New Tax Impacts for Trusts with Capital Gains – Part I

Originally published in the Cedar Street Times

November 1, 2013

In order to discuss the new challenge trustees have regarding capital gains, let us first review some basics regarding revocable and irrevocable trusts.

A revocable living trust is a trust created during your lifetime that spells out what you want to happen with, and who you want to control, your assets if you become incapacitated or pass away.  This is the most common type of trust, and many people set these up because it has many advantages over just having a will upon death: the chief reasons are that it provides more control, has more tax advantages, it is more private, it is faster, and it is less expensive than the default court process called probate.

I would say the one major drawback of a trust administration process compared to probate is that you do not have the standardized court oversight and genuine closure that you have with the probate process.  If there are difficult problems with trust administration, it often stems from that fact that most people appoint one of the recipients of their assets (beneficiaries) as the person responsible for carrying out the trust terms (the trustee).

Money does strange things to people, and I have witnessed it lead to families ripped apart when the non-trustee siblings start questioning the integrity of the sibling appointed as trustee.  Generally, beneficiaries want their money yesterday!  And they do not understand that it still takes a good bit of time, effort, and expense to handle everything.  That said, I would still choose to have a trust 98 percent of the time, instead of just a will.  If there are concerns about the solidarity of the beneficiaries, a corporate trustee could always be a solution.

Another characteristic of a revocable living trust is that it can be changed or even scrapped at anytime while you are alive – hence the name “revocable.”  As a result of this control feature, of being able to terminate the trust and retain the assets, the trust is disregarded as a separate taxpaying entity, and you just report all the eligible income and expenses of the trust on your personal 1040.  Everything gets reported under your Social Security Number instead of having a separate taxpayer identification number.

Now let us turn the tables and speak about irrevocable trusts.  These are trusts that generally cannot be changed once they are created.  (Of course, nothing is set in stone, and well drafted trusts with trust protector language can assist in making changes, or if all the beneficiaries agree and the court approves a petition, changes or even revocation of an irrevocable trust are possible!)

An example of  an irrevocable trust would be your revocable living trust after you pass away.  At that point, your wishes regarding the disposition of your assets are irrevocable – locked-in as you specified – and the trustee must carry out your wishes.  Often a revocable living trust will contain provisions to set up other trusts.  For married couples, it has been very common to create an irrevocable trust called a bypass trust, (aka credit shelter trust, ‘B’ Trust, etc.).

Prior to some new “permanent” laws passed in January ($5 million indexed-for-inflation estate tax exemption with portability), it was important for estate inheritance tax reasons for many people to create bypass trusts. For most people estate inheritance tax will not be a concern now, but bypass trusts, or similar types of trusts, can still be important for controlling where the deceased spouse’s assets end-up, especially in blended family situations with children from prior marriages.  In other words, dad doesn’t want mom to disinherit the children he had from a prior marriage once he dies!

Another type of common irrevocable trust is a gifting trust.  These are commonly created by a parent or a grandparent to permanently move assets out of their estate and into a trust for the benefit (or future benefit) of a child or grandchild with certain stipulations and protections governing the assets in the trust.  We saw a lot of these set up in 2012 due to the uncertainty of the estate tax laws and the possibility of missing an opportunity to save estate inheritance tax down the road.

Due to the fact that you have relinquished a lot of control with an irrevocable trust, and it will no longer be included in your estate, the taxing authorities view this trust as a separate tax paying entity.  This means it has its own tax return each year and gets its own taxpayer identification number.

In two weeks we will begin discussing the new tax rate changes and their impacts on trusts.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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