How to Handle Irrevocable Trust Assets Tax-Efficiently

The words irrevocable trust written on a spiral notebook against a yellow background.

(Image credit: Getty Images)

published 15 July 2024

Editor’s note: This is part eight of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.

In the previous article (part seven) of this series, we discussed grantor trust provisions. As noted, an irrevocable trust agreement must be designed, drafted and implemented to deal with two primary categories of taxes: 1) transfer taxes, such as gift and estate taxes, as well as the less common generation skipping transfer tax, and 2) income taxes, such as earned income taxes, income taxes on investment or capital gains taxes, which are income taxes on property appreciation after the property is sold or exchanged.

Although grantor trust provisions in a trust primarily address who will pay the tax on trust income (the trust maker vs the trust itself), grantor trust provisions also can have a significant effect on whether trust assets will be included in the gross estate of a decedent for computation of estate transfer taxes. Although it may seem like it is a good idea to permanently remove assets from the gross estate for transfer tax purposes, making a completed gift is often a costly tax mistake that will result in a trust failing to qualify for a step-up in basis to reduce capital gains taxes. Even worse, removing assets from an estate that is exempt from estate taxes doesn’t save on estate taxes, in addition to failing to qualify for the step-up in basis for capital gains taxes.

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What is the gross estate for estate tax purposes?

The gross estate for estate tax purposes consists of the net value of all assets owned by a person at the time of their death. The gross estate is the number used to calculate the estate transfer taxes, which are currently 40%, although U.S. citizens and residents currently have an exemption from estate taxes of $13.61 million per person in 2024 ($27.22 million for married couples). The exemption changes every year because of congressional acts and also because of inflation adjustments.

The gross estate includes real and personal property, tangible and intangible assets, businesses, business assets, collectibles, digital assets and assets located anywhere in the world. It important to note that many trust makers mistakenly believe that assets they put in trusts for purposes of avoiding probate or to keep creditors away are not part of their gross estate for tax purposes, but this is not correct. The gross estate for tax purposes includes all assets, whether the assets are in a trust, corporation, LLC or titled directly in the decedent’s name.

The primary factor that causes an asset to be included in the gross estate is whether the decedent has possession, enjoyment or control over the assets. The fair market value of the assets is generally used in calculating the gross estate, not the original purchase price or value when acquired.

It is also worth repeating that the gross estate for tax purposes is not used to calculate trust income taxes, which are a separate tax on earnings of the trust, regardless of the size of the gross estate. However, trust grantor powers can impact whether a trust or estate is subject to both income taxes and estate or transfer taxes.

Qualifying for a step-up in basis of trust assets

Many grantor trust powers will simultaneously cause the trust income to be taxable to the trust maker and cause the trust assets to be included in the gross estate of the trust maker, qualifying for a step-up in basis on the trust assets. These grantor trust powers that trigger both income inclusion and estate tax inclusion can both keep income taxes lower and allow the trust maker to get a step-up in the basis of trust assets after the grantor’s death to save on capital gains taxes. Structuring a trust with grantor powers while also including assets in the gross estate of the trust maker is very desirable where the total gross estate of the trust maker (or grantor) is less than the estate tax exemption, because the trust will be income tax-efficient, the potentially taxable gross estate will not owe estate taxes, and the trust assets will qualify for a step-up in basis.

Some grantor trust powers cause the trust maker (or another person treated as grantor) to pay only income tax, but do not result in the trust assets being included in the grantor’s gross estate. For example, the grantor trust powers to add charitable beneficiaries (Internal Revenue Code 674), borrow from the trust without adequate security and substitute trust assets (IRC 675) and use trust income to pay premiums on insurance of the grantor or grantor’s spouse (IRC 677), will all result in the grantor paying income taxes on the trust income, but the IRS has decided that even though the grantor trust power will cause the trust maker to pay income taxes on trust income, the trust assets will not be included in the trust maker’s estate.

Put differently, trusts with grantor powers to pay income taxes that simultaneously are treated as “completed gifts” out of the gross estate of the trust maker function to remove more property out of the gross estate because the grantor is paying taxes on the trust income that would otherwise reduce the growth of the trust property.

Example. A wealthy trust maker transfers property into a trust, retaining grantor powers to borrow from the trust without adequate security (collateral or promises). The trust maker retains no possession or enjoyment over the trust, and the trust maker retains no control or powers over the trust. Because the trust maker has given up control, possession and enjoyment over the trust, the trust maker files a Form 709 gift tax return, claiming that the transfer of property into the trust is complete. However, even though the trust property is outside of the trust maker’s gross estate, because the trust maker retained the grantor trust power to borrow against the trust property without adequate security, the trust maker continues to pay taxes on the trust income. What is more, the trust does not even distribute the trust income out of the trust to the trust maker, so the trust maker uses their remaining personal assets to pay the income taxes on behalf of the trust. Effectively, the trust maker is “burning off” their personal assets subject to estate taxes while preserving the estate-tax-free assets in the trust.

