I get asked the question above on an almost weekly basis.  The short answer is that if you put your assets into a trust, you still get taxed.  A trust is not a magical way to avoid all taxes on assets, despite persistent myths to the contrary.  A trust can help to minimize taxes, but not eliminate taxes completely.

The IRS publishes a list of the “Dirty Dozen” tax scams each year.  These are easily identified ways that try to scam the tax system.  This year’s list includes the following: “Abusive tax structures including trusts…are sometimes used to avoid paying taxes. The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them.”

Years ago, I had a tax resolution client who was convinced that if they put all of their assets into a trust, they did not have to pay tax on any of the income generated by the assets.  By the time they came to me for help, they had accrued almost $500,000 in past due taxes, and the husband had severe Parkinson’s disease. This was not a good time to owe the IRS money, and they became very angry at me for not agreeing with them that taxes could be completely avoided by using a trust.  You don’t want to end up like those people, on the wrong side of the IRS!

Instead, I will talk today about how trusts can minimize taxes, depending on they type of tax involved, and how you may be able to accomplish your tax minimization goals without using a trust.  A trust can help reduce taxes, but reducing taxes should probably not be the primary reason to set up a trust, in most cases.

 

What Type of Tax Can a Trust Legally Avoid, Reduce, Minimize, or Eliminate?

The right type of trust can be set up to minimize estate taxes.  The current (2019) Federal estate tax limit is $11.4 Million per person, meaning that unless you have more than $11.4 Million, you will not be subject to the estate tax.  For married couples, who can transfer the $11.4 Million between the two individuals without penalty, the number is $22.8 Million.  This means that very few people will be subject to an estate tax. So, if you use a trust, you will likely not need to pay any estate tax, but you could also accomplish the same thing using just a will.

For those who have estates that exceed the $11.4 Million per person, or $22.8 Million, asset limit, there are ways to plan around those estate taxes using irrevocable trusts and other estate planning techniques.  These type of techniques exceed the scope of this blog, but if you have a taxable estate, please feel free to contact me, and we can discuss what you need to do.

 

Can I Avoid Income Tax by Using a Trust?

Income taxes are separate from estate taxes, and need to be treated separately.  If you put your assets into a trust, then income tax will be due on the income those assets inside the trust generate.  Such income tax may need to be taxed to the trust, or to the person who created the trust, depending on how a trust is structured.  A “grantor trust” is one where the IRS taxes income from the assets to the person who created the trust.  A “non-grantor” trust is one where the IRS taxes income to the trust itself.

Many people who have less than $11.4 Million dollars in their estate mistakenly believe that they will not need to pay any taxes when they die, and neither will those who inherit from them.  This is not true of most retirement accounts.  Retirement accounts like an IRA, 401(k), 403(b), and other tax advantaged accounts can be passed on to beneficiaries of a trust, but if they are passed on to trust beneficiaries, those types of accounts are still subject to income taxes.

Retirement accounts like this were most likely tax advantaged when the money was put into them, meaning that you got a break on your taxes when you put money into the trust; or got a tax discount by not needing to pay taxes at the time you earned the money because you saved the money for retirement.  You also did not pay taxes on the money when it grew inside the retirement account. But, you will pay taxes on the money when you pull it out. If you pull the money out, you will pay taxes on that money.

If you leave retirement accounts to your heirs inside of a trust, you may end up getting taxed on all of the money as it goes into the trust from your retirement account.  Careful planning with a trust can create an IRA Stretch Trust to avoid taxes when the retirement account pays out to the trust, and when the beneficiaries pull money out of the retirement account.  Nobody wants to pay taxes twice, but you can avoid double taxation with correct planning. The structure of the trust dictates how this works.

If you use a trust to accomplish this type of planning, you can make a good financial decision for your beneficiaries by dictating how they can inherit retirement accounts.  However, you may also be able to accomplish the same result by just using an inherited IRA, without a trust.  Minimizing income taxes on retirement accounts is a good thing to do in a trust, but it can be accomplished without a trust.

 

Can I Avoid Capital Gains Tax by Using a Trust?

I get asked if a trust can avoid capital gains tax all the time.  Capital gains taxes are a type of tax on income from selling capital assets, so a trust cannot simply eliminate capital gains just by putting assets into a trust.  However, you can minimize capital gains for the beneficiaries of a trust, if the trust is properly structured.

If the person who creates the trust has the ability to control the property, then the asset inside of the trust can get what is known as a stepped-up basis at the death of the person who created the trust.  The sale of a capital asset is taxed when the asset is sold, and the tax is calculated on the gain only, the difference between what you sell an asset for and what you paid for it.  What you paid for an asset is called basis.

A stepped up basis means that an asset will be inherited for the value it has when the person who created the trust dies.  As an example: if a person buys stock for $10,000 and it is worth $100,000 when they die, the beneficiary of a trust inherits the stock worth $100,000.  So, if the beneficiary sells the stock for $100,000 and inherited it worth $100,000, then the taxable gain is $100,000 – $100,000 = $0, so no capital gains tax is due.  This works for capital assets like stocks, real estate, bonds, and other similar types of assets.

Some assets are treated differently and do not get stepped up basis, like annuities, so you want to check with your financial and tax advisor when setting up a trust to minimize capital gains taxes.  You also may be able to accomplish the same tax planning for income and capital gains tax as an individual, without needing a trust.

 

What Type of Trust Can Avoid Taxes?

As described above, no trust can avoid all taxes.  A trust can be helpful in minimizing taxes, but that generally should not be the only motivation for creating a trust.  Even minimizing taxes taxes careful planning to make sure the taxes are minimized and do not run afoul of the IRS rules.  Planning to minimize income taxes requires careful attention to the IRS rules and careful drafting of trust language to fit within those rules.  You want to work with someone who knows how to draft trusts to work within the IRS rules, and structure the trust properly. To make an appointment to talk with an attorney who knows how to do that, please go here.