Trusts and Tax-Free Gifts

Trusts are wonderful estate-planning tools that can used to replace or supplement a will. A trust is put into place to manage the distribution of a person's property by transferring it upon his or her death. There are several reasons to create a trust, the most popular of which are to avoid probate and to potentially reduce the amount of tax that is owed.

The reasons behind tax-free gifts between individuals are fairly simple. In many cases, a parent or grandparent attempts to reduce his or her taxable estate by gifting a portion of it to a child or grandchild. The amount that can be gifted tax-free – the current annual exclusion for 2011 is $13,000 – does not produce a tax deduction for the donor or income for the recipient.

If you're thinking of establishing a trust or gifting a sizeable amount of your estate away, make sure you follow the rules and regulations established by the Internal Revenue Service and consult a financial advisor.

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Creation of a Trust

Creating a trust is for the most part fairly simple. The property owner transfers legal ownership to a person or institution that will manage the property for the benefit of another person. The trustee typically receives compensation for his or her management of the trust. A trust creates a "fiduciary" relationship between the trustee and the beneficiary. If a trustee does not perform this duty, then he or she is legally responsible to the beneficiary for any damage that occurs. The person who establishes the trust may act as the trustee and retain ownership of the property instead of transferring it.

The Difference between Testamentary and Living Trusts

Trusts established for the benefit of estate planning fall into two very broad categories known as testamentary trusts and living trusts. A testamentary trust transfers property upon the death of the person who establishes the trust. A living trust, which is also known as an inter vivos trust, starts while the person who establishes it is still alive. A living trust can be designed to end or continue after the death of the establisher. A living trust is the more popular type of trust and can help beneficiaries avoid probate if all assets are transferred into the trust prior to the owner's death.

A living trust can be established as revocable or irrevocable. A person who establishes a revocable trust can change the terms at any point after the trust is established. An irrevocable trust, however, cannot be changed once it takes effect. A revocable trust is typically executed to act as a supplement to a will.

Transferring Assets Through a Trust

The primary reason for establishing a trust is to transfer assets upon death. It may not be a pleasant topic to discuss or consider, but allowing your heirs to hold on to the assets you've accumulated during your working life should be incentive enough to establish a trust. An irrevocable trust transfers the assets into the trust before you die, which allows all assets to bypass probate. Revocable trusts, however, transfer assets to the trust upon your death, so no assets pass through probate. The important thing to remember about trusts is that even if you die, the trust does not die with you.

What are Tax-Free Gifts

Tax-free gifts are those that you receive but don't have to declare as income. Provided the gift is under the allowable amount, you can take the money and spend it as you please. There are, however, a couple of important rules regarding tax-free gifts. For example, a gift can't be something you've worked for. In other words, you can't declare earned income as a tax-free gift. If the gift produces income, it is not a gift. For example, if you are gifted property that results in income, you have to declare that income. This is true for rental property that produces income, stocks that produce dividend income, and bonds that produce fixed income.

The Basis of Property Gifts

If a gift is comprised of property, the basis, or starting point that determines the value, and the holding period, transfer over to the person who received the gift. It's vitally important for the recipient of the gift to know when and at what cost the donor acquired the property.

The Basis of Stock Gifts

Although at present there is no income tax levied on gifts, there is what's known as a gift tax that is imposed on the donor. Most of us generally don't have to worry about a donor gift tax because it usually doesn't apply until the gift exceeds the annual gift limit. And there are other exclusions that often prevent the gift tax from applying. The annual exclusion amount is adjusted for inflation each year. The exclusion amount for 2011 is $13,000. Provided the gift is less than this amount, neither the donor nor the recipient need declare it, and the donor does not have to pay tax on the gift.

For married couples, each spouse can also make a gift under the exclusion amount, even if you file a joint federal tax return. If you or your spouse gift more than the annual exclusion amount to a single person in one year you will be required to file a special gift tax return. Note that current Internal Revenue Service rules and regulations allow you to gift $5,000,000 during your lifetime without being subject to the special gift tax. And, you don't begin to use this amount until your gifts to a single person in a single year exceed the annual exclusion amount.

The amount you choose to use out of your lifetime gift tax exclusion counts toward the estate tax exclusion, which as of 2011, is also $5,000,000. If you use $300,000 of the limit by giving tax-free gifts during your lifetime, you have effectively reduced your taxable estate by $300,000. Don't ignore the lifetime limit even if you're sure that the lifetime gifts you give won't add up to that amount. Plan your tax-free gifts around the allowable annual exclusion amount and you'll be on the right side of the IRS and reduce your taxable estate.

While we've covered the basics of estate planning here, there is much more to implementing a solid estate plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

More Estate Planning Guidance

  • Estate Planning Guide — The complete guide to estate planning.
  • Wills — Learn how to draft a will, power of attorney, and a health care proxy.
  • Life Insurance — Learn how life insurance can be used to reduce estate taxes.
  • Estate Taxes — Find out how estates are taxed at the state and federal levels.
  • Estate Planning FAQ — Frequently asked questions about estate planning.