Trusts are excellent tools for asset protection, but many use these vehicles mostly or even exclusively for tax benefits. In fact, if you set up the right trust and use it correctly, you can mitigate the taxes your estate faces now and for several years in the future.
But what are the tax benefits of the trust, and how do they change depending on your trust’s structure? We’ll answer these questions and more right now.
Trusts and Taxes
Before we go any further, remember this one fact: trusts are not taxed the same way. You might think that putting money in a trust will save you money on taxes by default, but that’s not necessarily the case. Trusts and tax laws/rates depend on:
- Trust structure (i.e., the kind of trust it is)
- Your wealth and the amount of money you put into the trust
- Who is responsible for claiming any taxable income that emerges from the trust in the form of distributions
As a high-net-worth individual, it's in your best interest to understand how the different trust structures interact with tax laws in your home jurisdiction, such as the US, and in any offshore jurisdiction you use for your trust vehicles.
In general, any trust distributions to beneficiaries that come from the trust’s principal are non-taxable. That said, any capital gains on the principal trust amount could be taxable to the trust or the beneficiary (again, depending on the trust structure). Then, keep in mind that any amounts that are distributed to or for the beneficiary are taxable.
Trust Tax Benefits
Now that you know that trusts can be taxed, let's take a closer look at some of the tax benefits of a trust you might enjoy when you set up the right vehicle with Dominion's help.
The Gift Tax Exemption
The first big tax benefit of trusts is the oft-mentioned gift tax exemption. If you put money into an irrevocable trust each year, some of that money can be contributed without being subject to the gift tax.
As of 2023, the gift tax annual exemption is $17,000. As an example, you can place up to $17,000 into an irrevocable trust with the goal of giving it to a beneficiary as a gift later on. That $17,000 will not be taxed.
Note that the gift tax annual exemption is total – it includes all the gift tax contributions you make as an individual. It’s not per-beneficiary. For instance, you can’t contribute $17,000 to a gift trust for one child, then contribute $17,000 to another gift trust for another child, and expect both contributions to be exempt from the gift tax.
Estate Tax Exemptions
High-net-worth individuals also frequently use trusts to avoid or minimize estate taxes. Normally, estate taxes kick in when ownership of property or other assets transfers from a deceased individual to another person.
For instance, you pass away and pass on your estate to your first child. If the property in your estate goes through the probate process – which involves the reading of your will and other legal matters – the assets within that estate will be taxed. This effectively reduces how much money or wealth you can pass on to your descendants.
However, if you put assets into certain types of trusts, like estate planning trusts and irrevocable asset protection trusts, those assets don’t need to go through the probate process. This has several benefits by itself, like keeping the property in the estate from becoming a matter of public record.
But assets and wealth passed from person to person through a trust may also allow you to avoid the estate tax, at least to some extent. So, if you want to pass on as much of your liquid capital, property, or other assets as possible to your future family members or other beneficiaries, a trust is the way to go.
Beneficiary Trust Tax Benefits
When a beneficiary receives money from a trust, whether or not they pay taxes on that income depends on how they received it.
In the US, a beneficiary has to pay taxes for money that they inherit from a trust (in most cases). However, a beneficiary does not have to pay taxes on income that is distributed from the trust's principal.
Being smart about your distribution schedule can help you minimize taxes and maximize transferred income to your beneficiaries.
Is the Trust a Grantor or Non-Grantor Trust?
The tax benefits of a trust also depend on whether it is a grantor or non-grantor trust. A grantor trust is any trust where you, the grantor, control the assets. That means you are responsible for reporting and paying taxes on the income of the trust.
By default, all revocable trusts are grantor trusts, though not all grantor trusts are revocable.
The reverse is true for a non-grantor trust. With this type of trust vehicle, the grantor isn’t responsible for reporting income or paying taxes based on the trust.
The trust instead acts like a separate tax entity. It, or rather, the trustee, is responsible for reporting and paying taxes on income generated by the trust and the assets inside.
So, how is this a tax benefit? If you are an extremely high net worth individual, your tax bracket might be very high. If the assets within your trust collectively amount to a lower net worth, that trust will be taxed at a lower bracket.
In essence, you can ensure that your trust assets are taxed at a lower rate compared to the assets you keep under your name.
This is a good way to make sure that assets you want to pass on to the next generation or otherwise protect against legal attacks aren't taxed at the same rate as you and your primary estate/holdings.
Is this the right strategy for your overall estate? That depends on your goals. When you work with Dominion, our legal advisors will go over your books with you and help you determine whether this matters for your long-term financial desires.
Revocable Trust Taxes
Most trusts are revocable, meaning they can be changed later on. Any income made by a revocable trust, as noted above, is taxable to the trust’s grantor. Say you make a revocable estate planning trust – the income made by that trust then gets taxed according to your tax bracket/tax laws.
Why? Since you have full control over the terms of the trust in the assets contained within, the law reasonably assumes that you should also take responsibility for trust taxes.
Irrevocable Trust Taxes
With irrevocable trusts, it’s not so simple. Typically, irrevocable trusts have separate tax ID numbers (and that can be even more complicated if your trust is offshore or in a jurisdiction other than the US).
Irrevocable trusts are their own entities, so they can be taxed at different tax brackets and may take advantage of tax breaks, like the above-mentioned gift tax limits, separately from their grantors.
Trust Tax Rates
To recap, trust tax breaks include exemptions from certain taxes like gift taxes and estate taxes. But you can also use trusts to ensure that the assets within those trusts are taxed at lower rates compared to yourself.
This is a smart strategy for very high-net-worth individuals with income or assets to the tune of hundreds of millions of dollars or more.
If you are the grantor of a revocable trust, the trust’s income is taxed the same way as yours. You can think of the income of the trust being added to your overall income. The entire pool of money is taxed altogether.
The tax rate is different for non-grantor or irrevocable trusts. As of 2023, the maximum tax rate for irrevocable trusts in the US is 37%.
What About Offshore Trusts?
That depends on the specific offshore jurisdiction in which you set up your asset protection trust. Dominion’s advisors can tell you which jurisdictions are best based on their overall protection, tax laws, income generation opportunities, and more.
All of these comprise the attributes and factors we consider when recommending different jurisdictions for your asset protection strategy.
Never assume that the tax laws in one jurisdiction will be the same as those in the US! Countries can vary heavily in terms of their trust laws, taxation rules, and exemptions.
There's a reason why many businesses and high-net-worth individuals – and wealthy families or dynasties – set up trusts in specific areas. It's because those jurisdictions have very favorable tax laws and special exemptions.
In addition to these benefits, offshore trusts can offer enhanced privacy and confidentiality. Many jurisdictions have strict privacy laws that shield the identity of the settlor and beneficiaries, adding an extra layer of protection for your assets.
All that said, it’s crucial to remember that offshore trusts are not a fix-all solution. They require careful planning and expert guidance to ensure compliance with both US and foreign regulations.
Therefore, you’re going to want to weigh the benefits against potential limitations, such as the irrevocable nature of asset transfers and ongoing maintenance costs. If you feel the positives outweigh the negatives, an offshore trust could be the way to go.
Contact Dominion Today to Learn More
The tax benefits of the trust can vary depending on its structure, your goals, and the overall shape of your estate. With this in mind, it makes a lot of sense to contact knowledgeable trust experts like Dominion.
Dominion can help you put together the right trust structure based on your short and long-term financial goals, plus ensure that you maximize tax exemptions and other benefits based on your trust’s eventual jurisdiction. Get in touch with one of our representatives today to learn more about how we can assist.
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