Trusts are one way in which assets can be sheltered from estate taxes and in which the probate process (associated with wills) can also be avoided. In recent years, Americans have begun to use trusts and trust funds in increasing numbers, and many Americans now have Living Trusts which make it possible to pass on assets and proceeds from assets to heirs without paying estate taxes or having the estate go through a lengthy and sometimes costly probate. The use of trusts does not eliminate taxes altogether, however, and it is important to understand how the taxable income of a trust (the distributable net income) affects the trust and beneficiaries. This research examines the use of trusts and some of the issues surrounding distributable net income.
Trusts are legal documents created by an individual (the grantor) to manage assets in a particular way for the benefit of others (the beneficiaries). The administrator of a trust is the trustee. Trusts can be revocable, meaning that they can be modified or canceled at some point in the future, or they can be irrevocable, meaning that they are permanent. They can be valid for a fixed period of time, or for an unspecified period of time. Depending on the way they are structured, trusts can save or shelter tax dollars to the benefit of both the grantor and the beneficiaries. There are four types of trusts which are used in conjunction with estate planning: revocable living trusts, testamentary trusts, credit shelters and irrevocable trusts.
A revocable living trust is established during the grantor's lifetime and is usually created to benefit the grantor. As its name implies, this trust can be modified or revoked at any time. Since the grantor retains a large degree of control over the assets, tax is paid on all of the income, and the trust principal is included in the taxable estate. The revocable living trust is used to issue provisions in case of incapacity; the grantor ser...