The one thing stopping good people from engaging the full force and effect of tax and estate planning using trust instruments is the language. Acronyms make it hard to understand what lawyers are saying and most of us simply put ourselves out of commission when it comes to this type of tax planning.
It does not need to be that way. Trusts are not THAT complicated when broken down. The best place to start is with the language. Resist the urge to be intimidated by it or the acronyms it brings.
A "trust" generally speaking is defined as a right of property held by one party for the benefit of another. A trust will hold legal title to the assets in the trust and the beneficiaries of the trust hold equitable title to the same assets.
The most common type of trust is the revocable living trust. It is generally a grantor type trust in which the trustor reports all income on his or her personal income taxes via IRS Form 1040. Upon death of the trustor the trust becomes irrevocable and any income earned by the assets post death in excess of $600 for the tax years must be reported on IRS Form 1041.
Three important mentions:
- In this light a revocable living grantor type trust offers the trustor generally speaking no immediate tax savings and is used more for the avoidance of probate, which is a good goal unto itself.
- Often times assets in the trust are distributed to the beneficiaries at a time reasonably correlated with the date of death of the trustor and before any income is generated by the trust assets.
- As a result quite often the trust may not necessarily be obligated to file an any income tax forms whatsoever after death.
When it comes to setting up trust instruments that offer immediate tax savings the planning gets subtly more involved as there are many different types of trusts to consider. The following is intended to serve as a summary of the more commonly used trusts and their respective acronyms.
A Charitable Lead Trust (CLT) is a split interest trust consisting of an income interest and a remainder interest. During the term of the trust, the income interest is paid out to a named charity. At the end of the trust term, the remainder (whatever is left in the trust) is paid to non-charitable beneficiaries (e.g. children of the donor) designated in the trust document.
A Charitable Lead Annuity Trust (CLAT) allows the beneficiary to receive a stated amount of the initial trust assets each year. The amount received is established at the beginning of the trust and will not change during the term of the trust regardless of investment performance unless inadequate investment performance causes the trust to run out of assets.
A Charitable Lead Unitrust (CLUT) allows the beneficiary to receive a stated percentage of the trust’s assets each year. However the distribution will vary from year to year depending on the investment performance of the trust assets and the amount withdrawn.
A Private Foundation (PF) is an entity set up by an individual or group of individuals for philanthropic purposes. Generally PFs are exempt from income tax, but there are exceptions and excise taxes. Compliance is usually burdensome and expensive. Also stricter Adjusted Gross Income (AGI) limitations apply to the deductible amount that can be contributed in a given year.
A Charitable Remainder Trust (CRT) facilitates the tax advantaged transfer of highly appreciated assets. The Donor receives an immediate income tax deduction for present value of the remainder interest, at least 10% of the value of the assets originally contributed. At the donor’s death (or at the end of the trust term), the charity receives the residual assets held in the trust. Annual (or more frequent) payments for life (or a term of years).
A Charitable Remainder Annuity Trust (CRAT) allows the beneficiaries to receive a fixed percentage of the initial trust value or a stated amount annually or more frequently. The amount paid doesn’t change from year to year. The annual payment must be 5-50% of the fair market value of the assets at the time of contribution.
A Charitable Remainder Unitrust (CRUT) allows beneficiaries to receive a stated percentage of the trust’s assets revalued each year. The distribution will vary from year to year depending on the investment performance of the trust assets and the amount withdrawn. In standard CRUTs payout is a fixed percentage of not less than 5% or more than 50% of the fair market value of the trust’s assets. The character of income received by the recipient is subject to and controlled by the tier rules of IRC §664(b). First, distributions are taxed as ordinary income. Second, distributions are taxed as capital gains. Third, distributions are taxed as tax-exempt income (e.g. municipal bond income). Finally, distributions are assumed to be the non-taxable return of principal.