Trusts and taxes - Understanding how one affects the other can benefit your estate plan

Adler Pollock & Sheehan P.C.
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Trusts typically are a main component of an estate plan. But do you know how higher taxes can impact a trust’s overall effectiveness? Because the income thresholds for trusts are low, it’s worth your time to understand how the current tax environment affects your trust planning.

2016 rates

For 2016, the top marginal individual income tax rate is 39.6%. And the capital gains rate for taxpayers in the highest bracket is 20%. High earners are also subject to a 3.8% tax on net investment income — including interest, dividends, annuities, rents, royalties, net capital gains and certain passive business income. The income levels at which these tax increases apply may vary.

This year, trusts are subject to the 39.6% ordinary income rate and the 20% capital gains rate to the extent their taxable income exceeds $12,400. And the 3.8% investment tax applies to undistributed net investment income to the extent that a trust’s adjusted gross income exceeds $12,400.

Implementing the proper strategies

Thankfully, there are estate planning techniques that can help you offset the bite of higher taxes on trust income. For example, an intentionally defective grantor trust (IDGT) is designed so that you, the grantor, are treated as the trust’s owner for income tax purposes — even though your contributions to the trust are considered “completed gifts” for gift and estate tax purposes.

IDGTs offer significant advantages. The trust’s income is taxed to you, so the trust itself avoids taxation. This allows trust assets to grow tax-free, leaving more for your beneficiaries. And, by virtue of paying the tax on the trust’s income, you’re able to reduce the size of your estate. Further, as the owner, you can sell assets to the trust or engage in other transactions without tax consequences.

Keep in mind that, if your personal income exceeds the applicable thresholds, using an IDGT won’t avoid the tax increases described above. Still, the other benefits of these trusts make them very attractive.

Another option is to change your investment strategy. Despite the advantages of grantor trusts, nongrantor trusts are sometimes desirable or necessary. At some point, for example, you may decide to convert a grantor trust to a nongrantor trust to relieve yourself of the burden of paying the trust’s taxes. Also, grantor trusts become nongrantor trusts after the grantor’s death. One strategy for easing the tax burden on nongrantor trusts is for the trustee to shift investments into tax-exempt or tax-deferred investments. 

Finally, you can distribute your income. Generally, nongrantor trusts are subject to tax only to the extent they accumulate taxable income. When a trust makes distributions to a beneficiary, it passes along ordinary income (and, in some cases, capital gains), which are taxed at the beneficiary’s marginal rate.

Thus, one strategy for avoiding income, capital gains and investment taxes is to distribute trust income to beneficiaries in lower tax brackets. The trustee might also consider distributing appreciated assets, rather than cash, and letting the beneficiary sell the asset personally if he or she is able to take advantage of a lower capital gains rate on the sale. 

Of course, this strategy may conflict with a trust’s purposes, such as providing incentives to beneficiaries, preserving assets for future generations and shielding assets from beneficiaries’ creditors.

Taking the next steps to reduce taxes

Even though your estate plan likely contains a variety of trust types, it can be easy to overlook the impact of taxes on them. A primary goal of your estate plan is to ease the tax burden on your family as much as possible after your death, so talk to your estate planning advisor to learn how to reduce the effects of high taxes on your trusts. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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