Tax benefits of trusts

How are trusts taxed?

• Revocable living trusts are subject to estate tax, even though they avoid probate. The grantor will have paid taxes on any income the trust generated while they were living.

• In some cases, irrevocable trusts can avoid estate taxes as well as inheritance taxes. The trust itself will pay its own income taxes.

• Any money put into a trust may be subject to the federal gift tax if it goes over the annual limit.

• Testamentary trusts are established in the will. They are part of the probated estate and taxed accordingly.

• Trust beneficiaries may end up owing taxes on earnings or gains made by the trust assets after they receive them.

In the weeks after your loved one has passed away, you and your family may find out that they left a fair amount, if not all, of their assets in various trusts. One of the most popular ways of organizing one’s assets, trusts are legal arrangements in which a third party holds one’s assets based on various goals or instructions one has outlined within it. 

Each type of trust comes with its own set of tax benefits that will be important to understand after your loved one’s passing. It’s important to know about the various kinds of trusts so that you and your family can prepare for and understand what will be happening with all of your loved one’s assets.

Trust basics

There are three key players in a trust:

• Trustee: the person, people, or entity who hold(s) the assets

• Grantor: the person who creates the trust

• Beneficiary: the individual(s) who ultimately will receive the assets held in the trust

For example, your loved one (the grantor) may have opened a trust and named a close friend as trustee. The trustee will subsequently manage all the assets the grantor placed in it for the benefit of you and your siblings (the beneficiaries). The assets your loved one placed in the trust are called the principal. 

Why your loved one may have opened a trust

Many people choose to open a trust when they are developing their estate planning strategy to determine how they would like their assets to be managed after they pass away.

If your loved one was wealthy, they may have opened a trust to decrease their estate’s value. An estate incurs a federal estate tax if its total value exceeds a certain threshold: $11.7 million is the 2021 estate tax exemption. There may also be state-level estate or inheritance taxes, based on where your loved one lived. Depending on the type of trust, placing assets in it can mean that your loved one no longer owns them, effectively removing them from the calculation during the valuation process.

In the case of an irrevocable trust, for example, as we will see below, your loved one separated themselves from ownership of their assets, and these assets will no longer be considered part of their taxable estate after they pass away, for the purposes of federal or state estate taxes or state inheritance taxes. (The money they put into the trust may, however, have been subject to the federal gift tax at the time of funding.)

On the other hand, any income that the assets in the trust generate, such as interest or dividends, will be taxable, and when you receive assets from the trust, you will generally need to declare those as part of your income tax. And if the assets increase in value, you will be subject to capital gains tax on that increase in value if you choose to sell them at some future point after the assets are distributed to you.

Not all trusts function the same way, however, and the type of trust in which your loved one chose to place their assets can make all the difference in how you and your family access assets and how these assets are protected.

What are living trusts? 

A living trust, also known as an inter-vivos trust, is a trust that someone establishes during their lifetime. It is immediately effective upon being funded. There are several types of living trusts, but the most common distinction is between revocable and irrevocable trusts.

If your loved one opened a revocable living trust, that means that they maintained ownership of all the assets they placed in it and had to pay income tax on any money the trust generated. 

One of the main advantages of a living trust, including revocable trusts, is that any assets in it avoid the probate process. The bottom line is that a revocable living trust gave your loved one flexibility to do what they wanted with the principal, since they were still its legal owner. 

Keep in mind that even though these trust assets are not part of a probated estate, they may be subject to estate taxes, and can be made available to pay off creditors should the estate itself not have enough resources. 

Alternatively, your loved one may have funded an irrevocable living trust during their lifetime. If it is set up correctly, it is outside of the reach of the estate's creditors, and will not be subject to any estate or inheritance taxes. In order to accomplish this, your loved one cannot be a beneficiary of the trust or otherwise have any control over the assets in the trust. The trust also can not have been set up in order to avoid creditors or otherwise commit any fraud.

Although it is generally considered outside of the taxable estate, any assets placed in an irrevocable trust may have been subject to the federal gift tax (or reduced the person’s total estate tax exemption) at the time of funding.

If the assets in the trust generate any earnings (rent for property or dividends from stock, for example), the trust itself will be subject to the income tax—and the trustee will be responsible for paying those taxes out of the trust until the assets (or the income) are transferred to a beneficiary. When a trust pays its own taxes, it pays at the highest possible tax rate once it is over a certain low threshold ($13,050 in 2020), and therefore it is usually in the best interest of the beneficiary for all the income of the trust to be distributed to them.

What are testamentary trusts?

Unlike a living trust, a testamentary trust is created after your loved one’s death. Only assets passing through the estate can be transferred to a testamentary trust.

Sometimes called a will trust, a testamentary trust is established in accordance with instructions left in your loved one’s will. Multiple will trusts can be opened, depending on how your loved one wanted their assets to be distributed.

Testamentary trusts are managed by trustees who ensure the estate is distributed according to the instructions your loved one left. A common reason testamentary trusts are established is to give a minor child their fair share of the estate while preventing them from inheriting a large sum of money all at once. For example, the will may state that the beneficiary gains full access to the trust once they have reached a certain age or met specific requirements.

As with any trust, the trustee controls how the assets are held, organized, and distributed. Generally, the executor of the estate is also named the trustee of a testamentary trust. However, this is not a rule; it simply makes more sense for the executor, who is already in charge of the estate, to oversee how its trusts are managed.

The trustee will need to file a U.S. Income Tax Return for Estates and Trusts for any year that a trust generates over $600 in income. The plus side of this taxation is that it cannot be doubled. Either the trust pays the tax, or the beneficiary does. Consult with a tax specialist to understand how the taxation breakdown functions if there are multiple beneficiaries. 

Understanding how your loved one’s estate planning affects you once they have passed away can make the financial aspects of these difficult months much more manageable. Use the services of tax specialists and financial advisors, particularly if your loved one’s estate and trusts are sizable. The more expert advice you have, the better you will manage the distribution of your loved one’s assets and establish a favorable tax situation for you and your family.