Trusts: Income and Estate and Gift Tax Issues

A trust is a legal arrangement in which a donor or grantor transfers assets to a trustee who manages the assets for beneficiaries. Trusts are one method of providing for the inheritance of assets, along with wills. This report focuses on transfers to trusts that are potentially subject to the estate and gift tax, and which can be differentiated by the person liable for income taxes on the earnings from those assets and whether the assets remain in the donor or grantor’s estate. In general, assets transferred by estate or gift are subject to a tax of 40% on amounts in excess of the combined estate and gift tax exemption, currently $15 million per person (indexed for inflation). There is also a generation-skipping tax (GST), which is applied to estates that skip generations (e.g., leave assets to grandchildren rather than children), applying the tax to the skip generations (generations before the recipient of the assets). Appreciated assets transferred by an estate are eligible for a step up in basis, so that any capital gains tax due is on the amount in excess of the fair market value at death, while assets transferred by gift retain the original basis (generally the cost of purchasing the asset). Most trusts are revocable trusts (trusts which can be dissolved) used to avoid probate. Revocable trusts involve no tax issues while the grantor is alive because income from the assets is taxed to the grantor and assets remain in the estate. Other trusts are used for tax planning, with the aim generally to reduce or eliminate the estate and gift tax. Tax planning involves irrevocable trusts, especially those that are also grantor trusts (trusts which allow the grantor some control over the assets). These grantor trusts are treated as complete gifts under the estate and gift tax (and removed from the grantor’s estate), but for income tax purposes are treated as owned by the grantor. Thus, transactions between the grantor and the trust do not generate income. Data on trusts are incomplete and somewhat outdated, but indicate that as of 2014 there were 2.8 million irrevocable trusts, of which about 600,000 were grantor trusts. The general type of irrevocable grantor trust, known as an intentionally defective grantor trust (IDGT), allows grantors to minimize the taxable gift to a trust by exchanging assets for a promissory note discounted at a low rate and retaining a high value. Taxes paid on income by the grantor are not considered gifts, allowing assets to appreciate tax free. Grantors can swap low-basis assets in a trust for high-basis assets, minimizing the loss of step up in basis. Other grantor trusts can be used to transfer assets out of one spouse’s estate or for other purposes, including split-interest trusts that make annuity payments to charities but leave the remainder to family members. A special type of irrevocable grantor trust—the grantor retained annuity trust (GRAT)—can be used to reduce the taxable gift amount or even eliminate it by paying an annuity to the grantor. The present value of the annuity, discounted at the typical relatively low discount rate, offsets the gift. If the assets in the GRAT grow faster than this rate, assets will remain in the trust after the payment of an annuity. Dynasty trusts are trusts that last for many generations, or indefinitely. They can make payments to intermediate beneficiaries while reserving the bulk of the assets in the trust to be retained indefinitely without estate taxes. These trusts can avoid generation-skipping taxes by applying GST exemptions to the tax and minimizing the original gift. Not all states allow these perpetual trusts. Some estimates suggest that as much as $13 trillion, close to a quarter of the wealth of the top 1% of households by net worth, is held in all trusts with income reported on fiduciary tax returns (irrevocable nongrantor trusts). All of these mechanisms can be enhanced by contributing assets to family limited partnerships, which can result in significant minority and marketability discounts in the valuation. Members of Congress, researchers, and interest groups have made numerous proposals to address the tax treatment of trusts. For irrevocable grantor trusts, proposals have been made to recognize transactions between grantors and trusts for income tax purposes and retain them in the estate. Specific proposals for GRATs would impose minimum and maximum terms for annuities and required remainders, or disallow the up-front deductions for annuities. Proposals aimed at dynasty trusts would limit the duration of such trusts, or limit the number of generations eligible for the GST exemption. Some proposals suggest a withholding tax for dynasty trusts or a wealth tax that would include trusts. For discounts, proposals would disallow these discounts for certain assets, such as nonbusiness assets or assets with majority family control.