Taxation on Wills and Beneficiaries

Taxation of wills and beneficiaries of wills is dependent on state and federal tax law within ones country of primary residence. In the United States, beneficiaries of wills are potentially subject to estate tax, inheritance tax, probate court proceedings, and income tax depending on the value of assets, existence of trusts and types of financial instruments within an estate.

Estate tax is higher than income tax and does not eliminate the requirement of income tax on inherited assets, nor does it eliminate taxation of the deceased via inheritance tax i.e. income tax for the dead. These multiple layers of taxation can potentially cause taxation levels in excess of 80%. For this reason, considering tax related options concerning taxation on will related matters and their beneficiaries is an important element of financial planning.

Ways to reduce beneficiary taxation

In light of the potential for estate, income and inheritance tax a few financial instruments and tax planning techniques can be utilized to minimize and avoid potential and existent taxation of assets passed on to heirs and/or beneficiaries. A few of these tax hedging facts and methods are illustrated below.

• Estate tax limits: Estate tax is applicable only to estates valued between $1 million and $3.5 million depending on the year. The elimination or re-evaluation of estate tax is a matter of political decision and may be best considered as a possible scenario in financial planning.

• Life insurance trusts: Assets held within a life insurance trust are exempt from estate valuation and therefore can serve as a useful hedge against possible estate taxation.

• AB Trusts: AB trusts, unlike living trusts are the property of trust managers with rights to the assets passed on to beneficiaries including spouse and children. Due to the structure of AB trusts, assets held within them are not subject to estate tax.

• Charitable lead and Charitable remainder Trusts: These two types of trusts reduce taxable inheritance, possibly to the point of falling below the taxable estate value limit. These trusts also allow capital gains avoidance, annuity receipt of funds and beneficiary revocation despite the trusts being irrevocable.

• Marital deduction of IRA's: A stipulation with regulation of individual retirement accounts makes possible the deferment of taxation of IRA distributions and inherited value until the death of the beneficiary spouse. This means that if the income is 1) paid in the form of annuity and 2) Is not fully claimed before the death of the IRA owners spouses/beneficiary then taxation of the IRA will be limited and/or reduced. This marital deduction may be facilitated through the rolling over of IRA's. (unclefed.com). The rules regarding this are quite involved and may require the assistance of a financial planner, accountant or attorney.

• Income tax of inheritance: If a beneficiary receives inheritance outside of a tax protected annuity or financial instrument, that inheritance will become subject to income tax. This can be especially costly especially after an estate tax is imposed. For this reason, planning for receipt of inheritance in the form of annuity payments can potentially lower taxation of income.

• Inheritance tax: Inheritance tax is the taxation of the deceased persons estate. Not all states are subject to the inheritance tax, Rhode Island being one such state. However, for residents of other states avoiding the inheritance tax can be assisted via establishment of specific types of trusts that transfer "ownership" of assets but not rights of beneficiaries to the assets and reduction of estate value via annual gift reductions.

• Additional exemptions: To further lower estate value, an estate may be reduced in value by up to $1 million via gift exemption and $2 million for "generational pass over" of beneficiaries. (Themoneyalert.com) An estate tax schedule based on income amount and taxable year is included with the references to this article.

Summary

Taxation of assets referred to in wills, within estates and after death have the potential to be very large due to the multiple types of taxation imposed on the deceased, the estate of the deceased and the beneficiaries of the deceased. Financial planning for such taxes can be a very good idea especially in cases where the asset value of an estate is above $1 million dollars or more. The techniques in this article are not exhaustive of all the possibilities for tax planning and do no replace the advice of an accountant or lawyer but serve as a guide to the potential taxation of willed assets and ways in which that taxation can be reduced.

Sources:

1. http://www.smartmoney.com/tax/homefamily/index.cfm?story=estatetax
2. http://www.nolo.com/article.cfm/objectId/426FB79B-AC11-432F-9E3204F6BAAC7FFD/309/227/QNA/
3. http://www.savewealth.com/planning/estate/charitabletrusts/
4. http://www.unclefed.com/AuthorsRow/TaxBusProf/ira.html
5. http://query.nytimes.com/gst/abstract.html?res=9B03E2D71430E733A25753C1A9679C946397D6CF
6. http://soundmoneytips.com/article/2777-tip-for-avoiding-inheritance-tax
7. http://www.nber.org/reporter/spring06/kopczuk.html
8. http://www.forbes.com/2000/12/08/1208finance.html
9. http://www.hoaglandlongo.com/practices/Federal_and_State_Tax_Planning.cfm

How to Create a Living Trust

A living trust is a legal document that serves several purposes in the event of death of the primary trustee and concerns the assets of that person. Living trusts may be revocable or irrevocable, and each type has different legal protections, and functions. Depending on where the living trust is created, the effectiveness and creation of the document may have different requirements. This article will discuss the creation of living trusts in terms of its purpose, process and type. 

