How are living trusts taxed
An irrevocable trust is an arrangement in which the grantor departs with ownership and control of property. Usually this involves a gift of the property to the trust. The trust then stands as a separate taxable entity and pays tax on its accumulated income. Trusts typically receive a deduction for income that is distributed on a current basis. Because the grantor must permanently depart with the ownership and control of the property being transferred to an irrevocable trust, such a device has limited appeal to most taxpayers.
Irrevocable trusts, however, are useful in life insurance planning. For instance, a properly structured irrevocable life insurance trust can avoid probate costs and fees, and estate taxes on the insurance proceeds paid to the trust upon the grantor's death. Irrevocable trusts are also useful in providing children, especially those over age 14, with a fund for education or other specific planning purposes. Again, the trust is usually funded with "after-tax" dollars through a gift. The annual gift tax exclusion (an exclusion for gifts of $10,000 or less per year per donee) does not apply to gifts of a future interest (such as a gift to a trust), so the so-called "Crummy" trust provisions must be properly applied to make the gift a "present" interest. Drafting such clauses requires expertise.
A grantor's use of irrevocable trusts to avoid taxation of income, and to provide for accumulation of income to provide for beneficiaries at a later date, has been limited under the current tax system. The Revenue Reconciliation Act (RRA) of 1993 has made trusts subject to faster tax rate escalation than individual taxpayers. For example, trusts are taxed at 39.6 percent on taxable income in excess of $7,650. For filers of joint returns, the 39.6 percent rate does not begin
until taxable income is $256,500.
Ironically, the impact of RRA changes will not severely impact trusts whose grantors or beneficiaries are already in the 39.6 percent bracket; they will affect the smaller estates of middle and upper-middle income taxpayers, whose grantors and beneficiaries are in lower tax brackets.
To avoid being taxed at the higher rates, trust income can be reduced by increasing distributions to beneficiaries, reducing the amount of taxable income produced by the trust assets, or having the trust invest in assets that produce capital gain (maximum tax rate is only 28 percent) rather than ordinary income.
Since a trust is taxed as a separate entity on accumulated income, it is sometimes desirable to create as many trusts as possible for purposes of accumulating income at the lower tax brackets. However, two or more trusts will be treated as one trust if the trusts have substantially the same grantor and primary beneficiaries, and federal tax avoidance is the principal purpose of the trusts. Code §643(f).
Although limited in recent years, income splitting among family members through family trust arrangements remains a valid way of reducing overall family income tax. Although an assignment of income from one family member to another is not sufficient, an outright transfer of income-producing property can achieve income splitting. If the family member to be benefited lacks the ability to manage the assets, you can use a trust. If the beneficiary is a minor, you may consider the creation of a custodial account under the applicable state's Gifts to Minors Act or the Uniform Transfers to Minors Act.
The use of irrevocable trusts in sophisticated tax planning involves a multitude of complex tax rules. You should consult with a tax planning professional to obtain the optimal tax results.Source: www.taxprophet.com