Be aware of tradeoffs

The powerful strategy of allowing a trust maker to keep paying taxes for trust income effectively allows the trust maker to make more contributions into a trust — and avoid using estate-tax-free trust income to pay taxes. As powerful as grantor powers can be to increase the trust property that is excluded from the gross estate, keep in mind that transferring assets out of the trust maker’s gross estate also creates a tradeoff between capital gains taxes and estate taxes. When deciding whether to form a trust with retained powers that include trust assets in the trust maker’s gross estate, it is essential to carefully consider the potential cost of estate taxes vs the cost of capital gains taxes.

Non-grantor trusts, defined as “complex” by the IRS, are trusts that owe income tax at the trust level and do not push out income and deductions to individuals. Non-grantor trusts must comply with tax-reporting rules. An irrevocable non-grantor trust that doesn’t distribute all the income must file a Form 1041 trust tax return, and usually trusts pay income taxes at an even higher tax rate than the trust maker would pay. Form 1041 is usually prepared by an accountant or attorney who will need to file the income tax return for the trust if the trust earns more than about $300 annually (the trust deduction), as well as prepare any necessary reporting forms, such as the issuance of a K-1 to trust beneficiaries or trust taxpayers.

In contrast to trusts, an individual taxpayer has a much greater standard deduction to exempt income from taxes, where trusts get no standard deduction, and trusts instead get only the very minimal deduction. Even worse, trusts pay income taxes at the rates applicable to individuals, and if a complex trust paying income tax at the trust level earns just over $15,000 in 2024, the trust will pay at the highest marginal income tax rate of 37% for individuals. These compressed trust tax brackets almost always cause a trust to pay more income taxes than individuals, unless the individual is a very high earner.

Example. A trust maker discovers a company selling a trust that the company claims will help the trust maker to avoid paying income taxes on their income. The marketing company terms the trust a “non-grantor, irrevocable, discretionary, complex spendthrift trust” and tells the trust maker that to avoid income taxes, all the trust maker needs to do is put income-earning assets into the trust and allocate the income to the trust’s corpus. Unfortunately, the trust maker is unaware that the trust being marketed by the company is directly violating established U.S. tax laws, making the trust a scam and subjecting the trust maker to an IRS audit, penalties and interest. Trusts do not avoid income tax — either the trust itself, the trust maker or the trust beneficiary must pay income tax on trust income.

In fact, many marketing companies with few scruples pushed what they exaggerated as a “tax-free trust” on unsuspecting taxpayers, causing many of them to commit tax fraud. The IRS issued CCM AM 2023-0006 in August 2023, warning that trusts cannot avoid taxes and any trust promoted as avoiding taxes at both the individual and trust level is a fraud, and the trust relies on a misreading of the income tax rules. To repeat the often-misunderstood income tax principle: There is no escaping taxes on trust income — either the trust must pay income taxes on trust earnings, or the trust maker/beneficiary must pay the trust income taxes. Even though people often hope that they can stop paying income taxes by setting up an irrevocable trust, their hope may be based on a partial reading of the tax code or misunderstandings of the trust income tax rules.

Trusts can keep assets out of the gross estate or get a step-up in basis — but not both

Trusts with grantor trust provisions so that the trust maker pays taxes at their lower, individual tax rates, can still permanently remove property from the gross estate, potentially subject to the federal estate tax, which maxes out at 40% in 2024. While it may sound good to remove property out of the gross estate to be sure that there is no 40% estate tax, it may well be that no estate tax would have been owed anyway because of the trust maker’s exemption from estate tax.

More important, once property is removed from the gross estate, it will no longer qualify for the step-up in basis under IRC 1014 so that the beneficiaries of the trust will need to pay capital gains taxes on the trust property once it is sold. In other words, removing assets from the potentially taxable gross estate can be a costly mistake when the estate tax would have been zero because of exemptions, but the federal capital gains taxes reaches 20%, plus the 3.8% net investment income tax, plus the state capital gains rate (often 5% or more) — with no exemption from paying the capital gains taxes.

Before deciding to structure a trust so that assets are permanently removed from the gross estate for tax purposes, careful consideration must be given to whether a lack of basis step-up and the resulting capital gains taxes when assets are sold will be more costly than the potential of estate tax, which could be zero if the trust maker(s) have sufficient estate tax exemption.

My next article will focus on capital gains tax and estate tax tradeoffs with irrevocable trusts.