Irrevocable Trusts – Not as Frightening as You Might Think!: Part 3
For those who avoid irrevocable trusts because they worry about extra taxes, it is true that if you don’t set it up correctly a trust with earned income must file an income tax return. Earned income may include rental income, interest or dividends. However, if it is setup correctly; eg. if the spouses retain a limited power of appointment, they should not incur any increased tax liability as a result of establishing the trust.
A special power of appointment typically means that the grantor has special powers in the trust that do not affect its asset protection benefits. A special limited power of appointment is considered a grantor trust, which does not need to pay income taxes. The income flows through the trust to the grantors, or the husband and wife. They would pay taxes on trust income at the lower individual income tax rate rather than trust rates. In essence, the husband and wife would pay the same income tax that they paid prior to establishing the trust.
Potential Capital Gains Benefits
The estate inclusion also provides a significant tax benefit known as a step-up in basis for capital gains tax purposes. If a parent transfers an asset that has increased in value, the parent’s cost basis carries over to the child. That means, when the asset is eventually sold, the child will be assumed to have taken the asset at the same price as the parents and required to pay capitals gains taxes on the full increase in value. In our example with the Massachusetts couple, if the parents obtained their stock at $100,000 and transferred it as a gift to the children with a value of $500,000, the children are given a cost basis of $100,000. If they later sell the stock for $500,000, the children will realize and recognize a $400,000 capital gain, which translates to approximately $100,000 in federal capital gains tax liability.
Instead, if the parents transferred the stock to an irrevocable trust, the stock would be includible in the gross estate of the parents and given only a step-up in basis. The step-up in basis means the stock is valued as of the date of the parent’s death, not the time of purchase. If our parents put their home into an irrevocable trust with a fair market value of $500,000, the children’s cost basis is $500,000. Therefore, if the children sold the home soon after their parents’ deaths, there would be little or no capital gains to be taxed. As far as the children are concerned, this is a much more desirable outcome. This benefit is not available to individuals who transfer assets to their children as gifts.
In conclusion, the UltraTrust type of irrevocable trust is the only type of trust that allows parents to transfer assets in a manner that will provide protection from their creditors, including the costs of long-term care, and their children’s creditors (including ex-spouses) while allowing the parents to benefit from the assets comprising the trust during their lives. In addition, this trust provides some estate and income tax benefits for both the parents and their heirs. Therefore, the irrevocable trust is about as close as a couple can come to having their cake and eating it, too.