There are a plethora of reasons why trusts are formed, the question is why are there different trusts and what is their purpose?
Before we get into the reasons and taxation concerns, let’s define all of the moving parts of a trust. A trust is a legal document, containing a Grantor (sometimes referred to as Trustmaker), this is the person making the trust. Then you have a Trustee, the person or entity that controls the assets in the trust.
Then you have the beneficiaries, the person(s) that will receive the assets of the trust under the conditions laid out in the trust. An important concept to understand is that there are Revocable Trusts, meaning the trust document can be changed and Irrevocable Trusts, which cannot be changed.
For tax purposes, a Revocable Trust is a Grantor Trust, which means the Grantor pays any income tax that is due on the money that is earned in the trust. Revocable Trusts are usually formed to avoid probate, a process that varies between the states.
Generally, a person can die intestate, meaning they had no estate plan. The person’s estate will go through probate and the assets will be disbursed according to the laws of the state.
If you die testate, that means you had a will. The problem with wills are that they can be contested. For example, probate hearings are made public and anyone can contest a will and your assets can be distributed to someone they weren’t intended to be disbursed to.
With a Revocable Trust, assets pass to the beneficiaries through a legal process dictated in the trust. The assets that are in the trust need to be titled to the trust. Even with a Revocable Trust, you will still need a pour-over will.
The purpose of the pour-over will is to catch any small assets that were not named in the trust document. When the Grantor of the Revocable Trust dies, the trust becomes Irrevocable and you must obtain an EIN, and file Form 1041.
Irrevocable Trusts are a completely different animal. These trusts are taxable entities and they provide asset protection for any assets placed in these trusts. One important thing about these trusts is that once an asset is placed in it and beneficiaries are named, the Grantor loses all rights to the asset.
For example, years ago people would use Uniform Transfer to Minors Act (UTMA) accounts for their kids. Once assets were placed in the UTMA the child owned them. If you remember being 18 years old, you can remember being stupid. What if you had unrestricted access to all this money in the UTMA account? They were recipes for disaster.
An elementary example of how an Irrevocable Trust is used is to remove assets from a person’s estate. For example, let’s say your client wants to gift assets to their children. They can simply place them into an Irrevocable Trust.
In the trust document, you can control the different scenarios that have to be met before the beneficiaries receive the assets. Something else important is that if you have a taxable estate and remove assets from your estate by putting them in an Irrevocable Trust, the beneficiaries of the trust have to receive the assets by age 21.
However, the restrictions you can put on the transfer is a drug and alcohol provision. If the beneficiaries in the judgment of the Trustee have a drug or alcohol problem then they don’t receive the assets. Another stipulation commonly used is that the child has to go to college and maintain a 3.0 GPA.
Another thing to understand about Irrevocable Trusts is that you are gifting something to someone and the gift tax limits apply. In 2018, you can gift one person $15,000. If you are married and you and your spouse elect to split your gifts, the amount you can give to an individual is $30,000.
A good tax planner would recommend their client put appreciable assets into the trust. For example, let’s say you have mutual funds that you have a basis of $15,000, however their FMV is $50,000. You have stayed within the gifting limits and the trust picks up your basis. In reality you just removed a $50,000 asset from your estate, but because your basis was only $15,000, you haven’t exceeded the gift limitations.
As I previously mentioned, Irrevocable Trusts are also used for asset protection. Once you place an asset into an Irrevocable Trust, you lose all rights to the asset. You no longer own it, so generally that asset can’t be attached to any judgment that is entered against the Grantor.
There are so many uses for an Irrevocable Trust, but these are the generalities of how they work. An Irrevocable Trust is a taxable entity. It files Form 1041 and issues K-1 forms to the beneficiaries of the trust for any taxable income that the corpus has made.
These are just the basics, but if you have a client that wants you to do estate planning, you need to work with the attorney that is doing the planning so there are no tax surprises.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...