When thinking about estate planning, we often think mostly about estate taxes. Estate taxes are taxes imposed by both the federal government and a number of states. These taxes will be assessed based on the total value of your assets at your death. At the federal level, as long as those assets are less than $11.7 million, there is no federal estate tax. In Maryland, the threshold is $5 million. Based on these numbers, for most people there will be no estate tax due when they pass away.
But, are there other taxes you may need to consider? Often overlooked is the income tax implications of certain trusts.
The most common type of trust used in estate planning is a Revocable Living Trust. This is a fantastic tool that provides many benefits, such as probate avoidance, incapacity planning, revocability and control, and privacy. The typical structure is that the person setting up the trust (the grantor) is also the trustee and beneficiary, meaning they control their own assets for their own benefit. With this structure the IRS claims that because of the control, any assets in the trust will be treated as if they are the grantor’s and therefore any income reported on the grantor’s tax return.
But, what if there is a different structure? Let’s say Bill sets up a Revocable Trust. He is control during his lifetime, but upon Bill’s death the money passes to his son Joe. Joe is irresponsible and has some creditor issues so Bill’s trust directs his sister Suzie to hold Joe’s money in trust where Suzie has complete discretion whether or not to give any money to Joe. Upon Bill’s death there is $1 million held in trust for Joe. This $1 million is in an investment account that generates dividends and interest. These payments are taxable as income. Because Joe does not have control, this income is not taxed to him, it is taxed to the trust itself. Suzie will have to file a 1041 Trust tax return to report that income. This all sounds okay, but the trust tax rates are compressed with the top rate of 37% when the trust income reaches just over $13,000 for the year.
Often, in planning we need to be aware of these issues, but need to balance them with the desire for the right distribution pattern for the situation. It may be more important to Bill that Joe’s money is protected and managed for him than any potential income tax issues. Ultimately, it boils down to Bill’s goals and concerns.
If you have questions about how income taxes may play a role in your estate planning, contact your local estate planning attorney at Sinclair Prosser Gasior.