There is a great deal of confusion about the taxation of trusts. In this article, I hope to cut through the jargon and lawyer mumbo jumbo (technical term) so that you will have a better understanding of how trusts are treated by the tax code.
First, we need to step away from a monolithic view of the tax code. There are many different types of federal tax that could impact a trust at different times in the trust’s life cycle. For instance; estate tax, gift tax, generation-skipping tax and income tax (both ordinary income tax and capital gains tax). Also, depending on whether the trust is qualified as a ‘Grantor’ trust or not will impact how the trust is treated for federal tax purposes. In addition, there are different rules that come into play when dealing with non-U.S. taxpayers, which will not be covered in this article. Let’s discuss each separately.
Internal Revenue Code Sections 671-677 governs if a trust is a grantor trust. To simplify our understanding of this issue, if the trust contains certain provisions and/or powers, the government says that it is a grantor trust. Most people use Revocable Living Trusts (“RLTs”) as their primary estate planning trust. These trusts, by definition, qualify as grantor trusts. This distinction will have an impact on each of the following sections of this article.
26 U.S. Code Subtitle B, Chapter 11 (IRC Sections 2001 to 2210) deals with federal estate tax. Stripping away all of the technical confusion, if you own, control or have the beneficial use of something during your lifetime, it is most likely includible in your gross estate and potentially subject to federal estate tax. RLTs, as previously discussed, are grantor trusts and therefore the assets held by the RLT are includible in your gross estate. For a couple, the RLT can be constructed to allow for the capture of both of the spouses’ federal estate tax exemption, shielding the taxpayer’s estate/trust from a large amount (if not all) of the federal estate tax. The available exemption per person this year is $5,490,000. For estate and trusts with a gross estate value in excess of the available federal estate tax exemption(s), the effective federal estate tax rate is currently 40%. There is a link between the federal estate tax and the federal gift tax, called the unified credit. We will discuss this in the next section.
26 U.S. Code Subtitle B, Chapter 12 (IRC Sections 2501 to 2524) deals with the federal gift tax. Basically, everyone has both a lifetime gift exemption and an annual gift exclusion. The annual gift exclusion allows everyone to make a gift of up to $14,000 to anyone else, during that year, without that gift applying against their lifetime gift exemption (2017 numbers). If you make a gift in excess of $14,000, then the excess must be reported on IRS Form 709 and will reduce your lifetime gift exemption (which is part of your unified credit impacting your available federal estate tax exemption). Gifts made from RLTs will be treated as a gift made by the grantor of the RLT. As far as the IRS is concerned, the RLT and the grantor are the same entity and as such, they share the annual gift exclusion. The current lifetime gift tax exemption is the same as the federal estate tax exemption; $5,490,000, with the same 40% effective tax rate. This means that if a taxpayer (or their RLT while they are alive) makes aggregate gifts in excess of $5,490,000, they will begin to be subject to the gift tax for any amounts gifted in excess of the lifetime exemption amount. In addition, they will have depleted their federal estate tax exemption by way of the unified credit, between the two taxing systems. As such, the estate/trust will be subject to federal estate tax with no exemption amount available.
Governed by 26 U.S. Code Subtitle B, Chapter 13 (IRC Sections 2601 to 2664) the generation-skipping tax (“GST”) is the most confusing and arcane tax that may impact trusts. Basically, the government wished to prevent wealthy families from avoiding estate taxes every other generation by “skipping” a generation in the distribution pattern. For example, a grandparent skipping his/her children and providing a distribution from their RLT to their grandchildren instead. This prevented the IRS from having a proverbial ‘bite at the apple’ for estate tax purposes for the skipped generation. As such, the government decided that they would only allow so much wealth to transfer via a skip before it imposes a tax (the GST). The current GST exemption is the same as the federal estate and gift tax exemptions (see a pattern?) of $5,490,000 with an effective rate of 40%. However, the GST tax exemption has not always been the same amount as the federal estate and gift tax exemptions. This caused extra heartache for tax practitioners during the 1990s and 2000s when it was possible to avoid one tax with the higher exemption and still be subject to the other with the lower exemption. Fortunately, that is not currently the case. The GST may also impact distributions from an RLT to a non-family member beneficiary. The government considers a distribution to any beneficiary who is more than 37.5 years younger than the donor to also be a skip person. As such, it makes good sense to consider the ages of all your beneficiaries listed in your RLT, in relation to your age, to determine if there is a possible GST problem that must be addressed and hopefully corrected in advance.
Oh boy; this is the fun one. First, your RLT DOES NOT allow you to stop paying federal income taxes. In fact, as previously discussed, your RLT is a grantor trust and as such, uses your social security number as its federal tax identification number while you are living. IRC Section 1001 provides the basic framework for which all income tax is determined; being, do you have more than before. If yes, then you pay income tax on the ‘more’ unless there is a deduction, credit or exemption that allows you different tax treatment.
While you are living, the income generated by the assets in your RLT are reported on your personal Form 1040, at your own income tax rate. There is no separate treatment of your RLT for tax purposes at this time. In the eyes of the IRS, you and your RLT are one taxable entity. That means your RLT is completely income tax neutral to you, the grantor.
Upon your death, your Social Security Number terminates. Under certain circumstances in a joint RLT between a husband and a wife, the trust continues as one trust for the lifetime of the surviving spouse, using their social security number and remaining a grantor trust during that period. In other circumstances, the trust may split into two pieces, a Marital Trust and a Family Trust. The Marital Trust would typically use the Social Security Number of the surviving spouse and be reported on their Form 1040, while the Family Trust would obtain a new tax identification number (EIN) and be reported on a separate Form 1041 federal income tax return.
In many JGB trust plans, our clients choose to have their RLT separate into ‘subtrusts’ for their beneficiaries at the grantors death, as opposed to outright distributions. This is done for many different reasons to include: asset protection against lawsuits and divorce of the beneficiary, asset management and control for irresponsible beneficiaries, multi-generational bloodline distribution strategies, etc. Most of these subtrusts qualify as ‘simple trusts,’ which is a tax qualification that allows all of the income of the subtrust to flow out to the beneficiary and be reported on their personal Form 1040, rather than paying said tax at the trust level on the Form 1041. This allows the income to generally be taxed at a lower income tax rate, as the tax rate on non-grantor trusts is generally much higher and more compressed. However, this does not obviate the need for the subtrust to file an informational Form 1041, as it is this filing which will trigger the Form K-1 that will shift the reportable income to the beneficiaries Form 1040.
For comparison, a subtrust will not qualify as a ‘simple trust’ and therefore default to being a ‘complex trust’ if the income generated is retained by the subtrust, rather than distributing the same to the beneficiary. There are times when complex trusts are appropriate; however, they are generally not the norm for most trust-based estate plans.
Unfortunately, there is an unavoidable level of technical complication anytime tax strategy and application is involved. Regardless, it is my hope that this article provided you with some clarity of the interplay between our tax system and trust-based estate plans. If you have specific concerns about your estate plan, please contact our office to schedule a document review appointment with your JGB attorney.