Trusts
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.
Irrevocable
Trusts
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.
At
Penney and Associates, we are committed to providing
the best possible service so your law related needs
are handled with the utmost professionalism.
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