So, WHAT IS TRUST?
Per Fidelity: A trust is traditionally used for minimizing estate taxes and can offer other benefits as part of a well-crafted estate plan.
This is how I describe it – Trust is a separate tax entity created by an individual to transfer some or all of his/her asset to a Trust based on the objective(s) he/she intends to accomplish for the benefits of himself/herself and/or another individual(s) / entity.
COMPONENTS OF TRUST
Grantor: the person who creates the Trust and transfers his/her assets into it.
Trustee: the person who oversees the assets being held in the Trust for the benefits of the beneficiary. The Trustee duties includes but are not limited to administrating, accounting, etc. The Trustee has a fiduciary duty to the beneficiary.
Beneficiary: the person who receives the “benefits” of the Trust.
GRANTOR TRUST (Note: there are many different types of trust. For this article, only the Grantor Trust is discussed in detail.)
Although there is a named Trustee, the Grantor could manage the assets/investments held in the Trust and change the beneficiary, the income distribution amount, etc. and is also the beneficiary of the Trust. This kind of trust is often called as Revocable Trust and/or Living Trust.
Some of the Grantor Trust rules outlined by the IRS are as follows:
- The ability to modify the beneficiary of a trust
- The ability to borrow from the trust without appropriate collateral
- The ability to use income from the trust to pay life insurance premiums
- The ability to make changes to the trust’s assets make-up by replacing assets with those of equivalent dollar amount
However, Grantor Trusts could be Ir-revocable Trusts as well if they retain none of the controls.
INCOME TAX IMPACT
If the grantor retains access to the income and management of the Trust, then the income will be passed on and reported on the grantor’s individual income tax returns. Otherwise, the Trust will report its own returns.
FEDERAL ESTATE TAX IMPACT
For Non-Grantor trusts, since Grantors have no control over the assets being transferred to the Trust, the assets are therefore excluded from the grantor’s estate. However, if the transferred (gifted) asset amounts exceed the annual gift amount permitted, filing a gift tax return is deemed necessary.
PURPOSE OF GRANTOR TRUST
The ownership, control, receipt of trust income or use of principal are all factors to determine whether the Trust is considered a separate entity from the grantor, and hence determines who (Grantor or the Trust) is to report the income generated from the Trust and whether the Trust is able to be excluded from the Grantor’s estate.
Further, the type of assets being transferred to the Trust is governed by various income tax rules. One of the important tax advantages is capital gain exclusion on the sale of primary residence if ownership and occupancy conditions are both met (please refer to my other blog titled, “The Income Tax Capital Gain Exclusion on Home Sale”). Therefore, some benefits of the trust are:
- To avoid probate: the most common reason
- For Elder Care or Long-term Care Planning: by transferring the owner’s assets to a trust reducing the owner’s assets to help qualify for the Medicaid funding of the owner’s long-term care