When you have a trust, it’s important to understand how trusts are taxed. When you receive distributions from a trust, it’s equally important to know if the distributions are subject to tax. Trusts pay taxes in some situations, and some trust taxation laws have changed with the implementation of the Tax Cuts and Jobs Act. Here’s what you need to know about how trusts are taxed in 2019:

Different types of trusts are taxed differently

There are many different types of trusts. With the many different types of trusts come many different ways that trusts are taxed. When you start to learn about trusts and taxation, it’s critical to remember that each kind of trust has its own unique rules for taxation. If you create a trust or receive distributions for a trust, it’s important to get personalized, professional advice about the taxation of the trust. Likewise, if you’re considering creating a trust, it’s important to speak with a qualified professional about the tax implications of the trust.

Revocable and irrevocable trust taxation

The most basic way to understand trusts and taxes is to separate trusts into two categories – revocable trusts and irrevocable trusts. In a revocable trust, the grantor still owns the property in a trust. In an irrevocable trust, the property becomes a separate legal entity. In an irrevocable trust, the grantor no longer owns the property in the trust.

Trust taxes and revocable trusts

When a trust beneficiary funds their own trust and maintains control over the trust, the income from the trust is reported on the tax returns of the beneficiary. In a case of a revocable trust, the taxes pass through to the beneficiary’s tax return. There’s no separate tax return for the individual to file. In the case of a revocable trust, the taxes are carried over to the grantor’s individual tax return. The trustee uses Form 1041 – U.S. Income Tax Return for Estates and Trusts, but the taxes pass through to the grantor’s tax return.

Trust taxes and irrevocable trusts

For an irrevocable trust, the trust files its own tax return. The trustee must report all income even if the beneficiaries receive the income. Distributions that the trust makes to the beneficiaries are deductible from income that is subject to tax in the trust. The trust itself must pay taxes that it owes on income. Likewise, the individuals who receive distributions must pay taxes on the distributions. The trustee uses Schedule K-1 in order to detail payments to the beneficiaries so that the trustee, beneficiaries and the IRS are all on the same page about payments to beneficiaries and who owes taxes on the trust income. Beneficiaries pay different tax rates on different types of income like interest, dividends and capital gains.

Trust distribution classification for simple and complex trusts

A trust is a simple trust if it distributes all of its income to the beneficiaries. A trust is complex if it may not distribute all of its income to the beneficiary. When a trust is complex, distributions to the beneficiary come from the current year’s income and then from the trust’s principal assets. The distribution loses its character as income or principal upon distribution to the beneficiary.

Trust taxation and the Tax Cuts and Jobs Act

The 2018 Tax Cuts and Jobs Act brought significant changes to all income taxes including taxation of trusts. The law creates new tax brackets for trusts. There’s one set of tax brackets for income from a trust and another set of tax brackets for capital gains and qualified dividends.

The biggest difference between the two sets of tax brackets is that income tax has a much higher top tax rate than the top tax rate for capital gains and dividends. Income over $12,500 is taxed at a rate of 37 percent while capital gains and qualified dividends over $12,700 are taxed at a rate of only 20 percent. The difference is likely to keep taxes on capital gains in trusts in line with capital gains taxes for assets that are not kept in trust.

In addition to changes in tax rates, there are also rule changes that mimic the changes for non-trust assets. For example, state and local real estate and personal property tax deductions are limited to $10,000 per year. The rule doesn’t apply to taxes that come from a trust conducting business activities. In addition, a trust may no longer deduct investment fees and expenses or unreimbursed business expenses.

The net result is that taxes for many trusts are going to be higher than they would have been before the Tax Cuts and Jobs Act. However, a trust can still be an appropriate and financially beneficial legal and financial tool in many circumstances. Unless lawmakers extend the tax laws or make changes, the trust tax laws created by the Tax Cuts and Jobs Act expire in 2025.

But I thought the whole point of a trust is to avoid taxes!

You may have heard that creating a trust is an efficient way to avoid taxes. It’s true that a trust can be a good way to avoid inheritance taxes. As a way to transfer wealth from one generation to the next, a trust is an efficient way to shield assets from hefty estate taxes. However, a trust isn’t a way to avoid paying income, capital gains or dividend taxes. Beneficiaries of a trust can expect to still have these tax obligations when they benefit from a trust.

