One of the most common reasons to create a trust is to maximize the wealth transfer between generations, i.e., to make sure your beneficiaries receive the most assets possible. This is where potential tax savings through trusts comes in.

Tax savings through trusts

When properly designed and executed, trusts can have incredible estate tax advantages, most notably because of the federal government’s allowances of tax-free giving – up to a certain amount – during life and after death. To ensure you’re doing your best to take care of your loved ones once you’re gone, you must understand how to best maneuver through the various applicable taxes on property transfers between individuals both in life and after death.

Most notably, the federal government collects estate and gift taxes on certain property transfers between individuals as well as taxes on a generation-skipping tax (GST) on transfers from grandparents to grandchildren that skip the intervening generation. To maximize the tax benefits of trusts, then, it is imperative to understand how these three – the estate tax, the gift tax and GST tax – work together.

Estate tax

The federal government applies an estate tax, sometimes called a “death tax,” to those estates whose gross value exceed a certain threshold; the personal estate tax exemption permits each individual taxpayer to transfer property up to a certain amount without incurring any federal estate tax liability.

To determine whether an estate owes estate tax, the executor of the estate must first calculate the value of the “gross” estate. The gross estate includes all property in which the decedent had an interest.

This may encompass real estate, personal property, mortgages, cash, stocks and bonds, notes and certificates, and life insurance policies. If the decedent owned property as a joint tenant with a spouse, one half of the value of the property is included in the gross estate of the deceased spouse.

Some deductions that may apply against the gross estate value include the following:

• Funeral expenses
• Charitable bequests
• Certain taxes, debts, and administrative expenses.

In addition to the personal estate tax exemption, it is important to recognize that the federal government has also built in a marital deduction through which one spouse’s estate can pass tax free to the surviving spouse without facing any estate taxes. In order to qualify for the marital deduction, the receiving spouse must be a U.S. citizen and also must receive the property interest directly upon the other spouse’s death.

Once calculated, if the value of the gross estate reaches the limit of the lifetime exclusion amount, a representative of the estate must file an estate tax return to determine the amount of estate tax due and then pay the taxes out of the estate.

As an example, let’s say John dies with an estate valued at $30 million and through his will leaves $15 million to his wife Sara and $15 million to his son Bob. None of the amount left to Sara would be subject to estate tax assuming she meets the requirements stated above (that she is a U.S. citizen and received the property interest in the bequest directly upon John’s death). Of the $15 million left to Bob, however, a portion would be subject to estate tax -- $15 million minus the IRS lifetime estate tax exclusion for that year.

This example, of course, assumes that John’s estate may still claim the full value of the lifetime estate tax exclusion upon his death. The numbers would change, however, if John had already used up some of the lifetime exclusion through gifts, discussed more fully below.

Gift tax

Congress didn’t want individuals to be able to escape paying estate tax by simply giving away all their wealth during their lifetime, and so the gift tax was born. Accordingly, certain property transfers during an individual’s lifetime may be subject to gift tax, with the following exceptions:

• Gifts to a spouse
• Payment of tuition or medical expenses on behalf of someone else
• Charitable contributions
• Gifts valued at $15,000 or less to any one individual in a single calendar year (note that this amount is as of 2020, but it does change)

The lifetime exclusion amount that applies to gifts is the same that applies to the estate tax and works in conjunction with it, which means that the amount of gifts given within the lifetime of an individual reduce the available estate tax exemption amount upon their death.

Notably, the gift tax does not directly apply to trusts, but the value of gifts you give away during your lifetime could count against how much of the lifetime exclusion your estate has available at your death.

Using the above example, if John had “used up” $2 million in gifts during his lifetime, that would have reduced the amount of the estate tax exclusion available to his estate upon his death. In that situation, then, an additional $2 million of the bequest to his son would be subject to estate tax.

Stay tuned for part two of our Key Tax Implications of Trusts.

Questions? Contact us.