Trusts are a valuable tool for individuals and families seeking to manage and safeguard their assets while minimizing the costs of transferring wealth. However, navigating trust taxation can be intricate and confusing, particularly for those unfamiliar with the various types of trusts and how they are structured.
How Trusts are Taxed
Trust assets are generally classified as principal or income. The assets a trust owns, such as stocks, bonds, or real estate, represent its principal. Capital gains of a trust asset may also be considered principal, depending on the terms and jurisdiction of the trust instrument. The earnings yielded by a trust, such as dividends, interest, or rent, compose its income.
Trust taxation also varies depending on the type of trust, whether it is a grantor or non-grantor trust, revocable or irrevocable, or simple or complex trust.
Revocable vs. Irrevocable Trusts
Revocable trusts allow the grantor to make changes and update decisions as they see fit, while irrevocable trusts cannot be modified without approval from other grantors, trustees, and beneficiaries. It’s worth noting that trust instruments that are silent regarding revocability are generally construed as revocable trusts.
Assets transferred to a revocable trust are included in the grantor’s taxable estate at death and can receive a step-up in basis, which is important when considering capital gains taxes owed on the sale of an inherited asset. For example, John Doe purchases real estate at $50,000. Many years later, his daughter Jane Doe inherits the property worth $250,000. One year later, she sells the real estate for $300,000. If there were no step-up in basis, Jane would be required to pay capital gains tax on the entire $250,000 appreciation. However, because of the step-up in basis, she will only be obligated to pay capital gains tax on the $50,000 appreciation that happened since the date she inherited the real estate. For this reason, it is often wise to wait until a grantor’s death to transfer highly appreciated assets to beneficiaries to take advantage of the step-up in basis.
On the other hand, transfers of assets into an irrevocable trust are permanent. As such, they generally remove the assets from the grantor’s estate – protecting them from creditors. While irrevocable trusts can be structured to provide many tax advantages, assets transferred to the trust are typically not allowed the step-up in basis provided by a revocable trust.
Grantor vs. Non-Grantor Trusts
For income tax purposes, trusts are classified as either grantor or non-grantor trusts. One key factor determining whether a trust is a grantor trust is the level of control that the grantor retains over the trust. A trust will be classified as a grantor trust if the grantor maintains powers such as determining income recipients, directing the vote of stock owned by the trust, revoking the trust, or managing trust fund investments.
Revocable living trusts (RLTs), intentionally defective grantor trusts (IDGTs), spousal lifetime access trusts (SLAT), grantor retained annuity trusts (GRATs), and some dynasty trusts are all examples of trusts that are usually treated as grantor trusts.
Non-grantor trusts, on the other hand, are trusts where the grantor does not retain significant control over the trust assets or their distribution. This lack of control means the trust is considered a separate taxable entity for income tax purposes. In a non-grantor trust, the trust pays taxes on its income that is retained within the trust, while the beneficiaries pay taxes on any trust income distributed to them.
Charitable remainder trusts (CRTs), and bypass or credit shelter trusts are examples of non-grantor trusts.
Simple vs. Complex Non-Grantor Trusts
Non-grantor trusts may be classified as simple or complex. A simple non-grantor trust requires mandatory distributions of all income during the taxable year, prohibits distributions of principal, and prohibits distributions to charity. In this type of arrangement, income taxes are the responsibility of beneficiaries, while the trust is responsible for paying taxes on any capital gains.
Alternatively, a complex non-grantor trust gives the trustee more discretion regarding income and principal distributions. However, the trust instrument may still require certain mandatory distributions of income or principal. Depending on the circumstances in a given year, the taxes can be paid by the beneficiaries, the trust itself, or a combination of both.
Compared to individual taxpayers, trusts reach the highest federal marginal income tax rate at much lower income thresholds. For example, the top marginal tax rate for a single individual in 2023 is 37%, beginning after $578,125 of ordinary income. However, a trust is subject to that rate after reaching only $14,450 of income. Any income a trust earns beyond this threshold will be taxed at the highest rate.
Trusts may also be subject to the net investment income tax (NIIT) for undistributed investment income. The NIIT is calculated as a 3.8% tax on either the trust’s undistributed net investment income or the adjusted gross income above $14,450, whichever is lower. Conversely, an individual must pay the NIIT on the lesser amount of net investment income or the excess of modified adjusted gross income (MAGI) over $200,000.
How Do People Use Different Types of Trusts?
It’s imperative to understand the various types of trusts at your disposal if you’re considering using trusts as part of your estate plan. Each type of trust has its own tax implications and may be better suited for different types of assets and situations.
Revocable Living Trusts
RLTs enable the grantor to avoid probate and offer the flexibility and control of a grantor trust. However, they do not offer asset or creditor protection, and assets included in an RLT generally remain in the grantor’s taxable estate upon their death. As a result, RLT assets are entitled to a step-up in basis.
