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Part IV “The 4 Most Common Estate Planning Myths”You probably have heard the adage: “Nothing is certain in life except for death and taxes.” It may be trite, but it’s also true (as so many platitudes are). Before I go any further, I’ll begin in true attorney fashion: I am not a CPA and this article should not be substituted for tax advice. Rather, consider this article a warning – the type of warning the people who trusted Bernie Madoff wish they would have received sooner: “If it sounds too good to be true, it probably is” (my apologies for yet another platitude.) “Trusts avoid taxes” – this statement may be true or false depending on what type of trust and what type of tax you mean. What many people do not realize is that in addition to the federal income tax, there are many other types of tax imposed by the IRS, including, for example:
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What If the Federal Estate Tax Laws Change?The tax laws inevitably will change; this is certain. This is why it is so important to meet with your estate planning attorney on at least an annual basis. First, it gives you the opportunity to alert your attorney to changes in your family dynamic, asset holdings, and overall net worth. For example, did you buy a second home in the mountains of North Carolina last year? You need to make sure your estate planning attorney knows about the purchase so she can incorporate the same into your existing estate plan (actually, you should have told her about it before you bought it). Second, meeting with your attorney on a periodic basis gives her the opportunity to alert you to changes in not only federal tax laws, but also applicable state law updates relevant to probate, wills, powers of attorney, advance health care directives, and, yes, local tax laws. For this very reason, about seven years ago, I started offering “Complimentary Annual Reviews” to my estate planning clients to meet and review their estate plans on an annual basis. This keeps the lines of communication open, and my clients don’t have to worry about any “surprise” bills or charges for simply staying in touch with me.
Can Trusts Avoid or at Least Minimize Taxes?With the assistance of an estate planning attorney, your trust can take advantage of existing “safe harbors” within the Internal Revenue Code to reduce or even eliminate certain types of taxes, including wealth transfer tax.
- For example, the IRS allows you to leave unlimited assets at death to your spouse, who will not have to pay any estate tax otherwise due until she dies. In other words, her estate will be responsible for the estate tax due, but only to the extent the remaining assets exceed her available estate tax exemption when she dies. This concept is known as the unlimited marital deduction, and estate planners frequently take advantage of it, especially for larger estates. Essentially, the unlimited marital deduction allows you to delay the imposition of the estate tax until your surviving spouse dies; the estate tax may even be avoided entirely if your surviving spouse spends down the assets below her exemption amount.
- For example, did you know that the IRS wants to tax your grandchildren’s inheritance in addition to the federal estate tax? A seasoned estate planning attorney can advise you on how the generation skipping transfer tax (also known as “GST” or “GSTT” tax) may apply to your estate plan, and, better yet, include the necessary provisions in your trust to minimize or even avoid the GSTT tax altogether.
Do Trusts Pay Income Tax?The answer to this question generally is yes: income generated within a trust is taxable. If the answer were no, everyone in the United States would transfer their assets to trust immediately and avoid income tax for eternity – you didn’t think the IRS would allow that, right? In fact, trusts have their own type of tax return known as an IRS Form 1041. It is important to distinguish the taxation of revocable trusts vs. irrevocable trusts.
- The most common type of trust in estate planning is a revocable trust. Revocable trusts generally are pass-through entities for federal income tax purposes. This means that the trust will not interfere with how you currently report your federal income tax to the IRS: all items of income, deduction, depreciation, and credit will continue to flow through to you on your personal Form 1040, and the trust will not be required to file its own income tax return during your lifetime. Many clients simply assign their social security number to their revocable trust during their lifetime. The general rule is that when you die, your revocable trust becomes irrevocable (because you are no longer alive to modify or revoke it), at which time the taxation of the trust will change.
- The income taxation of irrevocable trusts is more nuanced (as compared to revocable trusts). Essentially, an irrevocable trust can be designed to be taxed as its own entity (like a corporation), but there are also ways to have an irrevocable trust taxed to a particular person, such as the person who created it (the “settlor” or “grantor”). Your estate planning attorney should discuss these options with you before the irrevocable trust is established.