In most cases, distributions to beneficiaries of a Trust are not taxable. The exceptions to this general rule involve estates subject to estate taxes and assets held by a decedent, or in his or her trust, that are tax qualified or tax deferred. Show Estate Tax ConsiderationsFederal law allows an individual to pass on up to $11.58 million in 2020 to their heirs without any estate tax being imposed, up from $11.4 million in 2019. An estate includes all assets owned by a decedent, including life insurance death benefits, whether held individually or in trust. If the total estate, including assets held personally or in trust, exceed the exemption, then the estate will be subject to estate taxes of approximately 40% of all assets that exceed the exemption. In the settlement of an estate that exceeds the maximum exemption, usually the executor of the estate or the Trustee of the trust will satisfy any estate tax obligations out of the estate before making distributions to the beneficiaries. This can often mean selling assets or property to pay the tax, and therefore does dilute the amount available to beneficiaries. Fortunately, few estates are subject to estate taxes with this relatively high exemption level. Tax Qualified AssetsTax qualified assets refer to qualified retirement plans (QRP), such as IRA’s, 401(k)’s, SEP IRA's, KEOUGH’s, 403(b)’s as well as deferred compensation plans. Qualified retirement plans are funds that are set aside tax free (through a deduction) and are allowed to grow tax deferred. The IRS will tax these funds at ordinary income tax rates as those funds are withdrawn, whether by the original account owner or their designated beneficiary(ies). If you are the beneficiary of a QRP, you will have to pay taxes on any amounts you withdraw. You may have options to further defer those taxes, but taxes on these types of accounts cannot be avoided unless a qualifying charity is named the beneficiary. Tax Deferred AssetsTax deferred assets are those assets you are able to invest with after tax dollars, but which are allowed to grow tax deferred until withdrawn. The most common tax deferred asset class are annuities. Similar to a QRP, tax deferred assets are subject to ordinary income taxes as the funds are withdrawn. However, you will only be taxed on the earnings in the policy and not the original after tax contributions. A Note About Capital GainsWhen an individual dies owning appreciated assets such as real estate or stocks, the IRS provides a tax break known as “step up basis.” This means that, for tax purposes, such assets are revalued as of the date of death which serves to eliminate any capital gains on the assets up to the value as of the date of death. The most common example is the family home that may have greatly appreciated since its purchase. After the death of the owner, all capital gains — including any depreciation taken over the years (in the case of investment property) — is forgiven. This is true whether the appreciated asset is held individually or in trust. One of the most common additions to a well
thought out estate plan is a trust, sue in large part to the fact that a trust can accomplish such a wide range of estate planning goals. In order to know whether a trust could be a beneficial addition to your estate plan, you need to better understand your trust options and how each type of trust operates as well as the various benefits each type of trust offers. The North Andover trust attorneys at DeBruyckere Law Offices explain when an irrevocable trust pays taxes and who pays the tax. Trusts all fall into one of two categories – testamentary or living trusts. A testamentary trust is activated by a provision in the Settlor’s Will at the time of death whereas a living trust activates once all formalities of creation are in place and the trust is funded. Living trusts can be further divided into revocable and irrevocable living trusts. Because a testamentary trust is activated by a provision in the Settlor’s Will, and
a Will can always be revoked up to the time of the Testator’s death, a testamentary trust is also revocable up to that point. Capital gains taxes are paid when you realize a gain on the sale of an asset. For example, if you purchased real property for $100,000 and sold it ten years later for $200,000, you would realize a gain of $100,000. Determining when capital gains taxes are due, how to calculate the gain upon which the tax is paid, and how
much tax is due can be quite complicated because of the numerous and varied factors involved and the complexity of the tax laws. Whether or not capital gains taxes are due after the sale of a trust asset will depend on several factors, starting with the type of trust involved. If the trust is a revocable trust, the trust is not usually a separate tax entity during the lifetime of the Settlor. As such, the Settlor retains
incidents of ownership over the property held by the trust. If a trust asset is sold, and a gain is realized, triggering a capital gains tax obligation, that gain must be reported on the Settlor’s personal tax return. Conversely, an irrevocable trust is typically a separate tax entity because when you transfer ownership of property into it, you give up control and any opportunity to take the assets back. For this reason, gains or losses are not reported on the Settlor’s personal tax
return. Unfortunately, however, that is not the end of the capital gains tax analysis. You must still consider what type of irrevocable trust is involved. A simple irrevocable trust is required to disburse all income made by the trust every tax year. Those disbursements are then taxable to the beneficiaries as income. Some irrevocable trusts, however, are more complex and are permitted by law to retain income. This type of irrevocable trust may only distribute some of the income to the trust beneficiaries. Capital gains, however, are not considered to be income to irrevocable trusts. Instead, capital gains are viewed as contributions to the principal. Consequently, if the trust sells an asset and realizes a gain, that gain would not be distributed, meaning the trust would have to pay taxes on the gain as profit to the trust. Transfer to a BeneficiaryIf an irrevocable trust distributes, or transfers, an asset to a beneficiary, instead of selling the assets and distributing the gain, then the beneficiary becomes responsible for any taxes due. Although the initial distribution may not be taxable, capital gains taxes may become due if the beneficiary sells the asset down the road. In that case, the amount of capital gains tax due will usually be calculated using the value of the assets at the time it was distributed to the beneficiary as the basis, not the value of the asset at the time it was originally purchased. Contact North Andover Trust AttorneysFor more information, please join us for an upcoming FREE seminar. If you have additional questions about how capital gains taxes impact an irrevocable trust, contact the North Andover trust attorneys at DeBruyckere Law Offices by calling (603) 894-4141 or (978) 969-0331 to schedule an appointment. What is a trust? A trust is a legal relationship where property is held by one party for the benefit of another party. What does a Trustee do? The person who creates a trust is referred to as the “Settlor”, “Trustor” or “Grantor.” The Settlor transfers property to a Trustee, appointed by the Settlor. The Trustee holds that property for the trust’s beneficiaries as well as invests trust assets and administers the trust terms according to the terms created by the Settlor. Why would I want my trust to be irrevocable? A primary reason for creating an irrevocable trust is to protect the assets held by the trust from creditors and other threats.
Attorney Daniel A. DeBruyckere has been practicing law in New Hampshire and Massachusetts since 1998, and has helped hundreds of clients with their estate planning and elder care issues. He is very well respected in the area of estate planning, probate, trust administration, elder law issues, and business planning.  |
Are distributions from an irrevocable trust taxable to the beneficiary
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