Understanding trust taxation

Taxation of trusts is complex. How a trust is taxed depends highly on the characteristics of each particular trust. If you’re involved in a trust as a trustee or beneficiary, it’s critical to understand the tax implications and obligations that go along with your role in the trust. It’s important to understand that taxation of trusts is not created equally. You must understand the type of trust and the types of income that you have in order to correctly determine how your trust is subject to tax.

Even though trust taxation may seem overwhelming, trusts are still critical and valuable financial management tools in many circumstances. An experienced trusts attorney can help you determine whether a trust is right for you. At Wilson Ratledge, we can advise you on the best course of action taking into account the legal and tax implications of a trust created for your unique situation.

With tax day 2019 coming up, the last thing you want to think about is an IRS notice telling you there’s a problem with your filing. Usually, when you get one of these notices, it’s because the numbers in your return don’t match what the IRS has calculated on their end, and that will occasionally result in an audit.

While tax avoidance within the guidelines is legal and acceptable, premeditated tax evasion is illegal when the Internal Revenue Service can provide sufficient evidence to press a case strongly. And when they do, they are serious. Very serious.

This leaves the audited delinquent taxpayer in a very precarious situation, to say the least, and the only recourse is to either pay up in full or retain an experienced tax attorney who understands how a tax lien can impact their estate. Here are a few steps that anyone being audited should consider.

Negotiating a Reduction During the Audit

The first step in stopping a potential tax lien is discussing the issue with the Internal Revenue Service agent during the audit. However, this should only be done with experienced legal counsel who can help mediate the discussion and evaluate the government claims based on existing tax laws. There is no code in the federal law statutes quite as extensive as the tax code, and the IRS has wide latitude when selecting a rule to apply.

Sometimes, those rules are technical and do not account for common mistakes, but sometimes minor differences could be negotiated away when the agent sees an opportunity to actually collect a significant portion of the delinquent amount in short order and settle the account quickly. This happens more often than taxpayers realize when they are honest about their return.

Bargain for an Installment Agreement

Installment agreements are a common method of settling a tax liability. An installment agreement allows the tax bill to be paid over an agreed-upon amount of time, which can work well for tax levies of under $25,000, because tax liens are not typically filed below the $25,000 threshold. However, taxes beyond the threshold can result in certain property being placed in lien and cause other issues with your estate.

Submit an Offer in Compromise

An offer in compromise, also known as an OIC, is a common method that many couples use when their tax debt is of any amount, but the delinquent taxpayer must prove they are qualified for this agreement. It is important to note that nearly two-thirds of all OIC submissions are denied. But, it can be a good faith step in getting a classification from the IRS that a debt is collectible but does not rise to the level of a lien motion.

They could also determine the tax debt is not collectible. The primary difference in these two rulings is that payments can be made toward the debt, which can help when there may be extenuating tax problems in following years, or that nothing is required to be paid. However, outstanding tax obligations are always filed against a couple’s credit report and stay in place until the debt is satisfied.

Paying in Full

The best method of settling an IRS tax debt to avoid a lien is paying the debt in full in any way possible, including applying for a loan that could make the matter one of a personal budget. While this may not work for all people, this is actually what the Internal Revenue Service prefers. This will also stop any damage the tax debt may have regarding personal credit ratings as well as ending a tax lien possibility.

One thing is for certain when dealing with the Internal Revenue Service – not paying taxes can assuredly result in final outcomes that no one wants to face. It is always important to address the problem as a serious life event, including how long it may take to emerge from the debt in good financial condition. Having an experienced estate planning and tax attorney who has dealt with estate planning issues and tax liens before can be the difference in an acceptable outcome or a lingering financial problem.

When you consider your family’s financial planning needs, you may be surprised to learn that a trust may be the best option. A trust is a versatile family planning instrument. It can give you flexibility and control over your family finances. It can help you protect assets and ensure that assets are managed responsibly.

What are some scenarios where a trust is beneficial?

Here are seven scenarios where a trust may be appropriate:

Example 1: Senior who wants protection and simple asset transfers

Louise is 80 years old. She has $200,000 in assets that she wishes to leave to her children. Social security provides the rest of her income. Louise needs funds to live in an assisted living center.

A trust may be appropriate for Louise for several reasons. Having a trust can shield Louise’s assets from personal legal liability. If Louise were to be at fault in a car accident, the funds in the trust may be off-limits from individuals who may want to make a claim against her assets.

