Part IV “The 4 Most Common Estate Planning Myths”
You probably have heard the adage: “Nothing is certain in life except for death and taxes.” It may be trite, but it’s also true (as so many platitudes are). Before I go any further, I’ll begin in true attorney fashion: I am not a CPA and this article should not be substituted for tax advice. Rather, consider this article a warning – the type of warning the people who trusted Bernie Madoff wish they would have received sooner: “If it sounds too good to be true, it probably is” (my apologies for yet another platitude.)
“Trusts avoid taxes
” – this statement may be true or false depending on what type of trust and what type of tax you mean. What many people do not realize is that in addition to the federal income tax, there are many other types of tax imposed by the IRS, including, for example:
||Wealth Transfer Tax:
- Estimated Tax
- Employment Tax
- Self-Employment Tax
- Excise Tax
- Estate Tax
- Gift Tax
- Generation Skipping Transfer Tax
This list is not exhaustive by any means. Thus, when someone says, “Trusts avoid taxes
,” it is important to realize that both “trusts” and “taxes” are loaded terms that can have different meanings, depending on the context.
In estate planning, mainly we are concerned about two categories of federal tax: wealth transfer tax and income tax. The “wealth transfer tax” category includes the estate tax, gift tax, and generation skipping transfer tax. Many Florida residents are surprised to learn that, as a result of the 2017 Tax Cuts & Jobs Act
, they may no longer need to worry about the imposition of estate tax. This is because: (1) Florida does not impose a state-level estate, death, or inheritance tax, and (2) the federal estate tax laws provide an exemption of approximately $11.6 million per person in 2020. The “per person” part is important, because under current law, married couples basically can double the federal estate tax exemption, meaning unless the couple’s assets are worth more than $23 million combined, the federal estate tax likely will not apply to them. This is a simplified explanation of how the federal estate tax works, and the amount of exemption you personally have may need to be reduced by any taxable gifts you have made during your lifetime. The interplay of the federal estate and gift tax is beyond the scope of this article and will be addressed in future articles, but a good overview is available here: Federal Gift Tax Overview
What If the Federal Estate Tax Laws Change?
The tax laws inevitably will change; this is certain. This is why it is so important to meet with your estate planning attorney on at least an annual basis. First, it gives you the opportunity to alert your attorney to changes in your family dynamic, asset holdings, and overall net worth. For example, did you buy a second home in the mountains of North Carolina last year? You need to make sure your estate planning attorney knows about the purchase so she can incorporate the same into your existing estate plan (actually, you should have told her about it before you bought it). Second, meeting with your attorney on a periodic basis gives her the opportunity to alert you to changes in not only federal tax laws, but also applicable state law updates relevant to probate
, wills, powers of attorney, advance health care directives, and, yes, local tax laws. For this very reason, about seven years ago, I started offering “Complimentary Annual Reviews” to my estate planning clients to meet and review their estate plans on an annual basis. This keeps the lines of communication open, and my clients don’t have to worry about any “surprise” bills or charges for simply staying in touch with me.
Can Trusts Avoid or at Least Minimize Taxes?
With the assistance of an estate planning attorney, your trust can take advantage of existing “safe harbors” within the Internal Revenue Code to reduce or even eliminate certain types of taxes, including wealth transfer tax.
- For example, the IRS allows you to leave unlimited assets at death to your spouse, who will not have to pay any estate tax otherwise due until she dies. In other words, her estate will be responsible for the estate tax due, but only to the extent the remaining assets exceed her available estate tax exemption when she dies. This concept is known as the unlimited marital deduction, and estate planners frequently take advantage of it, especially for larger estates. Essentially, the unlimited marital deduction allows you to delay the imposition of the estate tax until your surviving spouse dies; the estate tax may even be avoided entirely if your surviving spouse spends down the assets below her exemption amount.
- For example, did you know that the IRS wants to tax your grandchildren’s inheritance in addition to the federal estate tax? A seasoned estate planning attorney can advise you on how the generation skipping transfer tax (also known as “GST” or “GSTT” tax) may apply to your estate plan, and, better yet, include the necessary provisions in your trust to minimize or even avoid the GSTT tax altogether.
Do Trusts Pay Income Tax?
The answer to this question generally is yes: income generated within a trust is taxable. If the answer were no, everyone in the United States would transfer their assets to trust immediately and avoid income tax for eternity – you didn’t think the IRS would allow that, right? In fact, trusts have their own type of tax return known as an IRS Form 1041
. It is important to distinguish the taxation of revocable trusts vs. irrevocable trusts.
- The most common type of trust in estate planning is a revocable trust. Revocable trusts generally are pass-through entities for federal income tax purposes. This means that the trust will not interfere with how you currently report your federal income tax to the IRS: all items of income, deduction, depreciation, and credit will continue to flow through to you on your personal Form 1040, and the trust will not be required to file its own income tax return during your lifetime. Many clients simply assign their social security number to their revocable trust during their lifetime. The general rule is that when you die, your revocable trust becomes irrevocable (because you are no longer alive to modify or revoke it), at which time the taxation of the trust will change.
- The income taxation of irrevocable trusts is more nuanced (as compared to revocable trusts). Essentially, an irrevocable trust can be designed to be taxed as its own entity (like a corporation), but there are also ways to have an irrevocable trust taxed to a particular person, such as the person who created it (the “settlor” or “grantor”). Your estate planning attorney should discuss these options with you before the irrevocable trust is established.
If income is accumulated within an irrevocable trust that is taxed as its own entity, the trust may be taxed on ordinary income at the highest marginal rate. For this reason, many irrevocable trusts allow, or even mandate, that the Trustee distribute net income to the trust beneficiaries on at least an annual basis. In most cases, this has the effect of reducing overall income tax since many trust beneficiaries are taxed in a lower tax bracket than the highest marginal rate applicable to trusts. It is important that your estate planning attorney discuss with you the income tax effect of any trusts the attorney is recommending.
Can Trusts Avoid Tax Altogether?
Only if the Internal Revenue Code permits. The Code contains specific safe harbors that allow tax to be delayed or even avoided entirely if precise rules are followed. I recommend taking the conservative approach and following established rules sanctioned by the IRS. For example, payment of federal estate tax can be delayed or even eliminated by taking advantage of the unlimited marital deduction, discussed above. Another example is that a properly structured dynasty trust can eliminate wealth transfer tax for future generations. With respect to income tax, a common technique to defer payment of taxable gain on the sale of real estate is a so-called 1031 Exchange
, and the use of Opportunity Zones
to defer taxable gain is becoming more prevalent. All of these techniques have already been “blessed” by the IRS. However, if you are looking for a tax “loophole” or heard about a technique that sounds “too good be true,” my advice is: either be prepared to pay a pretty penny for a Private Letter Ruling
, or stick with tried-and-true techniques that are respected by the IRS.
I hope you gathered from this article that trusts serve many important purposes and, perhaps more importantly, the IRS will tax anything it can get its hands on (yet another platitude). A seasoned estate planning attorney not only will be well-versed in wealth transfer tax, but she also will examine the income tax ramifications of any proposed transaction involving revocable or irrevocable trusts.