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Tax consequences of irrevocable trusts create confusion

March 20, 2012 | 12:45 PM
This is tax season and as an estate planning/elder law attorney, I spend a lot of time discussing the tax implications of irrevocable trusts. Since trusts typically pay a compressed rate of tax, it is beneficial for clients to pay income taxes at their individual rate. The way to accomplish this favorable tax treatment is to create a trust that adheres to the Grantor Trust Rules in the IRS Code.

Most irrevocable trusts that protect assets from the cost of long-term care are structured as grantor trusts and, as a consequence, the income earned in the trust is reported on the grantor's tax return and taxed at the lower individual tax rate.

For instance, consider an elder law client who creates an irrevocable income-only trust in which he transfers his home and $200,000 in stocks and bonds. The client may also transfer other assets, like bank accounts, other real estate and annuities to the trust as part of his asset protection plan. For Medicaid eligibility purposes, the trust protects the assets and the transfer to the trust does not make him ineligible after five years. While there may be some variations, in the typical situation, the grantor retains the right to live at the premises and collect all of the income from the trust. If the trust assets are stocks, then he receives the dividends. If the trust owns bank accounts then he receives interest earned. If the trust owns rental property then he receives net income. Upon the grantor's death, the property transfers to his heirs

The question is who pays the income tax on the trust earnings. If the trust is structured as a grantor trust, the income is taxed to the client at his individual rate. In order to achieve this favorable tax treatment, the trust must conform to the Grantor Trust Rules.

The Grantor Trust Rules are provisions in the IRS tax code that allow the trust entity to be disregarded for income tax or estate tax purposes. In many instances, this is a good thing. Then tax season is upon us and I receive calls from the client, his financial advisor or his accountant advising that a separate tax return must be filed for the new trust and that the trust will pay a much higher rate of income tax.

The confusion is the result of the word "irrevocable." Most accountants and financial advisors consider an irrevocable trust to be a separate entity. However, the Grantor Trust Rules, if they apply, ignore the trust as a separate entity and all of the income tax implications are reported on the settler's individual income tax return. Furthermore, if the irrevocable trust owns real property, the grantor will report the sale on his individual return and may apply his or her $250,000 capital gains exemption.

The Grantor Trust Rules are found in the IRS Code. If properly drafted, the irrevocable trust for Medicaid purposes will satisfy the grantor trust requirements. In addition to paying income tax at the lower individual rate, the assets in the trust will receive a step up in basis at the grantor's death. In other words, the grantor's heirs will most likely avoid paying capital gains tax on inherited property that may have appreciated during the grantor's life.

However, not all irrevocable trusts are grantor trusts. There are some instances where an irrevocable trust is created for the specific purpose of transferring the assets out of the grantor's estate. One example of a nongrantor irrevocable trust is the insurance trust. Many clients do not know that life insurance is taxable in the insured's estate if the insured retains any ownership rights. It is common for highly insured clients to transfer their life insurance policies to an irrevocable insurance trust and give up all rights of ownership.

If done properly, the insurance proceeds will avoid estate taxes at death. This income tax consequence of the irrevocable insurance trust is often confused with the Medicaid qualifying trust. While both trusts are irrevocable, they are designed for different purposes and if drafted well, they are taxed very differently. If the insurance trust has cash assets, they will be taxed at the compressed tax rate.

Other irrevocable trusts, such as qualified personal resident trusts (QPRTs) and intentionally defective grantor trusts (IDGTs), are used to reduce estate taxes as well. The estate tax savings can be significant. However, the savings realized in the estate tax arena must be measured against any potential capital gains tax incurred once the beneficiaries receive the assets. If you have an irrevocable trust, make sure you discuss the tax implications before transferring assets. Not all irrevocable trusts are the same.

Nancy Burner, Esq. has practiced elder law and estate planning for 15 years. The opinions of columnists are their own. They do not speak for the paper.

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