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Can a Living Trust Reduce Estate Taxes?

Troy Werner and his family

Written by Troy Werner

Troy Werner has been an indispensable asset to The Werner Law Firm since joining in 2009, providing exceptional legal service to its clients.

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POSTED ON: December 20, 2018

One of the main advantages of undertaking estate planning is the avoidance of the probate process. Probate is the procedure by which a specialized or district court undertakes the distribution of a dead person’s belongings, which includes real estate, the contents of bank accounts, and personal items. The probate process can be unsettling, public, tiring, […]

One of the main advantages of undertaking estate planning is the avoidance of the probate process. Probate is the procedure by which a specialized or district court undertakes the distribution of a dead person’s belongings, which includes real estate, the contents of bank accounts, and personal items. The probate process can be unsettling, public, tiring, and expensive, especially when undertaken at the same time as grieving the loss of a loved one. The best way to avoid it, and to safeguard your estate for your intended beneficiaries, is to prepare for your incapacitation or death with the help of a qualified attorney.

Laws, both state and federal, involving estate taxes are constantly evolving, so it’s a good idea to re-evaluate your end-of-life documents on a consistent basis. This will ensure that they are best arranged to protect your loved ones and assets. Also, periodic revisiting of these plans can help keep them up to date about shifts in marriages, newly born children, and the death of potential beneficiaries. Whether a living trust can reduce taxes depends on which state it was developed in.

What Is a Living Trust, What Does It Do?

Before delving into whether a living trust can reduce estate taxes, it’s important to understand what it is and what it does. A living trust is also known as an intervivos, which is a Latin term for “among the living.” It is formed while the settlor, or person who owns the assets, is still alive. The settlor, in some states, is also called the donor or the trustor.

A living trust allows for the dispersal of assets either while the settlor is still alive, or after he or she has died. The establishment of a living trust can help avoid the probate process because it clearly indicates who the intended beneficiaries are. If the donor has decided that the assets should be distributed upon his or her death, all the beneficiary has to do is produce a legally valid death certificate. Therefore, it allows the recipients to receive the settlor’s property, money, or personal items without frustrating legal complications.

Who Makes Decisions About the Trust?

More than one person can act as trustee, or manager, of the assets within a trust. Often, the trustor is also the trustee. This is most often seen in the case of a married couple, amongst siblings, or in a business arrangement. The trustee or trustees may name a backup trustee to manage the trust in their name should they become incapacitated.

It’s important to realize that a living trust is revocable. This legal term means that the terms of the trust can be changed during the lifetime of the settlor. In the case of co-settlors, they must agree to the alternations. The settlor or settlors may also dissolve the trust. Once the grantor dies, however, the trust is considered irrevocable: It can no longer be changed or destroyed.

What Is Subject to Taxation, What Kinds of Taxes Are There?

The fact that the trust is revocable is the crux of whether it is subject to state or federal taxes. Because the trust can be changed, it is usually considered part of an estate, and therefore taxable.

While the donor is still alive, he or she must report on and pay income taxes on the contents of the trust. In the eyes of the government, the assets are still treated as if they are still under ownership of the settlor. In the event the donor and the trustee are not the same person, the settlor is still responsible for monitoring, reporting, and paying such taxes. The trustee is not.

Some states impose gift taxes on assets. In a revocable or living trust, assets are not subject to such taxes. They are, instead, considered part of the trustor’s estate. That means the contents of the trust are indeed subject to estate taxes.

Role of Estate Taxes in Living Trusts

The Internal Revenue Service defines an estate tax as “a tax on your right to transfer property at your death.” Estate taxes used to be quite heavy and administered on real estate and other assets upon transference to beneficiaries. But in beginning in 2017, a personal exemption permitted a certain amount of money or fair market value of property to be transferred tax-free.

As of 2018, people can inherit assets tax-free up to the amount of $11.2 million dollars. For married couples, the amount is $22.4 million. This amount will match the rate of inflation in 2019 and beyond. In the event the value of the estate is over the limit, a tax rate of at least 40% will apply. Assets left to spouses who are American citizens or to charities also transfer unburdened by taxes.

While this relieves the federal estate tax burden on all but a tiny portion of American citizens, certain states may still have estate tax laws in place. Income taxes, on the other hand, still need to be paid on any income the settlor accumulated in the year he or she died. The contents of the trust can be used for this purpose.

For the most part, a will and a living trust are interchangeable when it comes to avoiding estate taxes. This brings us back to probate:  If the legal validity of a will is in question, it becomes subject to the probate process. This is especially true if a potential beneficiary decides to contest its terms and cannot come to an agreement with those who the will names. And probate can quickly become expensive. So if a donor’s goal is to pass on as much of an estate as possible, establishing a living trust in addition to a traditional will is a good idea.

Anyone who set up a living trust before these new tax laws were enacted should consult with an attorney, to ensure their trusts are responsibly constructed.

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