How to create a living trust

A living trust must be created in accordance with State law and therefore is ideally created by a lawyer licensed to practice law in that State. There are online legal services that allow state trusts to be customized online, one such example being lawyers.com. that offer 1 free legal document to first time users and/or within the free trial period of 30 days. There are several considerations and elements within a living trust that should be included in the document and defined before its creation. 

1. Define the purpose of a living trust 

There are many purposes for living trusts, therefore defining the purpose will aid in choosing the correct type of trust for that purpose. For example, in a generational skipping trust, assets are passed onto grandchildren rather than children in the event of death of the grantor or primary trustee. A more complete list if trusts can be found at livingtrustnetwork.com. 

2. Locate a reliable living trust creator 

Since living trusts can be complex especially in the case of large estates that will be divided in several ways, consulting a licensed trust attorney in one's state of permanent residence can be helpful. When choosing a source for the living trust be sure to ascertain the validity of the living trust by confirming the following details:

• State(s) of effectiveness

• Compliance with State laws and/or regulation
• Appropriateness of trust to individual and/or family goals
• Proper terminology and listing of beneficiary, trustees and assets 

3. Write the trust 

When the living trust is written it will include several items and will likely need to be notarized to become effective. Notarization may be performed by a licensed notary within an attorney's office or independently at an external licensed notary such as a bank notary. Some typical elements included in a trust are listed below.

• Type of trust i.e. revocable or irrevocable

• Sub-type of trust i.e. A/B trust
• Primary trustee/Grantor's name
• Secondary trustee(s) name(s)
• Asset list
• Distribution terms and allocation amounts 

4. Transfer chosen assets into the living trust 

After the living trust is completed, an additional step of signing over assets to the trust is necessary to avoid legal complication. This means ownership of all assets within the trust must become part of the trust. For example, a home's title deed can be signed over to the trust, bank accounts can be changed to list the trust as the owner etc. There may or may not be filing fees for some of the reclassification of assets. 

The purpose of living trusts 

Living trusts serve several purposes as made evident by the many types of living trusts available. Essentially, living trusts are created by living persons to pre-determine who will distribute assets after the death of the primary trustee and how it will be done. Living trusts provide legal protection to the passage of ownership after death of the grantor.

• Allows beneficiaries and/or trustees to avoid probate court

• Makes possible non-taxation of transferred funds if a trust company is owned by the trust
• Assigns a fund executor to carry out the provisions set forth in the living trust
• Defines how assets are distributed, to who they will be distributed and by whom
• Creates a legal entitlement to assets 

Types of living trusts 

There are two primary types of living trusts, revocable and irrevocable. These types of trusts are distinguished by their ability to reverse decisions set forth by the initial trust. For example, in a revocable living trust, trustees can be removed or added whereas in an irrevocable living trust, this is not the case.

In addition to these two primary trusts are several sub-types of living trusts that include the following according to livingtrustnetwork.com of the following trust sub-types determine how assets are used, allocated and treated when the terms and instructions of the living trust are implemented.

• A/B Trusts

• Asset protection trusts
• By-pass trusts
• Charitable trusts
• Generation skipping trusts
• Grantor trusts
• Life insurance trusts

Summary

Creating a living trust can be done relatively easily but takes a few important considerations regarding the distribution of one's assets after death. These types of trusts come in several types as outlined above and are ideally prepared by an attorney familiar with and skilled in the creation of such documents.

To create less expensive living trusts, online legal trusts may be obtained through state specific documents available through websites such as lawyers.com. When the purpose and use of the trust is defined, the document is then customized, signed by the relevant parties such as the grantor and trustees and then assets are legally reassigned to the trusts ownership.

Sources:
1. http://trusts-estates.lawyers.com/State-Living-Trust-Forms.html
2.http://livingtrustnetwork.com/revocable-living-trusts/types-of-trusts.html

Filing taxes on revocable living trusts

Income earned through and distributed from a revocable living trust is taxable and may be taxed at higher amounts than regular income if income is reported on an IRS form 1041. Revocable living trusts are legal documents that define heirs and trustees of a person's assets in the event of death. These documents can be changed to remove, add or adjust heirs, trustees, and terms of distribution during the life of the primary trustee who is the creator of the trust. The purpose of a living trust is to avoid the lengthy probate court process after the death of a loved one.

