Series 65 Exam Tip

Here is some great information on how trusts may be tested on your series 65 exam.

Trusts may be revocable or irrevocable. With a revocable trust, the individual who established the trust and contributes assets to the trust, known as the grantor or settlor , may, as the name suggests, revoke the trust and take the assets back. The income generated by a revocable trust is generally taxed as income to the grantor. If the trust is irrevocable, the grantor may not revoke the trust and take the assets back. With an irrevocable trust, the trust usually pays the taxes as its own entity or the beneficiaries of the trust are taxed on the income they receive. If the trust is established as a simple trust all income generated by the trust must be distributed to the beneficiaries in the year the income is earned. If the trust is established as a complex trust the trust may retain some or all of the income earned and the trust will pay taxes on the income that is not distributed to the beneficiaries. The grantor of an irrevocable trust is generally not taxed on the income generated by the trust unless the assets in the trust are held for the benefit of the grantor, the grantor’s spouse, or if the grantor has an interest in the income of the trust of greater than 5 percent. While most trusts are established during a person’s life time ( known as an inter vivos trust) a trust may also be established to hold or to distribute assets after a person’s death under the terms of their Will. Trusts that are established under the terms of a Will are known as Testamentary trusts. All assets placed into a Testamentary trust are subject to both estate taxes and probate.  Trusts can be established to both protect assets from legal claims as well as for estate tax planning purposes.  A bypass trust is one that is established to reduce the tax liability of an estate left to beneficiaries other than a spouse, such as to children. The bypass trust allows the grantor to take advantage of the life time estate tax exclusion and allows individuals with significant wealth to reduce the tax burden to their heirs. A generational skipping trust is a type of bypass trust that is established for the benefit of relatives more distant than one generation from the grantor such as grand children or great grandchildren. This type of bypass trust will allow assets to be passed on to grandchildren without first being passed to their parents and without potentially being taxed again upon their parents death.  Assets left to grandchildren or unrelated persons more than 37.5 years younger than the grantor may be subject to a generation skipping transfer tax (GSTT). 

Example A grantor established generational skipping trust to provide income to his children during their lifetime and leaving the principal to the grandchildren upon the death of his children. Upon the death of the children the grandchildren would inherit the principal sometimes known as the corpus or body of the trust. At the time the grandchildren inherit the principal and the money would be subject to the generational skipping transfer tax. The trustee is responsible for paying the GSTT.

An additional benefit of the generational skipping trust is it will allow for the assets to appreciate over time without triggering additional tax liability. If a grantor funds the trust with assets in an amount under the estate tax exclusion limit and the assets in the trust appreciate over time past the estate tax exclusion limit after the grantor’s death the assets will not be subject to estate taxes. A grantor retained annuity trust (GRAT) is yet one more way a trust can be established and used for estate planning.  With this trust the grantor places assets into the trust with the intention of drawing an income from the trust as an annuity payment for a set number of years. Upon the grantor’s death the remainder of the principal will be left to the beneficiaries. The IRS determines the value of the gift to be the estimated value of the remainder based on IRS discount models. If the account earns more than this rate the extra income will be added to the remaining principal left to the beneficiaries.
Trust taxation can be a complex matter. The income tax rate for net income received and retained by trusts can be subject to a very high rate of taxation and a relatively low level of net income . To avoid the high tax rate most trusts will be set up to distribute net income to the beneficiaries and the distribution will be taxable as income to the beneficiary. Should one of the beneficiaries to a trust die that person’s interest in the trust will usually pass to his or her children known as their issue per stirpes
Trust and estates that retain net income must report that income to the IRS on form 1041.

TAKE NOTE Capital gains on assets that are sold and reinvested as principal in the trust are not taxable to the trust and are not considered part of net income to the trust.