A living trust is a document that a person creates while he is still alive, which enables him to financially provide for the beneficiaries he names. The creator of the trust, or grantor, takes some of his property and gives it to a third party, known as a trustee. The trustee, a person chosen by the grantor, manages the property and distributes it to the beneficiaries, subject to terms outlined in the document that established the trust known as a trust agreement. A trust, if structured appropriately, can protect assets from creditors and can allow for assets to be transferred quickly without having to go through probate. What effect the trust will have on taxes depends on how the trust is structured.
Revocable vs. Irrevocable
There are two types of living trusts. A revocable living trust permits the grantor to change the terms of the trust whenever he wants. This means that the grantor can unilaterally choose a new trustee, remove or add beneficiaries, add or withdraw assets from the trust, or even terminate the trust altogether. An irrevocable trust prohibits the grantor from making any changes; once he creates the trust, he cannot make any changes to it.
The estate tax is a charge that the federal government charges for the right to transfer property after someone’s death. The tax is based on the value of the property the decedent owned when she died. If the grantor of a revocable trust dies, the value of the trust property is included in her estate for tax purposes. While the trust may own the property, the assets must be included in the estate because of the grantor’s control. On the other hand, the assets of an irrevocable trust are not included in a grantor’s estate. Not only does the trust own the assets, but the grantor retains no control. As a result, the trust property is excluded for tax purposes.
While the grantor is alive, the assets in the trust may generate income. If the income is generated in a revocable trust, the grantor is responsible for reporting that revenue on his personal return by paying tax on that income. If the income is generated in an irrevocable trust, the beneficiaries are responsible for including the income on their returns and for paying tax on it.
When the grantor of a living trust dies, the assets in the trust are generally “stepped up” to their current value. This is true whether the trust is revocable or irrevocable. For tax purposes, that means when the asset is sold the taxable gain will be calculated using the price as of when the grantor died. This should decrease the amount of gain, which would in turn decrease the amount of tax that the beneficiaries would owe on that gain.
Grantor trusts may also provide a means to minimize capital gains taxes. All revocable trusts are grantor trusts. Irrevocable trusts that allow the grantor to retain some sort of power over the trust's assets, such as by making the grantor a beneficiary or a trustee that controls who receives the property, are also grantor trusts. An example of such an irrevocable grantor trust is a Medicare Trust. In these cases, the grantor is taxed on all income and capital gains the trust generates. However, the grantor is also able to apply personal exemptions against capital gains from the sale of trust assets, such as the $250,000 exemption on capital gains from real estate sales.
Sometimes a living trust will be combined with a pour-over will. A pour-over will transfers all of a grantor’s property into the trust after her death. While the property will be placed in the trust and distributed subject to its terms, all of the property that the will transfers is still subject to the estate tax.