Revocable Trusts have grown in popularity. They provide a lot of things that other estate planning tools do not – control, privacy, and streamlining. While trust planning was a critical component of an estate plan when the estate tax threshold was much lower, now the threshold is so high that the majority of people do not have to worry about death taxes, and trusts are popular for their other advantages.
In many cases, a person or a couple create a trust and then fund that trust with their property while they’re living. They may also name the trust as the payable-on-death beneficiary of other assets, such as retirement, life insurance, or CD’s.
The effect of doing this is that when you die, the assets you put in the trust are not considered to be owned by you, so the probate court does not supervise the management of those assets. Rather, the trustee you have selected takes over immediately and can begin following the terms of the trust and administering the property.
Creating Your Own Rules
When dealing with a trust, a lot of advantages come in the form of creating your own rules for dealing with money going to children. The court system’s default system of making sure kids get their share is a travesty. The costs can be extraordinary. A bond fee would have to be paid, and if you’re talking about a young child and a lot of money, the bond premium could be tens of thousands of dollars. Also, the default system we have in place makes your child’s affairs public records.
They do not even bother to seal the files. You, or I, or anyone really can walk into a county courthouse and immediately pull files and see the assets a child has, the previous years’ accounts showing the income, expenses, etc., and then could use that information to exploit the child when the child is of age with “business opportunities” designed to separate that child from his or her inheritance. Finally, the court system releases money to children when they reach 18.
Now, frankly, I have been doing this long enough to know that putting a huge amount of wealth into the hands of a child that may have just recently lost their parents is potentially dangerous, but that’s our government folks. A trust can avoid that entire system by diverting the funds into an entity where you decide the ages of distribution, who is in charge, and all the other rules.
Now, when I suggest this tool to a client that is a candidate for a trust, one of the common questions I get are about taxes. Do I have to file a separate tax return? Does this make me have to pay higher taxes? Do I save any money on taxes?
When an individual or a couple has our office prepare a revocable trust, it will very nearly always be the type of trust that does not require separate tax returns to be filed while you are living. If I create a trust of this type, and I fund the trust with an asset, such as a rental property or a share of stock, and that results in income to the trust, I would just report that on my individual income tax return as if I earned it individually.
Similarly, a married couple that files their taxes jointly would report income on their joint return that their trust earns while they’re living. Essentially, the trust is disregarded, and this is how the IRS wants it treated. Whenever you are asked for the tax ID number of the trust, most people would use their own SSN’s.
Once you die, however, the trust would become irrevocable (cannot be changed), and the trust will need its own tax ID number, which can be obtained directly from the IRS. After that, the trust will file its own tax returns. This is where it gets interesting, and some careful tax planning should be done so as to minimize tax liability. Involving a CPA is important for many trusts.
When a trust pays taxes, it pays taxes at a higher rate. Where the tax brackets for individuals span over a large amount of income so that you have to earn several hundred thousand dollars in a year to be at the highest tax bracket, the tax bracket for a trust is truncated, meaning it will hit the highest tax rate with less than $13,000 of income in a year. It’s very easy to get hit with a 40% or more tax rate once you factor in state taxes.
Have a Plan
That is why it is incredibly important to plan. If you distribute income from the trust during the tax year (or within a short window after the end of the tax year) to the trust beneficiaries, the tax liability is essentially punted to the beneficiaries, and the beneficiaries pay tax on the income at their individual rate.
If the person is not an extraordinarily wealthy person, they will likely pay at a much lower rate than the trust, and ultimately the trust property can be stretched further as a result. Keep in mind that this typically would not apply while you’re living since you’re adding trust income to your own income and paying at your individual rate.
How does this play out after you die? Well first, the next trustee would go to the IRS and obtain a separate tax ID number. This can be done online fairly easily. Then, the trustee would carefully make decisions about trust distributions to the beneficiaries.
If, for example, the beneficiary is addicted to drugs and is not seeking help, but would likely spend money on drugs, the trustee may decide that the safety risk of distributing property to the beneficiary outweighs the tax benefit of giving them money. However, if the person is seeking help, the trustee might pay for detox, rehab, counseling, etc. and put the tax liability for income on the individual beneficiary to save tax dollars.
Also keep in mind that retirement in a trust is special, insofar as it has its own very complicated set of rules. If you have a retirement account going into a trust at your death, your successor trustee will need to very carefully consult the trust and tax rules to understand their obligations. A CPA and an estate planning attorney will be especially helpful with this issue.
The trust may have no provisions for a retirement account, which may result in all the funds having to be distributed within 5 years. The trust may have conduit provisions, requiring the trustee to make distributions from the trust each year of a certain amount of the trust property. The trust may have accumulation provisions, and in such case, the trustee will have to carefully plan the distributions and weigh the tax benefits and detriments along with the needs and circumstances of the trust beneficiaries.
When you’re filing an individual tax return, you would typically file a Form 1040. While you’re living, this is also where you’d report trust income if you have a Grantor trust. Once you have died, the trust will have its own tax return. This would be reported on a Form 1041, which is a return used to report income for both estates of deceased people as well as trusts. Certain items are deductible, such as trustee compensation, charitable contributions, taxes, legal fees, and tax prep fees.
A grantor trust, a term you may hear if you have a trust where you are using your own SSN to refer to the trust’s tax ID number, is the type of trust where essentially the trust is disregarded and you pay tax as if you earned the income. Essentially, a person with control of the trust can exercise control over the trust property that would ordinarily be consistent with ownership of the property.
As a result of this control, the IRS says the trust will be ignored for tax purposes and the deemed owner (usually the maker of the trust) will be taxed on all income to the trust as if it were his or her own income. This is intentionally done in the majority of cases so that the trust’s creator can enjoy the benefit of their individual tax rate as well as not having to prepare separate returns for the trust each year.
If you’re serving as a successor Trustee and you’re attempting to have a 1041 prepared, your CPA may ask if this is a simple or complex trust, and this is an issue that the trust maker would likely not have had if they had a grantor trust. A simple trust must distribute all its income each year.
Generally, it cannot accumulate income, distribute principal, or pay money for charitable purposes. If a trust distributes principal from the trust, the trust is complex for that year. A simple trust has a $300 exemption towards the tax owed and a complex trust has a $100 exemption. A complex trust is a trust that does not meet the criteria to be a simple trust.
With questions about revocable trusts, including whether one might be appropriate in your situation, please reach out to one of the estate planning attorneys at Hopler, Wilms, & Hanna. We have years of experience preparing and administering trusts.