Estate, Gift Taxes & Use of Trusts
Trust formation is in and of itself a legal issue, trust administration with respect to potential tax ramifications is legal and tax accounting related. Each state has its own nuances with respect to trust law and administration. Since Florida has no estate tax, the tax preparation aspect of trusts is somewhat less complex and less expensive to administer than in most other states. The most common form of trusts used today is known as a living trust, used because of the tax and legal benefits.
Living trusts ease the burden of estate administration. A testamentary trust (which is a trust created by a will, for example) does not become effective until an individual dies. A living trust generally activates during the life of its creator, and can form part of an overall estate plan. A revocable living trust may be revoked by its creator (the grantor, settlor or trustor) at any time, so long as he or she is legally competent to do so.
The document that creates the trust (a trust agreement, a deed of trust, or a trust indenture) names the trustee (often the grantor, so long as the grantor is able to act, or a bank, trust company, or trusted adviser) and sets forth the terms of the trust’s administration.
From a tax point of view, all of the assets of a living trust are potentially subject to death taxes upon the grantor’s death. They are usually entitled to whatever deductions, exemptions, and credits, such as the marital and charitable deductions, the applicable credit amount, or state death tax credit or deduction that would be available had they been owned by the grantor personally.
So long as the grantor is living, the living trust is a grantor trust for income tax purposes, so that all of its income, including capital gains, is taxed to the grantor as though the trust did not exist. If a living trust is revocable, its funding does not incur gift taxes. If, however, the document provides that the grantor loses the right to revoke it upon a specified lifetime event, such as the grantor’s incapacity, a gift tax may be incurred at that time. These are complex legal issues, which should be discussed with a knowledgeable estates and trusts attorney for specific advise of any kind.
Living trusts may have adverse tax consequences. For example, if the terms of the living trust require the division of the trust’s assets into two or more portions when the grantor dies, such a division may be considered a distribution, possibly resulting in capital gains taxes (and eliminating the six-month alternate valuation date for death tax purposes). Using portability of the unused portion, the first $12.92 million of an estate’s valuation (married couple has $25.84 million), including accumulated lifetime gifts- see below, is exempt from estate tax for 2023. Of course, a deceased married individual can pass by way of portability, all of his/her assets to the spouse tax free- and that person could then assume responsibility for potential estate taxes- that is, barring other methods of estate tax deferral or avoidance.
Gifts made over one’s lifetime are accumulated and thus reduce (“use up”) the $12.92 estate tax exemption amount. However, gift tax return form 709 is required to be filed generally only when gifts to any one recipient exceeding the 2023 annual $17,000, non-reportable exemption amount (but generally, taxes would not be due unless the accumulated estate tax exemption amount is exceeded. Generally, the recipient does not pay any tax). (Starting in 2025 (as of 2023’s regs.), accumulated gift tax exemption will drop to $7 million, so that could have adverse tax consequences – losing about $6 million of difference in accumulated estate tax.There is more to all of this of course- but not practical for this purpose of this overview.
Because of the $12.92 million of a spouse’s estate tax exemption, a married couple can now pass onto heirs $25.84 million, (thus avoiding unneeded tax planning and the use of once popular “AB Trusts”). Also, since an estate can pour into a trust, using a fiscal year for the estate and a calendar year for the trust can result in deferral of the payment of income taxes on estate income. This benefit is available to a combination of an estate and a trust, regardless of whether the trust is a testamentary trust or a living trust when both are used.
If all assets are held in a living trust (or are payable to or are held jointly with one or more surviving individuals) there may be no need to go through probate, which can be expensive. If, on the other hand, there are assets of any substantial value (such as a large bank account, or perhaps a car of significant value) held in the deceased’s own name, or without a designated beneficiary (or surviving joint owner), those assets typically will have to go through the process of probate, even with the existence of a living trust. The reality is many living trusts are set up and not fully funded or used, and the creators continue to hold some assets in their own names. This can prove to be a costly mistake.
A testamentary trust created by a will does not come into effect until an individual dies. A living trust usually starts to function during the life of its creator and can form an important part of the overall estate plan. A revocable living trust may be revoked by its creator (the grantor, settlor or trustor) at any time (as long as he or she is legally competent to do so).
The document that creates the trust (a trust agreement, a deed of trust, or a trust indenture) names the trustee (often the grantor, so long as the grantor is able to act, or a bank, trust company, or trusted adviser) and sets forth the terms of the trust’s administration.
In summary, this discussion of trusts illustrates the potential advantages of using trusts in conjunction with a sound overall estate plan. Many types of trusts exist, such as generation skipping trusts that can be used to offset as much as $12.92 million (2023). Because of the complexities of trusts, and with constant changes in the tax law regarding their use, it’s wise to seek professional advise – please contact my office for further discussion on these important issues.