One of the most common additions to a well thought out estate plan is a trust, due in large part to the fact that a trust can accomplish a wide range of estate planning goals. To know whether a trust could be a beneficial addition to your own estate plan, you need to understand your options and how each type of trust operates, as well as the various benefits each type of trust offers. For example, when irrevocable trusts sell assets, are capital gains taxes due, and if so, who pays the taxes?
Revocable vs. Irrevocable Trusts
A trust is a legal relationship in which property is held by one party for the benefit of another party. The person who creates a trust is referred to as the “Settlor”, “Trustor” or “Grantor.” The Trustor transfers property to a Trustee, appointed by the Trustor. The Trustee holds that property for the trust’s beneficiaries, invests trust assets, and administers the trust according to the terms created by the Trustor. Trusts fall into one of two categories – testamentary trusts or living trusts. A testamentary trust is created at the time of death by a provision in the Trustor’s Will. Because a testamentary trust is activated by a provision in the Trustor’s Will, and a Will can be revoked up to the time of the Testator’s death, a testamentary trust is always a revocable trust up to that point. A living trust is just that, it becomes effective while you are living once all formalities of creation are in place and the trust is funded. Living trusts can be divided into revocable and irrevocable living trusts.
Capital Gains Taxes
Capital gains taxes are paid when you realize a gain on the sale of an asset. If you purchased real property for $100,000 and sold it ten years later for $200,000, you would realize a gain of $100,000. Determining when capital gains taxes are due, how to calculate the gain upon which the tax is paid, and how much tax is due can be quite complicated because of the various factors involved and the complexity of the tax laws.
Irrevocable Trusts and Capital Gains Taxes
Whether or not capital gains taxes are due after the sale of a trust asset will depend on several factors, starting with the type of trust involved. If the trust is a revocable trust, the trust is not a separate tax entity during the lifetime of the Trustor and the Trustor retains ownership of the property held by the trust. If a trust asset is sold and triggers a capital gains tax obligation, that gain must be reported on the Trustor’s personal tax return.
Conversely, an irrevocable trust may or may not be a separate tax entity. If it is a “grantor” trust and continues to use your social security number as its tax identification number, then it is treated the same as a revocable trust. If it is a non-grantor trust, it is a separate tax entity and has its own taxpayer identification number. Once you transfer ownership of property into a non-grantor trust, you give up control and any opportunity to take the assets back. For this reason, gains or losses are not reported on the Trustor’s personal tax return. Unfortunately, that is not the end of the capital gains tax analysis. You must still consider what type of irrevocable trust is involved.
A simple irrevocable trust is required to disburse all income made by the trust every tax year. These disbursements are taxable to the beneficiaries as income. Some irrevocable trusts, however, are more complex and are permitted by law to retain income. This type of irrevocable trust may only distribute some of the income to the trust beneficiaries. Capital gains, however, are usually not treated as income by irrevocable trusts. Instead, capital gains are viewed as contributions to the principal. Consequently, if the trust sells an asset and realizes a gain, that gain would not be distributed and the trust would have to pay taxes on the gain as a profit to the trust.
Transfer to a Beneficiary
If an irrevocable trust distributes or transfers an asset to a beneficiary, instead of selling it and distributing the gain, the beneficiary becomes responsible for any taxes due. Although the initial distribution may not be taxable, capital gains taxes may become due if the beneficiary sells the asset down the road. In that case, the amount of capital gains tax due will have to be calculated, and you will need to know whether to use the basis (or value) of the asset at the time it was distributed to the beneficiary or at the time it was originally purchased.
Given the complex nature of irrevocable trusts and taxes, it is always best to consult with an experienced trust attorney before deciding what type of trust to create and what assets to fund into it.
Contact Oklahoma Trust Attorneys
For additional information, please join us for an upcoming FREE seminar. If you have questions or concerns regarding irrevocable trusts, contact the experienced Oklahoma and Kansas trust attorneys at Parman & Easterday by calling 405-843-6100 or 913-385-9400 to schedule your appointment today.