Taxation of trust income during life of the trustee

The Internal Revenue Service considers revocable living trusts to be a "grantor trust" because the primary trustee i.e. the owner and creator has the ability to retain, recall and revoke the trust. Income earned from these trusts during the life of the primary trustee is taxable as income and reportable through an IRS form 1041. The form 1041 instructions and guidelines for reporting income in a revocable living trust can be found through the U.S. Internal Revenue Service. Depending on the type of assets held within a trust, different tax forms and procedures may be necessary.

To illustrate the above, charitable contributions made through a trust are reported on Schedule A of the form 1041. The form 1041 instructions published by the U.S. internal revenue service indicate higher taxation rates on income earned through a living trust than through a normal taxable income. For example, income over $10.450 is taxable at a rate of 35% , any amount under which is taxable at 25.8%. The same amount of income taxed as regular income would be taxable at a 15% rate , $7550.00 of which is currently taxable at 10%.

Taxation of trust distributions after death of primary trustee

Once the secondary trustee has distributed trust funds to beneficiaries listed in the revocable living trust, the assets, assuming no liabilities, become taxable as estate property. To be taxable as an estate, the value of the trust must exceed a government determined minimum amount, which is currently over $1million.

If, after the death of the primary trustee, income is still generated within the trust before distribution of the assets within the trust takes place, the trust is taxable as income i.e. tax filings for the deceases must be filed and any taxes due will be paid for either from assets within the trust or from assets within the deceased's estate.

Tax avoidance, and tax fraud in revocable living trusts

According to the U.S. Internal Revenue Service, income within a revocable trust may be "distributed to other trusts so long as they are named as beneficiaries within the trust". In other words, to lower taxable income of a trust, the income can be spread around to a life insurance trust or an AB Trust. What is not considered legal by the IRS is the illegitimate reduction of trust income through false expense deductions.

Legitimate ways to lower taxation of living trusts include the above, optional tax reporting methods that do not use a form 1041 and selective allocation of assets within the trust. Since the primary trustee can amend revocable living trusts at any time, assets potentially subject to higher taxation can be added at later times to avoid potential higher taxation if a form 1041 is filed.

Revocable living trust tax tips

The use of a revocable living trust may be a good legal strategy but in terms of taxation, these types of "legal entities" may be best left to later years since the assets within a revocable living trust may be taxable at a higher rate than if they were in another financial instrument. A few tips one might consider before and after establishing a revocable living trust are the following:

• Consider alternative trusts: Trusts such as Life Insurance trusts can allow income to grow tax deferred and in the case of estate beneficiaries tax free.

• State Probate Law: Since revocable living trusts are used primarily to avoid probate and to increase privacy of beneficiaries, being familiar with the applicable state law may reveal certain advantages or legal mechanisms that exist within the probate process.

• Trust Assets: Certain assets within a revocable living trust may not incur income on an annual basis and/or provide negligible tax deductions to normal income. Such assets may be placed in a revocable living trust without disproportionate tax losses. Example of such assets may include jewelry, and art.

• Form 1041 Instructions: Become familiar with the tax consequences and preparation time associated with having a revocable living trust. If a revocable living trust must be used, consider optional filing methods.

• Estate Planning Professionals: Consulting with an estate planning professional, whether it be a financial planner, accountant or lawyer may be prudent especially in cases of large estates.

Summary

Revocable living trusts are subject to similar if not higher taxation than regular income unless income within the trust is re-distributed to not taxable trusts. To file taxes on revocable living trust income, an IRS form 1041 can be used, however the tax rates on income using this reporting method are higher. In light of this using an optional tax reporting method illustrated by the IRS may incur lower taxation.

Assets held within a revocable living trust become taxable as an estate after the death of the death and distribution of the trust owner(s) and may still incur regular income taxes if the trust earns income before assets have been distributed by the trustee(s). Becoming familiar with the purpose, techniques, benefits and disadvantages of revocable living trusts may assist one in appropriately reporting taxes as well as in the decision to list assets within such a trust.

Sources:

http://www.irs.gov/pub/irs-pdf/f1041.pdf
http://www.irs.gov/pub/irs-pdf/i1041.pdf
http://www.nysscpa.org/cpajournal/old/08770612.htm
http://www.irs.gov/instructions/i1041/ch01.html#d0e474
http://www.irs.gov/businesses/small/article/0,id=106538,00.html