Trusts & Taxes 101: Understanding the Basics

Posted by Deb Elfers, Jacqueline Kandray and Phi Bui

Wills and trusts are common estate planning tools individuals use to manage their assets and distribute their wealth after passing. The use of both of these vehicles can ensure your assets and possessions end up where you want them.

While a will is a legal document that can outline your wishes in terms of asset distribution, guardians for minor children and the executor of your estate, a trust offers additional types of protections and benefits. It is a legal entity that holds and manages assets on behalf of whomever you name as the beneficiary(s). Trusts can be used to avoid probate, minimize estate taxes and provide for ongoing management of assets after your death. They can be revocable or irrevocable and can be created during your lifetime or through your will. 

Below offers an introductory look at trusts, their uses and other important considerations.

What is a Living Trust?

A living trust is one that’s established during an individual’s lifetime. It’s created to manage, protect and distribute assets and is controlled by the “grantor,” e.g., the person who transfers the assets to the trust. For this reason, living trusts are also known as grantor trusts. They offer a high level of control and flexibility over trust property and income, and can offer important tax benefits. A living trust:

• Is not recognized for income tax purposes; the taxpayer who gave assets to the trust, the grantor, retains certain rights and is treated as the owner of the trust for income tax purposes. Trust income is passed through and reported on the grantor’s income tax return, and accounts are normally titled using the grantor’s social security number.  
• Typically is set up as a revocable trust.

Understanding the difference between a revocable and irrevocable trust is the next step in identifying the right type of trust for your goals.

What is a Revocable Trust?

A revocable living trust normally allows the grantor to amend or cancel the trust during their lifetime, and move assets in or out of the trust at any time. This makes it a flexible option for those who may change their minds about how their assets should be distributed after their death. This type of trust converts to an irrevocable trust at death, and the assets are distributed to the beneficiaries based on the terms of the trust agreement.

With a revocable trust, assets avoid probate at death; however, because the grantor retained control of them while alive, the assets are included in the grantor’s taxable estate.  

What is an Irrevocable Trust?

A grantor typically cannot change or terminate an irrevocable trust, permanently shifting assets from the grantor’s estate to its intended heirs under the trust terms. Any transfer of assets to an irrevocable trust are treated as completed gifts for gift tax purposes.  

This trust type is great for those aiming to minimize estate taxes, as the trust’s assets are not included in the grantor’s taxable estate but can still appreciate outside of the estate. Moving assets from the grantor’s ownership into an irrevocable trust can also protect those assets from creditors and can keep the assets out of probate. One downside to an irrevocable trust is that those assets are no longer under the grantor’s control; they are managed by the trustee solely for the benefit of the beneficiary(s).  Another downside is that the trust assets are in some cases taxed to the trust, which has very compressed income tax brackets.  

What is a Testamentary Trust?

Unlike a trust formed when an individual is living, a testamentary trust comes into existence after the decedent’s death and is often created by drafting in the last will and testament. Since this trust is established upon death, the assets are subject to probate and included in the decedent’s taxable estate. The trustee/executor manages the assets and distributes them to the beneficiary(s) according to the will and trust language.

Simple vs. Complex Trusts    

Irrevocable trusts are managed by a trustee the grantor appoints as part of the trust document. For income tax purposes they are categorized as simple or complex. The provisions of the trust agreement dictate if the trust is considered a simple or complex trust and how assets are distributed to the beneficiary/(s).

What is a Simple Trust?

A simple trust is  a type of irrevocable trust that has fewer tax and administrative requirements than a complex trust. A simple trust:

• Is required to distribute its “income” to beneficiaries each year and issues tax reporting to the beneficiary(s) in the form of a K-1, which results in them paying tax on the income. Capital gain, on the other hand, is considered part of the “principal” of the trust and is retained and taxed to the trust. 
• May permit the trustee to distribute principal in certain circumstances, but there is no requirement to do so.   
• Cannot provide that any amounts be paid, set aside or used for charitable purposes. 
• Has a $300 exemption and can take a distribution deduction for any amounts distributed to beneficiaries (when filing Form 1041).

What is a Complex Trust?

Complex trusts are irrevocable trusts that do not meet the guidelines to qualify as a simple trust. As a result, in a complex trust:

• Income may be accumulated or distributed at the trustee’s discretion. Any income not distributed is taxable to the trust. 
• Distributions can be made to charitable organizations if the trust provisions allow for it.
• When filing Form 1041, a complex trust has a $100 exemption. 

Some common types of simple and complex trusts include marital trusts, family trusts and gifting trusts: 

• A marital trust is an irrevocable trust that allows the transfer of a deceased spouse’s assets to trust for the surviving spouse without any estate taxes, due to a “marital deduction” on the estate tax return. The surviving spouse is required to receive all of the trust “income” to qualify for this treatment. 
• A family trust generally receives a decedent’s assets that are protected from estate tax by the estate tax exemption. The trust terms would dictate who receives assets from the trust after it is funded.  
• A gifting trust is created to pass wealth on from generation to another generation during the grantor’s lifetime. Normally this would be structured to avoid any gift taxes at the time of the gift.

Why Should I Use a Trust?

Everyone’s situation is different, but there are some meaningful benefits to placing your assets in a trust. In general, they:

• Avoid the often costly and time-intensive probate process.
• Have a higher level of privacy, as they are not subject to public record like probate assets. 
• Can provide asset protection from creditors, lawsuits and potential beneficiaries’ financial mismanagement.
• Can offer tax benefits, such as with irrevocable trusts, by removing assets and future asset appreciation from the grantor's taxable estate.

Are there Disadvantages to Using a Trust?

There are some downsides to using a trust. They:

• Can be more complex than wills, requiring more time and expertise to establish and manage. 
• Require ongoing record keeping, and some trusts can carry potential tax burdens. 
• Have higher costs to create and maintain than a will. 
• May not allow grantors to control the assets or modify the trust terms, in the case of irrevocable trusts.

While trusts can be complicated, it’s important to understand there are multiple types that allow you to protect various assets in different ways. It’s worth a conversation with your attorney and tax advisers to discuss what’s right for you.

Contact Deb Elfers, Jacqueline Kandray, Phi Bui or a member of your service team to discuss this topic further.

Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.