Can I Really Use A Trust To Avoid Inheritance Tax?
How do trusts avoid taxes?
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Trusts can help avoid or reduce estate taxes, gift taxes and income taxes, too.
How the Rich Can Avoid the Estate Tax. The idea of the estate tax, or death tax as it’s sometimes known, is scary for many Americans. This is understandable, though the absolute truth is that most people will never encounter it. That’s because the federal estate tax has a higher high exemption amount. In short, if your estate is worth less than the current year’s exemption, you won’t owe any federal taxes. However, there are state taxes to contend with within certain parts of the country. For help with your estate plan, consider working with a financial advisor.
Tax-Efficient Wealth Transfer. When the sunset provision built into the gradual repeal of the estate tax began to loom on the horizon, many wealthy taxpayers did everything they possibly could to reduce their taxable estates before the provision took effect in 2011. While, in most instances, estates with a value of only a few million dollars can generally avoid estate taxation with simple planning, larger estates require more creative estate planning techniques.
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What Is the Estate Tax?
The estate tax is a federal law that dictates that estates worth more than the current year’s exemption pay a certain amount of tax on any value above the exemption. For 2021, the federal estate tax exemption is $11.7 million. That means if your estate is worth less than that at your death, your estate owes nothing. In 2020, the estate tax exemption was $11.58 million.
Many different types of trusts can be used to accomplish various estate planning goals and objectives, but transferring large sums of money or other assets into these trusts at once can often result in gift liability. Although this dilemma can be resolved using a sprinkling, Crummey Power, or five-and-five power, it is not necessarily an optimal solution in many cases for various reasons. One alternative may be to establish a particular type of trust known as an intentionally defective grantor trust (IDGT).
A Simple Strategy
The IDT is an irrevocable trust designed so that any assets or funds put into the trust are not taxable to the grantor for gift, estate, generation-skipping transfer tax, or trust purposes. However, the trust’s grantor must pay the income tax on any revenue generated by the assets in the trust. This feature makes the trust “defective,” as all of the income, deductions, and credits that come from the trust must be reported on the grantor’s 1040 as if they were their own. However, because the grantor must pay the taxes on all trust income annually, the assets in the trust are allowed to grow tax-free and avoid gift taxation to the grantor’s beneficiaries.
The trust is invisible to the Internal Revenue Service (IRS) for all practical purposes. As long as the assets are sold at fair market value, there will be no reportable gain, loss, or gift tax assessed on the sale. There will also be no income tax on payments paid to the grantor from a sale. But many grantors opt to convert their IDGTs into complex trusts, which allows the trust to pay its taxes. This way, they do not have to pay them out-of-pocket each year.
What Type of Assets Should I Put in the Trust?
While many different types of assets may be used to fund a defective trust, limited partnership interests offer discounts from their face values that substantially increase the tax savings realized by their transfer. For the gift tax, master limited partnership assets are not assessed at their fair market values because limited partners have little or no control over the partnership or how it is run. Therefore, a valuation discount is given. Discounts are also provided for private partnerships that have no liquid market. These discounts can be 35-45% percent of the value of the partnership.
What is Wealth Transfer?
How to Transfer Assets into the Trust?
One of the best ways to move assets into an IDGT is to combine a modest gift into the trust with an installment sale of the property. The usual way to do this is by gifting 10% of the asset and having the trust make installment sale payments on the remaining 90% of the asset.
To avoid having your life insurance proceeds taxed, you can create an irrevocable life insurance trust. You’d essentially be setting up a trust and transferring the ownership of it to another person. The trust is irrevocable because, in the future, you wouldn’t be able to make adjustments to it without the consent of the trust’s beneficiary.
Your death benefits wouldn’t be part of your estate by transferring over your life insurance policy. It’s best to do this sooner rather than later, however. If you die within three years of making the transfer, your life insurance proceeds would still be considered part of your taxable estate.
Make charitable donations.
Another way to bypass the estate tax is to transfer part of your wealth to a charity through a trust. There are two types of charitable trusts: charitable lead trusts (CLTs) and charitable remainder trusts (CRTs).
If you have a CLT, some of the assets in your trust will go to a tax-exempt charity. By donating to charity, you’ll lower the value of your estate and end up with an extra tax break. Once you die (or after a pre-determined time), whatever’s left in the trust will be passed on to your beneficiaries.
On the other hand, if you have a CRT, you can transfer a stock or another appreciating asset to an irrevocable trust. Throughout your lifetime, you can make money off of that asset. And then, when you die, your investment income will go to charity. You’ll avoid the capital gains tax and lower your estate tax burden in the process. Plus, you’ll score a tax deduction.
Establish a family-limited partnership.
If there are any family-owned businesses or assets (such as properties) that you want your children to own after you’re gone, you can set up a family limited partnership. Typically, this involves establishing a general partnership and then making heirs and family members limited partners.
As the general partner, you’ll still be able to call the shots. But your partners (whether they’re your children or another relative) will have a stake in your company or own a portion of your assets. As a result, the size of your estate will be smaller.
Fund a qualified personal residence trust.
What Is a California Qualified Personal Residence Trust (QPRT)?
Suppose you have a primary or secondary home, such as a vacation home, that you intend to pass to your children or others. In that case, a California-qualified personal residence trust may allow you significant savings on transfer taxes. The QPRT accomplishes this in two ways:
First, you can value the property for gift tax purposes when you transfer the residence to the trust. Secondly, if you die after the trust term expires, your estate will not pay estate taxes on the property because you will not own the property at death. It will already have passed to the beneficiaries.
A California-qualified personal residence trust is irrevocable. This means that once the trust is in place, there are very few conditions under which you can undo it. The trust must be irrevocable to take advantage of the federal tax savings, which would likely not exist if a grantor could dissolve the trust at will. The court will set up the trust for a specific term of years, after which the property will pass to the beneficiaries, not back to you. But, during the duration of the California qualified personal residence trust, you will retain the right to live on or use the property. This reservation of the right to live in the home is called a retained interest.
IDGTs have many uses, but an exhaustive analysis of their benefits lies beyond the scope of this page. Specific strategies may be employed to avoid the generation-skipping transfer tax as well. Those interested in finding out more about these trusts should learn about all the factors to consider in estate planning and should consult our credible estate planning attorney.