Understanding the Types of Trusts

Brian Wegman, CPA (Feb, 2019)

The Tax Cuts and Jobs Act (TCJA) significantly increased the amount of the exclusion for estate taxes in 2018, essentially eliminating the federal estate tax for the majority of Americans (for estates below $11,180,000 in 2018).  However, there still continues to be many different benefits to creating a trust.  Trusts serve many different functions in addition to tax and estate planning. These include asset protection, as well as providing for an individual's long term care. 

Although there are many different types of trusts, each with different goals, they all have some fundamentals in common.  All trusts have a grantor (sometimes called a settlor or a trustor), a trustee, and a beneficiary (or multiple beneficiaries).  The grantor is the owner of the property that will be transferred to the trust.  The trustee has a fiduciary responsibility for managing and ultimately distributing the trust assets in accordance with the terms of the trust document and in the best interests of the beneficiaries. 

For tax purposes, there are two broad categories of trusts, the Grantor Trust and the Non-Grantor Trust.

Grantor Trust - The trust creator (also known as the grantor) retains one or more powers over the trust. Because of these retained powers, the trust is disregarded as a separate tax entity resulting in the net income of the trust being taxed to the grantor.  These same retained powers may cause the trust property to be included in the grantor’s gross estate upon death. 

Non-Grantor Trust - The grantor retains no interest or control over the trust property.  This type of trust is considered a separate tax entity.  The trust is responsible for paying its share of the tax. The trust assets are generally not includable in the grantor's gross estate.

Grantor Trusts

Revocable Trust - A revocable trust, also called a "living trust," is a very common type of trust where the grantor keeps full control over the trust property during their lifetime by retaining the power to revoke or amend the trust terms.  These trusts are often used as a tool to manage the financial assets of the grantor if they become disabled, or upon death.  The primary advantage to creating a revocable trust is the avoidance of probate thus avoiding potential delays in distributions to the beneficiaries and legal fees.  A revocable trust becomes irrevocable upon the death of the grantor.   The trust assets are includable in the gross estate of the grantor and receive a step-up in basis upon death.

Intentionally Defective Grantor Trust (IDGT) - The IDGT is an irrevocable trust that is complete for transfer tax purposes but “defective” for income tax purposes.  Because of this “defect,” the grantor remains responsible for the income taxes on the income generated by the trust assets.  Intended to remove the future appreciation of trust assets from the grantor’s estate, the grantor has not retained any power over the trust assets that would cause the assets to be includable in his gross estate. 

Qualified Subchapter S Trust (QSST) - The primary purpose of a QSST is that it allows the trust to be an eligible shareholder of S-corporation stock.  These trusts must be carefully structured following IRS guidelines.  They can be useful for estate planning purposes and may also hold S-corporation stock for the benefit of a minor or an incompetent person.

Grantor Retained Annuity Trust (GRAT) - A GRAT is often used in estate planning for large estates with appreciating assets (for example, a family business).  The trust creator (grantor) transfers an income producing asset to an irrevocable trust that pays the grantor an annuity amount for a set period of time.   When the trust term is up, the remaining assets pass to the beneficiaries at a discounted value.   

Non-Grantor Trusts

There are two basic categories of non-grantor trusts, “simple” and “complex.”  Under the terms of its instrument, a simple trust is required to distribute all of its annual income to its beneficiary, is not able to contribute to a charity and has made no distributions of trust principal during the year.   Any non-grantor trust that does not meet the requirements of a simple trust is a complex trust.  Complex trusts are generally allowed to accumulate income. 

Trusts have very compressed tax rates, with the highest rate of 37% beginning at just $12,501.  The Net Investment Income Tax of 3.8% also applies to trusts.  For these reasons, it is important to understand the tax consequences of income distributions. Trusts receive a deduction for distributions paid to beneficiaries.  This is an important tool in managing taxable income.  The net income earned by the trust is either taxed at the trust level or at the beneficiary's level, but not both.  The income maintains its character and distributions of dividends, interest, capital gains, etc. are reported as such on the beneficiary's tax return. 

The process of creating a trust is complex and defined by its purpose.  For this reason it is important to form an effective collaborative team of tax advisors, attorneys and financial planners.  This way you can ensure that the trust accomplishes your estate planning and lifetime giving goals in the most tax efficient manner.  For additional information or questions, contact an advisor at Dermody, Burke and Brown.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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