A revocable trust, or its more popular name a “Living Trust”, is an increasingly popular estate planning tool. The Living Trust serves many useful purposes, but many people are told that one purpose is to reduce taxes. This is not true. A Revocable Trust does not reduce income taxes, estate taxes, gift taxes, generation skipping taxes or inheritance taxes. In short, there is no tax advantage gained by a Living Trust. If someone is trying to sell you on the idea of forming a Revocable Trust based on tax savings, run away!
Some trusts do create various tax benefits. So why does a Living Trust provide no tax benefit?
In most revocable trusts the grantor (the person who forms the trust), is also the beneficiary. The grantor then transfers assets into the Living Trust, such as real property, liquid assets, CDs and bank accounts. After the grantor’s death, the trust serves the function of a will by disposing of the trust assets as the grantor determined. These trusts are “revocable trusts” because during the grantor’s life the trust expressly reserves in the grantor the power to revoke, terminate, alter, or amend the trust, whether or not this power can be exercised alone or with another person.
During the grantor’s life, the primary tax consideration for a revocable trust is the income generated by the trust. Internal Revenue Code (IRC) § 676 considers the assets of a revocable trust to be “owned” by the grantor for income tax purposes because the grantor has the power to revoke the trust. As such, any income generated during the trust is reported under the grantor’s Social Security number on the grantor’s personal income tax return. The IRS considers a revocable trust to be a “grantor trust” for tax purposes if the grantor has the power to revoke the trust and revest the trust assets (income, principal, or both) in himself. The power to revoke still invokes grantor trust status even if the grantor must exercise this power in conjunction with another person (such as a trustee), unless that other person is an adverse party. IRC Section 672(a) defines an adverse party as someone who (1) has a “substantial beneficial interest” in the trust, including a power of appointment over trust assets, and (2) where the beneficial interest would be adversely affected by the exercise or nonexercise of the power to revoke. Unless the grantor’s power to revoke the trust can only be exercised with the consent of an adverse party, any income generated by the revocable trust during the grantor’s life will be reported on the grantor’s personal income tax return.
A revocable trust becomes irrevocable upon the grantor’s death, so the power to revoke can no longer be exercised. Any income generated by the trust after the grantor’s death must still be reported to the IRS, but now this income is attributable directly to the trust, and will be reported under the trust’s tax identification number.
Additionally, the death of the grantor triggers the question of whether or not the trust assets are included in the grantor’s gross estate for estate tax purposes. IRC Section 2038 holds that a decedent’s gross estate includes the value of any trust holding assets transferred into the trust by the decedent during life if the decedent had the power to revoke the trust at the time of death. This means that as long as the grantor could revoke the trust up until the moment of death (even if the grantor never exercised this power), the trust assets will be included in the grantor’s gross estate. In the cases of property held jointly between the trust and another person, IRC § 2040(a) holds that the entire value of the property is includable in the decedent’s gross estate if the property is owned jointly with the right of survivorship. For property that is held as tenants in common, IRC Regulations § 20.2040-1(b) holds that only one-half of the value of the property is included in the gross estate upon the grantor’s death.
Revocable Trusts/Living Trusts serve many useful purposes, but income tax, estate tax or inheritance tax reduction is not included on the list.
Throughout our website, klenklaw.com, you may find more information about Revocable Trusts, Living Trusts and many other estate planning tools. Our firm focuses exclusively in the area of estate planning, probate, and the litigation surrounding estate planning and probate including Will Contests and Will Challenges. If you have a Revocable Trust question, please call one of our Experienced Estate Planning Lawyers for a free consultation. We practice throughout New Jersey, Pennsylvania, New York, Minnesota and Florida.