Trusts are common techniques used to protect assets and to transfer the contents of an estate to the next generation. Importantly, trusts are taxed differently than individuals, and are subject to different tax guidelines. It is important for estate planning professionals to be mindful of the tax implications of trusts and to work to ensure that their clients’ assets receive the best available and most appropriate taxation per the IRS guidelines.
The tax paradigm for trusts has shifted. In the late 80’s and early 90’s, trusts were taxed at a much lower rate than individuals, while the estate tax threshold was egregiously low. This resulted in assets being held in trust to shield them from taxes. Today, the opposite is true. We are in a tax paradigm where the estate tax threshold has been raised to a point where it applies to very few, and trusts are subject to a compressed tax rate. This compressed tax rate means that tax brackets for trust income increase at a much faster rate than for individuals.
For instance, income in trusts exceeding $12,400 is currently taxed at a compressed tax rate of 39.6%. Compare this rate to a single filer: one would need to earn upwards of $415,050 in income to be subject to this maximum tax bracket. In today’s tax environment, estate planners must be mindful of this tax dynamic and proactively draft estate plans to protect assets from excessive taxation.
Furthermore, how a trust is categorized affects how it is taxed. For example, a trust can either be classified as a simple or complex trust. A simple trust is one that is required to distribute all income each year to a beneficiary. A simple trust pays taxes on capital gains remaining in the trust. Complex trusts are permitted to accumulate income, but also retain the discretion to distribute this income among beneficiaries.
Drafting Tip: To help ensure the trust is classified as a simple trust, practitioners should draft the trust to prevent Trustee discretion to withhold income. Rather, including a provision to require income distribution would be necessary. Discretion to withhold income will result in a complex trust.
Portioning out the accumulated trust income among beneficiaries, or income sprinkling, is one method of minimizing the taxation of trust income. In such a scenario, the income accumulated in a trust is distributed before December 31st of the year, and it is counted as income for the beneficiary. Unless the beneficiary is also in the same high tax bracket, there will usually be significant tax savings.
Similarly, capital gains distributions usually remain within the trust and would be subject to higher tax rates. With complex trusts, however, it is possible to pass such capital gains or losses onto the beneficiaries. Depending upon state guidelines and the stipulations of the trust, some capital gains may be considered beneficiary income as well.
It is important to note that a trust can toggle between simple and complex, depending on the year. For example, a trust is complex if it is allowed to but not required to distribute principal in the years it actually does distribute principal, but is simple in any year it does not. Conversely, a trust that has the flexibility to either distribute or accumulate income is always a complex trust even in the years when no distribution is made.
Drafting Tip: Including Trust Protector provisions can be helpful for future flexibility, when flexibility today may result in negative tax consequences. Attorneys can include clauses that allow a Trust Protector to later give a Trustee the discretion to distribute income. This would allow the trust to qualify as a simple trust now, but later be converted to a complex trust, if desired.
Additionally, trusts are categorized as grantor and non-grantor trusts, depending upon how ownership and control over the trust are outlined. A grantor trust results in the grantor being responsible for the income tax liability of the trust, regardless of whether the trust income is distributed to beneficiaries or not. A non-grantor trust is considered a separate entity and is subject to income taxation as discussed in the context of either a simple or complex trust.
Drafting Tip: Practitioners should consider inserting a clause that specifically mentions whether the trust is intended to be either a grantor or non-grantor. This goes a long way to clarify the tax consequences. Importantly, specifying the intent does not determine whether the trust is a grantor trust or non-grantor trust.
Drafting Tip: Additionally, the use of Trust Protector provisions to trigger or toggle between grantor trust status can achieve beneficial tax consequences on a year-by-year basis.
As you can see, not all trusts are taxed equally. It’s important to know these taxation guidelines for trusts because they can have significant implications for your client’s assets. We recommend partnering with a CPA or other tax professional on an annual basis to determine the best course of action to minimize tax liability for your client. Additionally, WealthDocx® offers drafting tips and solutions to ensure your clients' assets receive the best available and most appropriate guidance to truly minimize their liability.
