Trusts can be beneficial for obtaining tax benefits that would not otherwise be available. This article explores some of the significant opportunities.
Think of a trust as a contract with a Trustee that sets forth the rules for governance of the assets owned by the trust. It is a special type of contract in that the Trustee has fiduciary responsibilities to the trust’s beneficiaries. It is much more than a simple contractual relationship.
Trusts can either be revocable, i.e., the Donor can change the rules when he likes, or irrevocable where the rules, once set, cannot be changed. Revocable trusts do not provide any tax benefits, and all income, gains, and losses are reported on the personal tax returns of the Donor. These are called Grantor trusts.
Irrevocable trusts provide the ability to choose who should be taxed on the income and gains as well as to secure other benefits. We now examine tax strategies using irrevocable trusts that are useful for eliminating or minimizing income and capital gains taxes, as well as estate taxes and gift taxes.
Income Tax Planning
We start with an example: Donor transfers $1,000,000 to a trust, and the beneficiary is one of his children. The Donor has three choices as to how income, gains, and losses (hereafter, we refer to just income) shall be taxed: to the trust, to the beneficiary, or to the Donor.
- Where the income is taxed to the trust, this is called, for tax purposes, a complex trust. Undistributed income is taxed to the trust, and distributed income is taxed to the beneficiary. The benefit of taxing income to the trust is that the Trustee maintains control over distribution and can determine what is reasonable and appropriate. Beneficiaries must justify requests for distributions and if the Trustee determines that a request is not appropriate, can decline to make the distribution. The negative is that trust income is taxed at the highest tax bracket once it reaches about $14,000, whereas for individuals, income must be at least $578,000 to get to the highest brackets. Also, a full income tax return is required for a complex trust, increasing administrative costs.
- Income can be taxed to the beneficiary, where the beneficiary is given the right to take out the income. These trusts are called beneficiary deemed owner trusts (BDOTs). This arrangement causes trust income to be taxed to the beneficiary at his tax rates, whether distributed or not. Where the income is not withdrawn, it is then added to the principal of the trust and not subject to further income taxes. BDOTs are great where the beneficiary is responsible and prudent; where the beneficiary’s ability to manage money is suspect, a BDOT may not be the best choice. The tax benefit is that the beneficiary is almost always in a lower tax bracket than the Donor, and this income shifting reduces the overall tax burden. Also, a tax return is not required. Typically, just an informational return is filed advising that the income is being taxed to the beneficiary.
- In some circumstances, income is taxed to the Donor of the trust. This is called a defective grantor trust. Where the Donor continues to have the tax liability, the assets in the irrevocable trust grow faster because it does not pay taxes. This is done in special planning circumstances, which are briefly reviewed below under Large Gift Strategy. Like a BDOT, just an informational return is filed with the IRS keeping administrative expenses down.
Estate Tax Planning
Trusts are very valuable for estate tax planning. Frequently the trust involved was a revocable trust that became irrevocable on the death of the Donor. As an example, one spouse sets up a trust that, on his death, funds a trust share for his spouse that is funded to the amount of his available federal estate tax credit, thus avoiding federal estate taxes on this portion of his assets. This is called a Credit Shelter Trust or Trust B. Assets not allocated to this trust are allocated to a trust for the spouse that qualifies for the estate tax marital deduction, which is unlimited in amount. On the second spouse’s death, Trust B assets are not included in her estate avoiding federal estate taxes.
Sale to a Defective Grantor Trust
This strategy is used for federal gift and estate tax planning and allows a person to “sell” an asset to an irrevocable trust without triggering capital gains taxes. The trust, which is the buyer, is “defective” in the sense that for income tax purposes, the Donor/Seller is treated as the taxpayer. Selling something to yourself (which for income taxes is what occurs) does not trigger a tax consequence. This arrangement does not upset the other tax consequences of the transfer of the asset to this trust, and the assets purchased are no longer owned by the Donor. The asset and all of its appreciation value are excluded from federal estate taxes on the death of the Donor.
Large Gift Strategy
Refer to the example above, where the Donor transfers $1,000,000 to a trust for one of his children. Besides achieving personal goals, these are the tax benefits:
- The first $17,000 of the property transferred is gift tax-free because of the gift tax annual exclusion and the amounts above this are not taxed by using a portion of the Donor’s gift tax credit.