The trust also provides for asset management and private distribution of the estate to her heirs upon her passing. Louise can place her assets in trust for her benefit with the remainder paid to her heirs. The trust can pay for her assisted living needs as well as pay for the other day-to-day expenses necessary to meet her needs. Having a trust provides the easiest asset management for Louise, the most financial security and the easiest transfer of the funds to her heirs in the future.

Example 2: Child with physical or mental impairments

Caden was born with significant physical impairments. He is going to need assistance for his care throughout his life. Over the years, Caden’s parents have saved $50,000 to help Caden with his living expenses.

Although Caden may qualify for disability payments from his state, if he has $50,000 in assets in his own name, he loses his eligibility. Caden’s parents may create a trust for the $50,000. The trust can pay for Caden’s expenses above and beyond what he receives in disability payments. Having a special needs trust ensures that Caden can access all available resources in order to meet his needs.

Example 3: Planning for children for an unknown future

Jack and Cheryl are the proud parents of three children ages 12, 8, and 3. Jack and Cheryl are preparing their estate planning package including their savings of $25,000. If Jack and Cheryl were to both pass away unexpectedly, their children are too young to manage the savings.

Creating a testamentary trust as part of the estate planning package can help these parents know that their savings are going to be managed properly in the future for the benefit of their children. The children are the beneficiary of the trust, and the managers of the trust must operate with the directive that they must use the trust assets for the children’s benefit.

The parents can specify whether the funds are for education, for daily living expenses or for another purpose. In this case, the trust can go into place in the event that the parents pass away while the children are minors.

Example 4: Leaving assets to charity

Jamie is 75 years old. Jamie is retired and has no children. He has $300,000 that he wants to leave to charity at his death, but he needs monthly income now. Jamie can use a charitable trust in order to receive a steady income stream from the funds now while committing to donate the funds to the charity upon his death.

To create a charitable trust, Jamie can place the assets in a trust. The trust can pay him income directly throughout his life. When Jamie passes away, the funds can go immediately to the charity. Using a trust, Jamie can meet his goals of preserving his income as well as leaving funds to the charity of his choice.

Example 5: Adult child who needs guidance

Charlie is 25 years old. He has a history of substance abuse. Although he graduated from high school, he has difficulty holding down a job. Charlie lacks direction. His parents have resources, but they fear that Charlie can’t manage a windfall of money.

Placing funds in a trust for Charlie can protect Charlie’s assets for the long-term. Charlie’s parents can structure the trust to provide for substance-abuse treatment. They can also set standards for trust distribution so that the assets last throughout Charlie’s life.

Rather than risking mismanagement and quickly depleting the assets, Charlie’s parents can have the peace of mind to know that the funds are going to be available for their child now and in the future.

Example 6: Maintaining privacy for asset distribution

The Rodriguez family is known in town for being a wealthy family. They own several businesses in town, and they make charitable contributions regularly. Because of their known financial success, community groups often ask for donations. The family often doesn’t know how to respond to the requests. They have limited time to respond to requests, and they want to ensure that they donate to organizations that they believe have the most impact in the community.

A trust can be the answer for the Rodriguez family. By placing assets in a trust for charitable purposes, they can tell people that their trustees handle donation requests. Family representatives can structure the trust in order to maintain as much control or as little control as they want as they decide where to donate the funds. With a trust, the family can keep their financial matters private as well as respond with an acceptable answer when others ask for contributions.

Example 7: Unique family situations

Katia married and had two children. Her husband died. Eventually, Katia remarried and had another child. Her third child is 12 years younger than her other two children. Katia wants to make sure that her spouse and minor child are protected. She also wants to ensure that her older children eventually receive a share of her savings in the event of her passing.

A trust may be the right answer for Katia. She can create a trust that provides income to her spouse for life as well as provides for her youngest child while the child is a minor. However, with a trust, she can ensure that her older children eventually receive a share of her assets. A trust can help Katia manage the complexity of her family situation to ensure that all family members have their needs met in the future.

Do I need a trust?

If you have assets that you want to manage for others, a trust may be right for you. Even if you’re the primary beneficiary of the trust, you may still benefit from the legal protections, privacy and convenience that may accompany a trust.

To know if a trust is right for you, consult one of Wilson Ratledge’s experienced estate planning attorneys. We can help you examine your entire situation in order to determine whether you and your loved ones can benefit from a trust. An estate plan can address all of your family needs and goals.