Can leaving amounts in trust for your loved ones save income taxes? Yes, it can.
Generally, there are two ways that you can leave your inheritance to your loved ones. The most common method is an outright distribution. Your will reads something like this: “Upon my death I leave the remainder of my estate to my son John, outright and free of trust.”
The second method is to create a testamentary (after death) trust for your loved one’s benefit. Here, your will reads something like this: “I leave the remainder of my estate in trust for the benefit of my son, John, subject to the following terms and conditions…”
Many clients are predisposed to leaving amounts outright since it is simple. “I don’t want any complications,” they might say. Another objection is that “I don’t want my son John to go begging to a trustee for his inheritance.” Often this concern is a product of a bad family experience where amounts were left in trust for a bank or brokerage firm to manage.
You do have the ability to leave amounts in trust for your loved ones, and they can serve as their own trustee. “I leave amounts in trust for the benefit of my son John. John shall serve as the trustee of his trust share.” This is perfectly legal. John won’t have to beg a bank or trust company for distributions since he is in charge and he determines the distributions, even to himself. So how does this save income taxes?
By creating a “sprinkle trust.”
A sprinkle trust is one that benefits more than one beneficiary. The trustee has the power to sprinkle the income by and amongst a group. As an example, assume that your son John has two children, Frank and Linda. You can direct your attorney to create a sprinkle trust that primarily benefits John, as his needs should be first considered, then in the trustee’s sole and absolute discretion income (or principal) can be sprinkled amongst Frank and Linda (or any other descendants of John).
Since John serves as his own trustee, he is the one to decide whether he takes the income for himself, or whether he wants to sprinkle that income to Frank and Linda. Assume that Frank needs $30,000 for a down payment on his first home purchase. If John wanted to gift the money to Frank, which exceeds the $14,000 annual gift tax free exclusion, John would presumably have to file a gift tax return for the excess ($16,000) and reduce his lifetime exemption from gift and estate taxes.
Instead, John could sprinkle $30,000 of the trust income that year to Frank. Since it is a direct distribution of income to Frank, he will pay the income tax associated with that distribution. Assume that Frank is in a lower income tax bracket than John. What’s happened? Well, the income that would have been taxed to John at his higher rate doesn’t happen; instead the income is taxed to Frank at Frank’s lower rate. There is no taxable gift as well. The family has achieved its goals while minimizing income and gift taxes.
The next year John can continue to send to himself all of the income. He can choose who should receive what income distributions annually since John is the trustee. If he wanted to “even things out” and send Linda a corresponding $30,000 of income the next year, he is free to do so.
As far as the “complications” argument, there really aren’t complications. The trust assets are segregated in separate accounts using a separate tax identification number. So long as the trust distributes all of its income annually there will be no tax paid by the trust, rather the income tax is paid by the beneficiary who receives the income. A 1041 must be filed, but in this scenario the return is a rather simple one.
If John had inherited the money as an outright distribution, none of the tax savings would have been possible. This is just one of the many benefits of leaving assets in trust for your loved ones as opposed to outright distributions.
Testamentary trusts can be drafted any number of ways. Further, there are certain words that you would want to include ensuring that the amounts you leave to your loved ones aren’t estate taxed in their estates when they die. So do meet with your estate planning attorney to discuss the details of what you would like to achieve before acting.