Irrevocable Trusts are generally created in order to obtain tax &/or asset protection benefits while extending some control over property placed in the trust. But if the Settlor refuses to give up the economic benefit & control of the property, the law will likely not allow the Settlor to escape taxes on the property & the Settlor’s creditors may still be able to reach the assets.
The transfer tax system includes the estate taxes, gift taxes & generation-skipping transfer taxes. All of these taxes highly favor transfers by gift, including gifts made during lifetime to an irrevocable trust, rather than transfers made at death such as through a revocable or “living” trust.
Potential advantages of gifts include the annual exclusion of gifts up to $15,000 per recipient & “valuation freezing” (meaning that the gifts may be taxed at their value at the time, even if the asset appreciates or produces further income). The “$10 million” transfer-tax exemption excludes estate taxes for lifetime & death transfers up to $11.58 million as of 2020.
Tax savings strategies are also implemented with certain irrevocable trusts, such as qualified personal residence trusts, special needs trusts, grantor retained annuity trusts & charitable remainder trusts. Tax consequences of irrevocable trust may be highly unfavorable if proper car is not taken in setting up & properly maintaining a trust. For example, if a trust has both generation-skip & non-skip beneficiaries (such as children & grandchildren), a gift tax return must be filed to allocate the exemption, or a GST tax may result, even on relatively small gifts.
Taxation of Trust Income
Income of a trust is generally taxable to the Settlor, so long as the Settlor or Settlor’s spouse retain any right to receive economic benefits from the trust or retains significant ability to control the trust.
If such benefits are not retained, the trust income may be taxable to the beneficiary if the beneficiary has significant control over the trust.
If neither the Settlor nor beneficiary has the required benefits or control, the trust income is taxable to the trust itself unless the income is distributed.
Trusts can provide income tax savings where the trust enables income to be deferred or or assessed to a taxpayer in a lower tax bracket. Use of trusts to shift taxes to persons in lower tax brackets is limited by the “kiddie tax” enabled in the Tax Cuts & Jobs Act, & when done improperly can result in punitive taxes. Disastrous scenarios can also occurs when multiple jurisdictions each contend that they are owed taxes on the same income of a trust.
Asset Protection Trusts
Starting with Alaska in 1997, approximately 18 states have now enacted statutes allowing the formation of Self Settled Asset Protection Trusts.
Some of the important benefits of utilizing American-based jurisdictions for asset protection trusts are:
- the high costs of administering trusts in foreign jurisdictions;
- the possibility that foreign jurisdictions that have may negatively change their attitudes toward trusts that have been established from overseas; &
- complicated taxation issues.