Don’t set it and forget it: How to minimize taxes with your trusts

Many wealthy families use irrevocable trusts to transfer wealth to future generations. You may have set up a trust for your own children and grandchildren. Your parents or grandparents may have set up a trust for you.

Irrevocable trusts are typically created with specific income and estate tax savings in mind. The focus on tax savings, however, often stops after the trust is created. That doesn’t need to be the case.

When it comes to tax planning, trusts should receive ongoing attention. Here are three of our top opportunities to save on taxes when reviewing your irrevocable trust.

1. Move Your Trust to a Low-Tax State and Limit Connections Elsewhere

Irrevocable trusts come in two varieties for income tax purposes. First, there are grantor trusts. These are not treated as separate taxpayers. The grantor who created the trust pays all the taxes individually. Second, there are non-grantor trusts. These are separate taxpayers and file their own returns.

If your trust is a non-grantor trust, it generally will pay the highest federal tax rates. You also need to pay attention to where the trust is paying state income tax. Depending on the states, state income taxes could add an additional tax of 10% or more.

Figure out the states where your trust is paying state income tax. Then, determine the trust’s ties to the state, allowing the state to tax the trust. Below are the main sources of those ties and what you may do to break them and limit the trust’s state taxes:  

• Does a beneficiary live in a high tax state? Consider limiting distributions. In general, a beneficiary must be receiving or entitled to distributions from the trust for their state of residence to tax the trust. A beneficiary can always move. More practically, consider whether distributions are necessary. There may be ways to lend money or provide income to that beneficiary, rather than making distributions from the trust. Other forms of gifting may be more tax-efficient than distributions from the trust if you take a family’s overall picture into view.
• Does your trustee live in a high-tax state? Consider giving them a different role. If your trustee’s residence results in state income tax, consider whether that person needs to be a trustee. Under modern trust law, it may be possible to give someone the desired input or authority without the negative tax consequences of being a trustee. This is often accomplished by appointing a trust company as trustee in a state, such as Delaware, where the trust is not subject to tax. Meanwhile, specialized non-trustee roles can be carved out for the individuals the family wants to be part of the decision-making.
• Is where the trust is administered causing tax? Move the work. Some states will tax a trust based on where you do the work. The trustees’ residences may not be the issue. Instead, the concern is where they conduct the administration of the trust. If you have two trustees, consider centralizing the administrative decisions, record-keeping and custody of assets with the trustee in the state with lower or no state income taxes.
• Does the trust have income sourced to a high tax rate? Make it part of your investment analysis. If the trust receives income sourced to a high tax state, you need to factor the state income tax impact into the trustee’s evaluation of the investments. In some cases, that may be enough to consider selling the investment or looking for an alternative.

2. Swap Assets in and out of Grantor Trusts to Minimize Capital Gains Tax

If your trust is a grantor trust and you are the grantor, check to see if you have the power to substitute assets in and out of the trust. If you do, you could save your descendants significant taxes with the right planning.

That’s because assets you own in your personal estate receive a “step-up” in income tax basis when you die. In essence, all your capital gains disappear at death. Your heirs can sell your assets after your death without realizing any of the gains that accumulated during your life. Meanwhile, assets in an irrevocable generally do not receive a “step-up.”

Ideally, you would pull assets with low-income-tax bases into your estate. At the same time, you would push assets with high-income-tax bases into the irrevocable trust. If you have the power to substitute assets in and out of the trusts, that’s exactly what you can do.

Of course, you never know when you may die to make this tax planning meaningful. But it is something to consider, especially if you have large unrealized capital gains in an irrevocable trust.

3. Avoid Adding to a Beneficiary’s Taxable Estate via Tactical Loans and Purchases

For wealthy families, the goal of many irrevocable trusts is to save estate taxes. This is particularly true with trusts that are exempt from generation-skipping transfer (GST) tax. A GST tax exempt trust can avoid estate taxes for multiple generations as long as the assets remain in trust.

 Lending money from the trust to beneficiaries versus making outright distributions can be a good way to preserve these tax savings. When distributions are made from a GST tax exempt trust, they move from not being subject to estate tax to increasing the size of the beneficiaries’ taxable estate.

Lending preserves the value of the trust since the trust retains a claim on the beneficiary’s estate.

Another option is for the trust to make a direct purchase on behalf of the beneficiary. For example, if a beneficiary wants to buy a home or invest in a business, the trust can make that investment and hold title to the assets. The trust provides the support for the beneficiary, but the value of the trust is not reduced and the beneficiary’s taxable estate is not increased. The trust also receives the upside of the investment.

Treat Your Trusts, Even Irrevocable Trusts, as Dynamic Relationships with Regular Reviews

Income and estate tax planning strategies don’t need to end once your irrevocable trust is in place. By staying aware of ongoing opportunities, you can keep saving on taxes. If you have questions or need guidance, our trust counsels and wealth advisors are always available to help you make the right decisions in the context of your goals and financial circumstances.