Answers From a Probate Attorney: Trusts and How They’re Taxed
Most of us are looking for ways to protect our assets and provide for our family’s future. However, wills, trusts, and other estate planning activities can seem complicated and confusing to the average person. Talking to a dedicated probate attorney allows you to investigate your options and learn more about how each will impact things like taxes and other probate matters.
What Is a Trust?
A trust is an estate planning tool that allows you to set aside assets and set strict guidelines about how and when they can be accessed and dispersed. Three parties are involved in a trust. The settlor is the person who establishes the trust and sets the terms, in conjunction with their estate planning attorney. The trustee is the person or organization that holds title to the trust and administers its terms. Beneficiaries are the people who reap the benefits of the trust.
Depending on how they’re structured, they can benefit family members, such as children after your death, or be created to distribute funds to various causes. Creating a trust also helps protect your property from claims that could tie it up in probate, helps shield assets from creditors, and provides several ways to reduce or eliminate some of your tax obligations.
In fact, there are nearly a dozen types of trusts, including medical trusts, charitable trusts, marital trusts, and bypass, trusts. If you have a special situation, a probate lawyer can tell you more about your options.
For the purposes of this post, we’re going to focus on the most common types of trusts, under what circumstances they should be considered, and the tax implications of each.
Special Needs Trust
This is a type of medical trust that’s meant to benefit persons with chronic health conditions or a disability. They can be used to assist parents, children, or other qualifying family members by allowing them to collect financial assistance without diminishing their quality of life.
For example, an adult child may have a health condition that prevents them from working. By creating a special needs trust to help with qualified living expenses, they’re still able to meet the economic threshold for government-funded housing and medical assistance without living in poverty. Because the money from the trust isn’t considered income, it isn’t taxed.
These are probably two of the best-known and most common types of trusts for estate planning purposes. A revocable trust is one that is created while the settlor, the person who is establishing the trust, is still alive, and it can be changed at any time before their death.
Revocable trusts are a valuable tool if you are unable to work due to a medical condition or are otherwise temporarily unable to manage your financial affairs. Funds are set aside in the trust, and a trustee is designated to manage any money or property on behalf of the beneficiary for a set period of time. You can also determine how your assets will be distributed after your death and spare your family a potentially lengthy or contentious probate process.
Irrevocable trusts usually benefit someone other than the settlor, such as a child or spouse, and the terms are pretty much set in stone. In other words, the funds or property must be managed to the specifications set forth in the legal documentation, they can’t be used for the benefit of anyone but the person named as beneficiary, and this trust cannot be changed unless a process for doing so is set forth in the terms of the trust.
Taxes on these types of trusts are paid by the beneficiary, but only on the income distributions rather than the principal amount of the trust itself. This means that the tax liability reported on the IRS forms K-1 and 1040 are on the smaller amount dispersed to the beneficiary, rather than the full financial value of the trust.
Another well-known type of trust is a charitable trust. This is the one we usually associate with celebrities and the well-heeled, but it can benefit almost anyone. Charitable trusts can be set up, so that income is provided during the settlor’s lifetime, but distributed to a charitable cause after their death or drafted to provide a set amount of money to charity and distributing the remainder of the bequest to family members.
Establishing a charitable trust allows you to avoid capital gains taxes and take advantage of the charitable contribution tax credit at the same time.
Creating a bypass trust will allow you to provide financial draws for a surviving spouse in times of need while leveraging the lifetime exemption from real estate tax and preserving the balance of the estate for other heirs.
This trust is similar to a bypass trust in that it allows limited financial access to the surviving spouse and still adds the benefit of qualifying for the real estate exemption. However, it sets stricter limits on how much the spouse may withdraw and for what purposes. It’s usually considered in cases where the settlor has children from a previous relationship.
Life Insurance Trusts
This is a lesser-known but an extremely beneficial type of trust that will help your heirs avoid an estate tax on the proceeds of your life insurance. Life insurance trusts are irrevocable, and they transfer “ownership” of your life insurance policy to the trust.
By establishing a life insurance trust, you’ll bypass the mandatory inclusion of the death benefit as taxable personal income. The trust owns the asset, not you.
If you want to be able to pass property to a relative without incurring estate or gift taxes, or at least substantially limiting your liability, consider a Qualified Personal Residence Trust. The QPRT stipulates that the settlor will live in the property until a specified time, after which it will legally pass to the ultimate beneficiary.
A Probate Attorneys Offer Legal Advice You Can Trust With Your Future
Peace of mind is just one advantage of putting your financial house in order. Trusts are a solid way to protect assets and provide financial assistance for people or causes that are important to you. However, it’s important to get legal counsel if you want to maximize the benefits and limit your tax liability. Seek a probate attorney to help you set up your trusts,
This blog is geared toward providing you with general information about taxes and trusts. Learn how this applies to your own unique situation by talking to an experienced probate attorney in Las Vegas today.