Why do we build wealth? Well, I know that we all would like to live more comfortably, enjoy finer things, and build up the money we need to fund a stress-free retirement. But, in my opinion, the true reason business owners work hard is to ensure a prosperous future for their families and, hopefully, begin a cycle of generational wealth. Today, I want to introduce my clients and readers to the tax advantages of a trust for business owners and families.
What is a trust? First off, a trust is going to be a part of your estate planning. And yes, entrepreneurs need to consider learning about trusts, even in the earliest stages of a financial plan.
Let’s answer the basics today: What kind of trusts are available? Which strategies are right for your business and family? How do you form a trust? Where do we start? Trusts are complex, so we’re going to get into just enough detail to demystify the subject and get you thinking about the future.
A trust is a legal arrangement between the creator of the trust and the beneficiaries.
Trusts are legal arrangements where one party holds assets on behalf of another. Several types of trusts exist, each with its pros and cons:
- Revocable trusts: With revocable trusts, you get flexibility, including the ability to amend the trust to adapt to life changes, but they do not provide substantial asset protection.
- Irrevocable trusts: These provide robust asset protection and tax advantages but cannot be easily changed.
Trust assets are generally divided into “principal” and “income.” The principal includes assets like stocks, bonds, or real estate, while income comprises what those assets produce, which is income from dividends, interest, or rental property.¹
Trusts have different tax treatments based on their type.
For income tax purposes, the treatment of trusts can vary significantly between grantor and non-grantor trusts.
- Grantor trusts: The grantor pays the income taxes, offering more control over the trust.
- Non-grantor trusts: The trust itself pays income taxes, which can be higher than individual rates.
Trusts come with a cornucopia of tax advantages and strategies.
Beneficiaries of a trust enjoy various tax benefits, especially if the trust is structured to distribute income efficiently.
Specific trust structures, particularly irrevocable trusts, can help reduce federal estate tax liabilities for larger estates. Options like the gift tax and estate tax exemptions allow you to transfer wealth without significant tax liabilities.
Trusts reach high federal marginal tax rates at lower income thresholds.
Trusts reach the highest federal marginal income tax rate at much lower thresholds compared to individuals.
For the 2024 tax year, the top marginal tax rate for a single filer, 37%, begins after $609,350 of ordinary income. In contrast, a trust is subject to that rate after only $15,200 of income.² To optimize tax savings, consider how much income the trust generates and strategically distribute the trust’s income.
You can reduce income taxes by structuring trusts to distribute income.
If beneficiaries are in a lower tax bracket than the trustee, then the resulting tax burden from the distribution of income generated by its assets will be lower.
Trusts also offer a level of discretion that is beneficial for protecting details about the assets held within the trust and the identity of the beneficiaries.³
Plan carefully to reduce estate taxes and protect the trust’s assets.
- Define clear short and long-term goals when setting up an asset protection trust. Are you protecting assets from creditors or planning for future wealth transfer? These goals will guide your decisions. Establishing certain types of trusts can reduce or eliminate the value of a taxable estate.
- A comprehensive asset protection and wealth management plan outlines strategies for protecting and growing your assets while minimizing tax liabilities. I can connect you with a trusted wealth management firm in Texas to help you create a robust plan.
- Tailor your trust based on your personal income level, tax bracket, and the types of assets you hold. This customization ensures that you maximize the tax benefits and protection offered by the trust.
- Choose the right jurisdiction for the effectiveness of your trust. Some jurisdictions offer better protection than others, so the tax advantages of a trust may vary based on location.
- Ensure that a responsible individual or organization manages the trust to maintain its integrity and compliance with legal requirements.⁴
This is complicated stuff, and it’s important that you do every step properly.
It takes tax-focused wealth management services and the right experts to secure your financial future. Schedule a discovery call to get started.
Talk soon,
Jeremy A. Johnson, CPA
References
- IRS. Top Marginal Tax Rate – IRS. Available at: https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024.
- IRS. Threshold for the Gross Receipts Test Increased to $29 Million for 2023. Available at: https://www.irs.gov/about-irs/threshold-for-the-gross-receipts-test-increased-to-29-million-for-2023.
- IRS. Basic Questions and Answers About the Limitation on the Deduction for Business Interest Expense. Available at: https://www.irs.gov/newsroom/basic-questions-and-answers-about-the-limitation-on-the-deduction-for-business-interest-expense.
- IRS. Estimated Income Tax for Estates and Trusts – IRS. Available at: https://www.irs.gov/pub/irs-pdf/f1041es.pdf.