules. You should consult with a tax planning professional to obtain the optimal tax results.
© Robert L. Sommers, 1996, all rights reserved. The Tax Prophet® is a registered trademark of Robert L. Sommers.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**