How Do Trusts Reduce Taxes?

Individuals often establish trusts to help reduce or eliminate taxes so that their loved ones receive as much of the original estate as possible. Learning about the tax benefits and possible disadvantages of selecting certain trusts can help people make informed decisions regarding their estate plans. Find out the answer to “How do trusts reduce taxes?” and learn how a seasoned California estate planning attorney from Von Rock Law can assist individuals with their estate planning concerns by contacting (866) 720-0195.

What Are Trusts?

As per the Internal Revenue Service (IRS), trusts, governed by state laws, are legal relationships in which one individual, known as the settlor or grantor, transfers their property into a trust, a separate legal entity. This trust is managed by another individual, called the trustee, who oversees the administration of its assets in accordance with the guidelines set out by the grantor in the trust document to benefit a third party, referred to as the beneficiary.

Why Do Individuals Create Trusts?

The American Bar Association (ABA) states that individuals create trusts and use other estate planning tools to protect their assets during their lifetime and distribute them to their loved ones upon their death according to the decedent’s wishes. Depending on the type of trust established, trusts may also help to avoid probate and reduce inheritance and estate taxes.

What Are The Two Main Types of Trusts

The two primary types of trust include revocable trusts, which the grantor may close or change during their lifetime, and irrevocable trusts, which the settlor cannot alter or terminate after transferring the assets and signing the trust documents. Any taxes owed by the beneficiaries of these trusts vary depending on the trust type and the income received by the trust.

How Does a Trust Reduce Income Taxes?

As with typical income tax returns for individuals, trusts can reduce income taxes via specific deductions for offsetting the trust’s income. Here are examples of permissible deductions when completing income tax returns for a trust:

  • Repairs to the trust’s real estate holdings
  • Administrative costs, like trustee fees
  • Estate expenses
  • Beneficiary distributions
  • Property taxes
  • Additional miscellaneous deductions that are subject to a 2% adjusted gross income limitation

What Taxes Can a Trust Deduct?

Instead of trusts paying any tax owed on the trust’s income, the trust’s beneficiaries usually pay this tax on any distributions they receive. That said, the beneficiaries do not pay taxes on any distributions received from a trust’s principal, which is the initial amount of money transferred to the trust. When the trustee makes distributions to the trust’s beneficiaries, they deduct any income distributed when completing the trust’s tax return and they give a Schedule K-1 tax form to the beneficiary, indicating the proportion of the distribution which is the income and which is the principal and, therefore, the amount of taxable income the beneficiary should indicate when completing their taxes.

Acquire a more comprehensive answer to “How do trusts reduce taxes?” and understand how a seasoned San Francisco estate planning lawyer can help people create effective estate plans by arranging a consultation with Von Rock Law.

How Do the Rich Avoid Taxes With Trusts?

Below are some of the methods used by wealthy individuals to avoid taxes via trusts:

  • Establishing irrevocable life insurance trusts: While the proceeds of a life insurance policy are usually not subject to tax, when an individual dies they become part of the decedent’s estate, potentially making them taxable. Individuals can avoid this by establishing an irrevocable life insurance trust and transferring ownership of the proceeds to someone else. For these trusts, it is not possible to make alterations without gaining consent from the beneficiaries of the trust. One caveat to note is that if the decedent dies less than three years after creating this trust, the proceeds remain part of the deceased person’s taxable estate.
  • Considering charitable donations: Some people transfer a portion of their wealth via charitable lead and remainder trusts to avoid estate tax. For the former, a proportion of the decedent’s assets within the trust transfer to the chosen charity, and the remaining amount goes to the deceased person’s beneficiaries. With the latter option, the grantor typically transfers an appreciating asset, such as stocks, to an irrevocable trust, accruing an investment income that transfers to the charity upon the decedent’s death.
  • Creating qualified personal residence trusts: This option involves transferring home ownership to a trust. Those who decide to do this continue residing in their home throughout the trust’s term; after which, the beneficiaries take ownership of the property. These trusts enable residents to freeze the market value of their property and avoid gift taxes, provided the grantor has not already surpassed the taxable gift lifetime limit, while also reducing their estate’s size (but not if the settlor dies before the trust’s term ends).

What Are the Disadvantages of a Trust?

Trusts generally have the following drawbacks:

  • Complexity: Trust documents contain complex legal language, which laypeople may find challenging to understand. In addition, trust documents tend to be lengthy to avoid vagueness and the potential for legal challenges, adding to their complexity.
  • Costs: Establishing a trust can be a costly procedure, as it entails paying various legal expenses, such as filing fees, title transfer expenses, and frequently attorney costs. Some trustees might also expect compensation for performing their role.
  • Record maintenance: When managing a trust, the trustee needs to keep consistent records of the trust’s assets, whether this involves adding assets or distributing them to beneficiaries. This can be a challenging process if the trust often acquires and sells real estate and financial holdings.
  • Creditor protection: While irrevocable trusts remove assets from the grantor’s control and, therefore, their taxable estate, revocable trusts offer no protection against creditors since the assets within these trusts remain part of the settlor’s taxable estate. This means creditors may try to claim a proportion of the beneficiaries’ distributions after the settlor’s death if the grantor had any outstanding debts.

Contact a California Estate Planning Attorney Today

Trusts may offer numerous benefits. These vary by the type of trust established but can include flexibility, tax savings, and financial protection. Consider contacting a San Francisco estate planning attorney to understand more about trusts and other helpful estate planning tools. Gain a more detailed response to “How do trusts reduce taxes?” by calling Von Rock Law at (866) 720-0195.

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