Be Wary of these Trust Shortfalls

Placing and keeping your property in a trust doesn't automatically mean that you won't have to pay tax on income from that asset. For tax purposes, virtually all forms of meaningful and ongoing control that you retain over trust property make it a grantor trust under the tax code. As a matter of fact, the mere power to revoke necessarily makes any revocable living trust a grantor trust. As far as the IRS is concerned, grantor trusts are ignorable; the grantor is liable for income tax just as if the property in the trust was owned in his or her individual name and no trust ever existed.

It's also beneficial to keep in mind that just because a living trust is effective in keeping property out of your probate estate, it does not necessarily mean that the asset is excluded from your taxable estate for federal estate tax purposes. If you create a trust with the intention of keeping property completely out of your taxable estate, you must have "no strings attached" to the property at the time of your death. As such, any trust that you can revoke will certainly be included in your taxable estate. This is also true if you simply retain the power to change the trust's terms in any significant way.

Simply put, the bottom line is that in order to transfer and keep property completely out of your taxable estate – whether you use a trust or not – you must fully relinquish both control and the right to receive any personal benefit from the property. In other words, you must literally have "no strings attached." On the other hand, if you only give up partial control of the property or still receive some benefit from it, it's often possible to transfer at least some of the property's value out of your estate. However, you cannot create any type of arrangement by which property is removed from your estate in order to avoid taxes while at the same time keeping full control and benefit.

Be especially careful with the tax code in this area – indeed, in all areas, but most certainly here. If something isn't allowed because of a particular IRS rule, think twice about trying to get around it. The overwhelming majority of times your efforts will be ineffective, and your survivors will be the unfortunate ones to find out that the price to be paid may likely be at their expense.

Revocable living trusts – and most other types with strings attached or benefits retained by the grantor – should be considered primarily with the intention of achieving non-tax objectives instead of tax savings; for example, avoiding probate court, planning for disability, or creating flexibility in property management. If tax savings are a primary goal, you should consider a trust that's irrevocable. Needless to say, irrevocability will also come with the obvious and significant drawbacks associated with giving up control over your property. A revocable living trust can be used in an estate tax-saving plan, but only if it's designed to create an irrevocable trust upon the grantor's death.

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