RLTs are more suitable for certain types of assets and circumstances. They are one of the simplest forms of trust, yet they still enable grantors to disinherit anyone who challenges their wishes after death, control a guardian’s spending habits for the benefit of minor children, and authorize another person to act on the grantor’s behalf if they become incapacitated. And, for married couples who acquired substantial separate property before marriage, an RLT can help segregate those assets from community property assets.
However, RLTs are typically not ideal for assets like Subchapter S stock or real estate located in foreign countries. Also, if your estate is likely to exceed estate tax exclusion amounts, more complex and creative trust strategies may be necessary.
Intentionally Defective Grantor Trusts
IDGTs are irrevocable trusts that allow assets to grow tax-free while avoiding gift taxation. IDGTs are structured to offer asset and creditor protection and avoid probate, but they offer much less flexibility and control than RLTs. The grantor’s estate is permanently reduced by the assets contributed to the IDGT, however, the grantor is responsible for paying the income tax on revenue generated by the trust’s assets. This tax liability is why the trust is considered “defective,” as all the income, deductions, and credits linked to the trust are reported on the grantor’s 1040 tax return.
Because IDGTs are irrevocable trusts, beneficiaries may not always receive the step-up in basis permitted by revocable trusts. Yet, depending on the trust provisions, IDGT grantors may be able to leverage “swap powers” to swap highly appreciated assets with cash or high-basis assets of equivalent value. This effectively permits the transfer of highly appreciated assets from the trust to the grantor’s estate, which may be eligible for a step-up in basis. Essentially the grantor can exercise the swap power to substitute the appreciated, low-basis assets with an equal value of high-basis assets such as cash. The grantor can retain the appreciated assets until their death to receive a step-up in basis to reduce capital gains taxes. This strategy may reduce the grantor’s taxable estate and overall tax burden, particularly in states that impose hefty estate taxes.
Simple Non-Grantor Trusts
A simple non-grantor trust cannot be modified or terminated by the grantors after its creation. Once assets are transferred into this type of trust, the grantor relinquishes all control and ownership. Also, because it is a simple trust, it must distribute income to beneficiaries, and cannot make any distributions to charity.
These types of trusts offer asset and creditor protection and avoid probate. However, they offer little flexibility and control. The assets in a simple non-grantor trust are not included in the grantor’s taxable estate at death and therefore do not receive a step-up in basis.
Simple trusts are a practical option if the grantor is in a high tax bracket while the beneficiaries are in a lower tax bracket. Since the trust is a separate legal entity, transferring income-producing assets over to the trust can reduce the grantor’s income tax liability while allowing earnings to be distributed to beneficiaries who will pay taxes at a lower rate. It also benefits grantors who may want to sever ties with the trust and its beneficiaries. For example, if a grantor is setting up a trust for an ex-spouse or estranged children, they may not want much involvement with the trust or its income distributions.
Complex Non-Grantor Trusts
A complex non-grantor trust is a trust that does not meet the qualifications for a simple trust under IRS regulations for any tax year. For example, if a trust that previously qualified as a simple trust makes principal distributions in a tax year, it will be considered a complex trust for that year.
A complex non-grantor trust offers more flexibility and control than a simple trust but not as much as a grantor trust. It also provides asset and creditor protection and avoids probate. Assets held in a complex trust are not included in the grantor’s taxable estate at death and do not receive a step-up in basis.
This type of trust is beneficial for those with a lot of income that they want to distribute to beneficiaries in different ways. Several categories of trusts, including charitable trusts and sprinkling trusts, are considered complex trusts. Sprinkling is a technique that allows a trustee to distribute income or principal from a trust to a group of beneficiaries in varying amounts, depending on their needs. This can allow the grantor to potentially avoid gift tax liability.
As their name suggests, complex trusts can be quite complicated, particularly when used by large estates to avoid or minimize taxes. Managing these types of trusts often necessitates the involvement of a professional trustee. Additionally, grantors typically work closely with experienced attorneys, CPAs, and financial advisors to ensure the trusts are structured and set up in the most effective and tax-efficient manner.
It’s important to note that a comprehensive explanation of complex trusts and their tax minimization strategies is beyond the scope of this article. Each individual’s financial situation and objectives are unique, and the most appropriate trust structure and strategies will vary accordingly. For this reason, it is crucial to seek individualized advice from qualified professionals when considering the establishment and management of a complex trust.
This article is intended to provide a brief overview of the types of trusts and navigating trust taxation. It is not to be construed as legal advice or individualized recommendations from an expert advisor. It is always advisable to consult with a qualified estate planning attorney and expert financial advisor to ensure that your estate plan is structured to meet your unique needs and goals. For more information, please contact one of our Estate, Trust and Gift Tax specialists.