What if I get sued? What if I have to go to the nursing home? What if my marriage fails? What if when I die, my estate exceeds the estate tax exemption of $4 million? What can I do to protect my farm and other assets from these risks?
Have you ever had any of these thoughts, or perhaps even asked your professional advisers these questions? What you own is exposed to these risks, and there is only so much you can do to protect it. However, as you pass your estate to the next generation, you have a perfect opportunity to protect it all from those same risks that they will face. By leaving the assets to your children in trusts established under your estate planning documents, you help assure that what they inherit from you will be safe from a lawsuit against them, their failing health, their divorce and any estate tax at their death.
This is not a trust for an immature or disabled beneficiary, but rather for the child who you believe can and should have full control of whatever he or she inherits. You design it so the child’s protective trust can be under his or her management. Your child can make all investment decisions, and can spend the income and principal as needed.
So why wouldn’t everyone with responsible children give them the inheritance in beneficiary-controlled asset protection trusts? The reason most often cited is taxes. There is a common perception that if the assets are held in trust, this will result in higher income taxes. Your accountant may have told you this. If so, he or she is mistaken!
The myth is based on the fact that tax brackets for trusts are highly compressed. In 2020, a single taxpayer does not hit the top federal tax bracket of 37% until his or her income exceeds $518,400; married taxpayers filing jointly reach the top rate at $622,050. A trust hits the 37% federal tax bracket after only $12,950. Doesn’t that mean higher taxes?
Take a closer look
Imagine your self-employed farmer son Frank inherits 200 acres from you plus $200,000. Assuming it is not in trust, the $200,000 will be invested, producing taxable interest, dividends and capital gain, taxed to Frank personally. He will farm the land and report all of the income he makes as self-employment income, subject to ordinary income tax as well as self-employment tax. Whatever tax bracket Frank is in, the income produced by the inheritance goes right up on top.
What if Frank’s inheritance were in trust? Say the $200,000 earned $6,000 dividends or interest. Since Frank doesn’t personally own the land, he rents it from the trust. Say the trust will net $200 per acre after it pays real estate taxes, for $40,000 of net rental income. It is nice to think of the trust protecting the inheritance from catastrophes, but if it makes $46,000, will the trust pay 37% tax on most of that? If Frank is in the 22% bracket, wouldn’t the trust pay 15% extra?
No. First, there are at least two ways to assure that this income is not going to be taxed at any rate higher than Frank’s personal rate. Even better, the trust has reduced income taxes.
What will happen to the $46,000? If the net income of the trust is distributed to Frank at the end of the year, then the trust doesn’t pay the tax; Frank got the money and pays the tax. The taxes paid are no different than if there was no trust.
A second way to assure the trust doesn’t increase taxes is to include wording that causes Frank to be considered the “owner” of the income. By giving him a particular right to withdraw a specified portion of the income, that portion is taxed to him even if he chooses to let it remain in the trust — again, just like if there were no trust.
If Frank lets the trust pay the income tax on its first $2,700, that will save about $300, because the trust has a standard deduction of $100 (no tax) and a 10% rate for the next $2,600. Further, by paying rent to the trust, Frank reduces his self-employment income by $40,000, saving at least 2.9% Medicare tax, or $1,168. There are other strategies as well for different situations, but just these two produce over $1,400 in tax savings, and Frank can still spend all of the income.
Why did we recommend the trust? Frank’s entire inheritance is protected from lawsuits, divorce, etc. We need to add another reason: The trust also reduces income taxes.
Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com. The opinions of this writer are not necessarily those of Farm Progress/Informa.