Should You Turn Off A Trust?
Published Tuesday, February 11, 2014 at: 7:00 AM EST
It may have been advantageous for you to set up a trust years ago, but suppose your circumstances have changed. Are you unconditionally locked into the trust for a term of years or could you undo it? And, if it is legally permissible to shut down the trust, should you do it?
The first question is easier to answer, although it brings its own complexities. Let’s start with the assumption that we’re dealing with a garden-variety “grantor trust.” (Other rules will apply to other types of trusts.) Generally, a grantor trust is one in which you, the grantor, possess control or have power over the trust’s administration. For instance, retaining the right to revoke or amend the trust will cause it to be treated as a grantor trust. In addition, if you maintain control over the assets in the trust, it is deemed to be a grantor trust.
This is often significant for various tax-related purposes. With a grantor trust, the income generated by the trust will be taxed directly to the grantor. Furthermore, the assets will be included in your taxable estate. A variation on this trust type, the intentionally defective grantor trust (IDGT), lets you transfer assets to a trust in which you are not the trustee. That way, you can avoid having those assets included in your estate.
Therefore, in most situations, you will be allowed to turn off a grantor trust by giving up control or power over it, although it is significantly more difficult to do that if your spouse is either a beneficiary or trustee of the trust. Assuming you’re still able to do so, the question remains as to why you might do it and whether you should.
Answering those questions requires an in-depth analysis of your personal situation. As one possibility, you may have decided that you already have provided sufficient assets to your beneficiaries or your own fortunes may have suffered in recent years. More often, though, it’s the potential for adverse income tax consequences that will dictate the change.
Remember that the trust income is taxed to the grantor. Suppose that you’re in a high federal income tax bracket—the current top rate is 39.6%—and you also have to pay the 3.8% Medicare surtax on investment income. When you add in state income tax, the overall tax bite on the trust could exceed 50%. Thus, if you expect to have a sizable gain soon from a disposition of trust assets, you may be motivated to move the income out of your high tax bracket and have it taxed to the trust or low-income beneficiaries.
However, the income tax brackets for trusts are relatively narrow, so it’s easy to quickly reach the top 39.6% tax bracket on trust income. That’s why it’s crucial to consider all of the ramifications before you turn off a trust for good.
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