- All appreciation in the trust investments is out of his estate. If the value of the trust assets grows to $2,000,000 by the time of his death, the appreciation of $1,000,000 is not taxed, which saves $400,000, whereas the federal estate tax rate is 40%.
- Where the trust is defective, and he pays the taxes, the value of the trust assets grows more quickly because the trust does not pay any taxes with consequent increased savings in federal estate taxes.
Tax Basis Planning
This is one of the most overlooked planning strategies for reasons that we at Cavitch do not understand. Basis is what was paid for the purchase of the assets. Appreciation is taxed once there is a sale of the assets, at which time the excess of the proceeds over basis is subject to capital gains taxes. At death, however, the rules change, and the tax basis is the date of death value. This is called stepped-up basis and applies to all assets except annuities and retirement plans, which have different rules. Stepped-up basis also does not normally apply to assets in an irrevocable trust because those assets are not typically included in the estate of the beneficiary. So how do we create irrevocable trusts such that a stepped-up basis applies to appreciated assets that it owns?
The answer is a strategy that John Tullio and I have developed called the Optimal Benefits Trust. In its essence, it gives to the trust beneficiary a general power of appointment (the right to direct the Trustee to distribute trust assets to someone designated by the beneficiary) as to appreciated trust assets but only as to a value of the assets that does not trigger federal estate taxes in the estate of the beneficiary. Property subject to a general power causes inclusion of this property in the estate of the power holder. What the strategy does is limit the assets subject to the power to assets that have appreciated in value, and the amount of property subject to the power is limited to values of trusts property that do not cause estate taxes in the estate of the beneficiary.
Life Insurance Trusts
Life insurance death benefits on policies over which the decedent had incidents of ownership are included in determining federal estate taxes. Where, however, the policies are not owned by the insured/decedent, estate taxes are avoided. The most common strategy for avoiding inclusion is for the policy owner/insured to set up an irrevocable life insurance trust (ILIT).
The ILIT owns the policy and is the beneficiary. Premium payments come from gifts to the ILIT. While the premium costs are taxable gifts, the gift tax consequence is usually avoided by the exclusion of annual gifts to the trust beneficiaries that do not exceed $17,000 per year per beneficiary. Where there are, for example, three beneficiaries, there is a total of $51,000 of gifts that are gift tax-free and that do not reduce the gift/estate tax credit. If the premium is larger than the available annual exclusion gifts, then the gift tax credit is used to avoid the payment of taxes.
Ownership of a life insurance policy by an ILIT does not affect the income tax-free receipt of the death benefits. Thus, an ILIT is perfectly efficient for estate and income taxation.
The federal estate tax applies to transfers from a decedent to his beneficiaries. The generation-skipping transfer tax (GST tax) applies to the taxation of transfers to beneficiaries in generations below those beneficiaries. This occurs when gifts are made that skip the next generation, such as gifts to grandchildren. It also occurs where assets are held in trust for the next generation, and on the death of a member of that generation, assets held in trust for that beneficiary pass to the succeeding generation. Tax planning requires that both the federal estate tax and GST tax be considered.
The GST tax has a tax credit in the same amount as the federal gift/estate tax credit, so there are substantial opportunities to avoid this tax. It is applied most commonly when a person sets aside assets in a trust either during a lifetime or at death and wants these assets held for successive generations of his family without the interference of further estate taxation.
The application of the gift tax credit for transfers during lifetime and the estate tax credit at death avoids gift and estate taxes. The role of the GST tax is supplemental, providing that subsequent transfers of trust assets to the following generations are not subject to estate taxes. In states such as Ohio, where assets can be retained in trust for perpetuity, a properly designed trust takes the trust assets permanently out of the federal estate tax system. Of great significance is that the GST tax exemption applies to all appreciation in the trust assets and does not just protect the original value to which it was applied.
Some Final Thoughts
Yes, these strategies really work. Recently, the application of the Optimal Benefits Trust strategy for one of our clients erased $2,500,000 of unrealized gains, saving the children $500,000 to $600,000 in taxes upon the sale of the appreciated assets.
The foregoing is just a survey of some of the major topics, and there are many more options for tax planning. All of this reminds me of an important fact: while estate planning is science as dictated by trust and tax laws, it is also an art requiring the attorney to blend all the options available into a cohesive, integrated plan that helps clients achieve their objectives. Or, as I like to joke with clients, our job as legal counsel frequently requires that we make stuff up!