HOW ARE TRUSTS TREATED FOR FEDERAL ESTATE, GIFT, AND GST TAX PURPOSES?
A trust is created when you (the grantor) transfer property to a trustee for the benefit of a third person (the beneficiary). The act of transferring property to a trust is generally treated no differently than if it were transferred to an individual outright. That is, transfers of property (whether into a trust or otherwise) may be subject to excise taxes known as transfer taxes. There are three types of transfer taxes: (1) estate tax, (2) gift tax, and (3) generation-skipping transfer (GST) tax. Estate tax may be imposed on transfers of property made after death (these are called bequests). Gift tax may be imposed on transfers of property made during life (these are called gifts). GST tax is imposed on transfers of property (either bequests or gifts) made to “skip persons.” A “skip person” is someone who is more than one generation younger than you (e.g., a grandchild or great-nephew).
ESTATE TAXATION OF TRUSTS
Trust property may be included in your gross estate for estate tax purposes if you have retained certain rights in the trust or if the trust is created at your death. The estate representative (executor) is responsible for filing an estate tax return on Federal Form 706 within nine months of your death (or at a later time if an extension is granted) and paying any estate tax owed from the estate proceeds.
GRANTOR RETAINED INTEREST
In general, a trust may be includable in your gross estate if you (the grantor) have retained an interest in the trust at the time of death–or given such interest away within three years of death.
Such interests include:
• Life estate: A life estate is the right for life to (1) receive trust income, (2) use trust property, or (3) specify who gets to enjoy the trust income or use of trust property. If any of these rights are retained, the entire value of the property is includable in your gross estate.
• Reversionary interest: A reversionary interest means that the trust property will revert to you (the grantor) if the beneficiary does not survive you. A reversionary interest is includable in your gross estate if, immediately before your death, the value of the interest exceeds 5 percent of the value of the trust.
• Rights of revocation: The right to revoke, amend, or alter the trust brings the trust back into your estate for estate tax purposes.
• “Incidents of ownership” in life insurance: The value of life insurance proceeds is includable in your gross estate if, either at the time of your death or within the three years prior to your death, the proceeds were payable to your estate, either directly or indirectly, or you owned the policy, or you possessed any right to benefit economically.
• Annuity interests: If you (the grantor) retain an interest in annuities in the trust, part or all of the trust may be includable in your gross estate.
GENERAL POWER OF APPOINTMENT
A power of appointment is the right to say who gets the trust property. The person holding the power is called the powerholder. The powerholder can be the grantor (creator of the trust) or anyone the grantor names. A general power of appointment is one that is exercisable in the powerholder’s favor directly or in favor of the powerholder’s creditors, estate, or estate’s creditors. In other words, there are no restrictions on the powerholder’s choice of appointees (i.e., beneficiaries), and the powerholder can use the trust for his or her own benefit. A general power of appointment held by the powerholder on the date of his death is subject to estate taxes. Because the general powerholder has the right to declare himself or herself as the owner of the property, the IRS deems that he or she is, in fact, the owner of that property. That means that the entire value of the property over which the power is held is includable in the powerholder’s gross estate for federal estate tax purposes.
TRUSTS CREATED AT DEATH
A trust that is created upon your death (i.e., a testamentary trust) is generally includable in your gross estate for estate tax purposes.
GIFT TAXATION OF TRUSTS
A gratuitous transfer of property to a trust during life may be a taxable gift, just as if you had given the property outright. However, with respect to a trust, the taxable event may occur either at the time the property is transferred or at some later time. You (the grantor) are responsible for filing Federal Form 709 and paying any gift taxes owed. The taxes are due on April 15 of the year following the year in which the transfer is made.
TAXABLE GIFT OCCURS IMMEDIATELY UPON TRANSFER
Transfers made into an irrevocable trust in which the grantor (the creator) is not a beneficiary or retains no interest are taxable upon transfer.
TAXABLE GIFT OCCURS UPON DISTRIBUTIONS TO BENEFICIARY
A transfer made to a revocable trust, a trust in which the grantor is a beneficiary, or a trust in which the grantor has retained an interest is not a taxable gift at the time the transfer is made.
TAXABLE GIFT OCCURS UPON POWERHOLDER’S EXERCISE, RELEASE, OR LAPSE OF THE POWER
A taxable gift may occur if a powerholder (either the holder of a power of appointment or the holder of Crummey withdrawal powers) exercises or releases the power or allows the power to lapse. These are considered gifts made by the powerholder to the beneficiary. These gifts are not being made by the grantor but by the powerholder and are thus taxable to the powerholder.
GST TAX TAXATION OF TRUSTS
Generation-skipping transfer (GST) tax may be imposed if the beneficiaries of the trust are skip persons (i.e., persons who are two or more generations below you). The GST tax is imposed in addition to gift and estate tax. GST tax transfers are taxed at the maximum gift and estate tax rate in effect at the time the transfer is made. Whether a transfer to a trust is subject to GST tax depends upon who the transferor is and how the transfer is classified (i.e., a direct skip, taxable termination, or taxable distribution). GST tax is reported on Federal Form 706 if the transfer is a lifetime gift or Federal Form 709 if the transfer is a bequest.
A taxable termination is a termination of an interest in a trust, which results in the skip person(s) holding all the interests in the trust. Termination can result from death, lapse time, release of a power, or otherwise. A taxable termination is taxable at the time the termination occurs. But, there is no taxable termination if gift and estate tax is imposed on the nonskip person. The taxable amount of a taxable termination is the net value of all property that goes to the skip person. As opposed to the direct skip, a taxable termination is tax inclusive. That means that the skip person receives the property after tax.
A taxable distribution is any distribution (other than a direct skip or a taxable termination) of income or principal from a trust to a skip person (or from a trust to another trust if all interests in the second trust are held by skip persons) that is nototherwise subject to gift and estate tax. Generally, gift and estate tax is owed when the trust is funded, not when the funds are distributed. The taxable event occurs when the distribution is made. The amount subject to the GST tax is the net value of the property received by the distributee (the recipient) less anything the distributee paid for the property. Like a taxable termination, a taxable distribution is tax inclusive. The distributee is obligated to pay the tax. If the trust pays the tax, the payment will be treated as an additional taxable distribution.
There is an exemption of $5,450,000 in 2016 and there are exclusions and deductions available that may help to reduce your gross estate as well as reduce any taxable transfers or taxable gifts.
If you have tax questions, BWFA’s professionals are here to help.