How Long Must a Trust Be in Place to Avoid Inheritance Tax?

By Cindy DeRuyter, J.D.

How Long Must a Trust Be in Place to Avoid Inheritance Tax?

By Cindy DeRuyter, J.D.

Trusts are often used as part of both estate planning and tax planning strategies, helping people pass assets to future generations in a way designed to minimize income and estate tax obligations. The date of a trust instrument isn't necessarily an important question when it comes to the trust's effectiveness in avoiding or lowering tax obligations. That determination hinges largely on whether the trust is revocable or irrevocable, on its structure, and on the types of assets held in trust.

Couple on couch

Current Estate Tax Law and Bypass Trusts

Under current law (as of May 2018), individuals have an $11.2 million federal unified gift and estate tax exemption, and couples have a $22.4 million exemption. So, as long as the assets in the estate at the time of death combined with lifetime gifts is less than the exemption amount, there are no federal estate taxes due. These exemption amounts apply whether or not a couple has engaged in estate planning. Some states also impose estate or inheritance taxes at lower exemption amounts.

Bypass trusts, often also called credit shelter trusts or A/B trusts, are designed to allow married couples to take full advantage of estate tax credits. These types of trusts are generally revocable trusts and it is the structure of the trusts itself—not the length of time assets were held in trust—that determines how assets are taxed after the trust creator's (grantor's) death.

Irrevocable Trusts

An irrevocable trust is a legal agreement where the grantor relinquishes title to and control over trust assets. The trust is a separate legal entity with its own tax identification number, and the designated trustee is responsible for tax filings. Assets transferred into an irrevocable trust can reduce the size of someone's estate, bringing the estate below the federal and state estate tax exemption amounts (as applicable.)

While the date of the irrevocable trust agreement is not determinative, Internal Revenue Service rules provide that assets transferred into an irrevocable trust within the three years preceding death will be brought back into the estate for purposes of calculating the estate tax obligation. This rule is designed to prevent people from making deathbed transfers of assets for the purposes of minimizing estate taxes.

Income Taxation to Beneficiaries

Beneficiaries who inherit assets at your death may also be subject to income taxation on some or all of the inherited assets. Life insurance generally passes income tax free to beneficiaries. However, other assets like 401(k) accounts, IRAs, or other tax qualified accounts usually pass to beneficiaries with each beneficiary responsible for paying taxes at ordinary income tax rates.

Nothing in this article should be interpreted as legal or tax advice. Estate, income, and inheritance tax laws can be complex and nuanced. This can be especially true when revocable or irrevocable trusts are involved. Talk to a qualified tax professional and a licensed estate planning attorney in your state to understand your potential estate or inheritance tax obligations and to create and implement strategies designed to help you achieve your goals for your wealth.

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