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Key Tax Implications of Trusts Part 2

February 22, 2022

When properly designed and executed, trusts can have incredible estate tax advantages. In part two of our taxation of trusts series, we dive into GST, TCJA and more.

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. Did you miss part 1? Find it here: Key Tax Implications of Trusts Part 1.

Generation-Skipping Transfer Tax (GST)

In another case of Congress wanting to avoid individuals’ wealth escaping taxation, the legislative body enacted the GST tax in 1976 so that families couldn’t avoid estate tax by simply making gifts or bequests directly from grandparents to grandchildren or greatgrandchildren, skipping the parents’ generation between them.

The GST tax applies a flat tax of 40% on generation-skipping transfers that exceed the allowable amount – again, the same amount as the estate tax lifetime exclusion. Essentially, the GST tax is designed to catch any inheritances that would have otherwise escaped taxation.

A GST trust, also called a dynasty trust, is a useful estate planning tool for affluent families especially, since you do not need to be exceptionally wealthy to take advantage of using one. The main disadvantage to creating a GST trust is that it must be irrevocable, which means that you cannot change its terms or cancel it once it is in place. Whether you are comfortable giving up control over the assets placed in trust depends on your familial situation, but other than that, there is generally little disadvantage to creating a GST trust.

Note that the GST tax doesn’t apply only to grandchildren or greatgrandchildren under the law, however, but rather to all “skip persons,” which encompasses other family members and unrelated individuals who are at least 37.5 years younger than the giver. Trusts may also be “skip persons.” Generally, anyone with a “beneficial interest” in the trust, which means having a present and immediate right to the trust’s principal and interest.

Just as with gift taxes, a donor can give away up to $15,000 each year to as many individuals as you’d like without incurring any GST taxes.

So-called “direct skips” in excess of $15,000 must be reported to the IRS yearly and count against the donor’s estate’s lifetime exemption.

Accordingly, using the above example, if John has given gifts directly to his son Bob’s children throughout his life above the yearly thresholds, those amounts would be deducted from his estate’s available lifetime exemption.

Tax Cuts and Jobs Act (TCJA)

The Tax Cuts and Jobs Act of 2017 (TCJA) became effective on January 1, 2018 and its provisions will remain in effect until 2025 unless Congress changes the law in the meantime. Among the most publicized aspects of the TCJA were its provisions to lower the corporate tax rate from 35% to 21% and to eliminate the corporate alternative minimum tax. But for trust makers, there was so much more in the Act to learn about, including the decrease in overall trust tax rates, marked increases in the estate and gift tax lifetime exclusion amount, and the much-discussed Section 199A qualified business income deduction.

Let’s start with the new income tax rates for estates and trusts, which are the following for the tax years beginning 2018-2025:

  • Income $0 to $2,600: 10% of taxable income
  • Income $2,601 to $9,300: $260 plus 24% of the amount over $2,600
  • Income $9,301 to $12,750: $1,868 plus 35% of the amount over $9,300
  • Income over $12,751: $3,075.50 plus 37% of the amount over $12,750

Before the TCJA, the lowest tax rate for trusts was 15% while the highest was 39.6%. As you can see, the TCJA made income taxes directly on trusts less burdensome.

The TCJA also changed the inflation index that applies to tax bracket figures so that it uses the chained Consumer Price Index (CPI), which is now more complicated than the old CPI but which generally means a lower adjustment for inflation.

Next comes the estate and gift tax lifetime exclusion amount that taxpayers may give away from their estates tax-free. Before the TCJA, the exclusion was $5.49 million, but the Act currently allows an individual to transfer $11.58 million (as of 2020) and a married couple to transfer $23.16 million without having to pay estate taxes. The amount will continue to be adjusted for inflation.

Note that the highest tax rate for estates remained at 40%.

The other substantial effect of the TCJA on trusts is through Section 199A, which provides a 20% deduction for the qualified business income of small business owners, trusts, and some real estate investors, subject to certain limitations.

The IRS treats non-grantor trusts as pass-through entities (PTE) so long as they distribute or are required to distribute their “distributable net income.” In this situation, the trust receives a deduction for the distributions and the beneficiaries pay income tax on them. With Section 199A, the trust may be eligible for a 20% deduction.

One important thing to keep in mind here is that a trust’s income is not comprised solely of qualified business income; it also includes W-2 wages and the unadjusted basis of the qualified trade or business. Trust creators must understand how to make distributions to take most advantage of the Section 199A deduction.

Questions? Contact us.

Melissa A. Sommer is the co-founder, CEO and President of Darwin Trust Company

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