"When inheriting money through a family trust, do you still pay income tax on the money?"
Q: A family trust avoids probate and estate or inheritance tax but I'm wondering if income tax must still be paid on the money inherited if you have a trust.
 
A: It depends on the amount, but yes you will probably have to pay taxes" The issue is actually rather complicated and you need to consult with an accountant to make the proper determinations for your situation, but in general here's what happens: A trust does not have to pay income tax on income that is distributed to the beneficiaries, but does have to pay tax on undistributed income. The trustee is free to distribute trust income to as many beneficiaries as possible, and in proportions that take best advantage of those beneficiaries' personal marginal tax rates. The beneficiaries then pay the tax on distributions made to them.

For example, if an adult beneficiary of the trust only receives income from a trust and has the benefit of the tax-free threshold (currently $6,000) for the year, the trustee could distribute part of the family trust's income to this person. The result is that the beneficiary will receive some income but may not have to pay tax if that amount is less than $6,000. If the distribution to the beneficiary exceeds his or her tax-free threshold, the excess amount will be taxed at the beneficiary's personal marginal tax rate.

Distributions received from a trust is not a special form of income, but instead forms part of a beneficiary's assessable income. If the beneficiary receives income from other sources in addition to distributions from the trust, all of the income will be taxed together.

Even if the beneficiary's income does exceed the tax-free threshold for a particular year, the rate of tax applied to the amount of the excess income over the tax-free threshold may be lower than for other beneficiaries because of the total income that these other beneficiaries already receive.

Undistributed income is taxed in the hands of the trustee at the top marginal tax rate of 45% for the 2006/2007 year, giving a strong incentive to family trusts to fully distribute the trust's income before the end of each financial year.

The trustee should also take care in relation to which beneficiaries are chosen to receive distributions, as penalty tax rates can apply to distributions made to minors.
http://www.cleardocs.com/extra_family_trust.jsp

Keep in mind that the above explanation is general for family trusts and not specific to inheritance issues, so most likely the entire trust will be distributed at once and thus taxes will be paid on any income over the threshold amounts during the first year. But again, I must stress that you should discuss the particular with an accountant or attorney to see if taxable income can be mitigated somehow.

I hope this helps!!
Sources: http://www.cleardocs.com/extra_family_trust.jsp
 

Difference Between an Estate Tax and an Inheritance Tax

Many people are not aware that there is a difference between estate tax and inheritance tax. An inheritance tax is imposed on the beneficiaries of an estate, whereas the estate tax is based on the fair market value of the entire estate. The beneficiaries are responsible for paying the taxes due on what they inherit and this is determined by the amount of the inheritance and their relationship to the deceased.

The property is passed to a surviving spouse does not usually carry a tax on it, but that which passes to children and other family members and friends does. For children there is a deduction of $3,000 allowed and the tax rate on the remainder is usually about 7.5 %. As the relationship between the beneficiary and the deceased gets more distant the deduction decreases to $100 and the tax rate can range from 10% to 30%. There are some states that do not have an inheritance tax at all, so this would not apply.

The federal government imposes an estate tax on all citizens and residents of the United States. However, there is a standard deduction of $1.5 million for exemption and most estates are valued at less than this amount, meaning that the majority of Americans do not have to pay any estate taxes.

With the changes in laws being passed by Congress it is becoming less likely that you will have to pay estate taxes. Currently the deduction for estates is $1.5 million, but this is expected to increase to $3.5 million by 2009. The reason for this is that while $1.5 million may seem to be an exorbitant value, in reality it isn’t. When you are trying to determine the value of your estate you have to look at what each item or piece of property is worth on today’s market. A home that you purchased for $30,000 thirty years ago and enhanced with additions and improvements could well be worth over $500,000 today. If you are an avid collector or if you have an old car, although these items may seem very cheap to you, they may be worth a fortune. If you have any amount of property that you rent, stocks and bonds, cash savings, life insurance policies or annuities, your estate might well exceed the allowable exemption. After your death the person you choose to be the executor will have to collect all the assets you have along with any debts and submit an estate tax return within nine months. Then the IRS will determine how much taxes the estate has to pay. For large estates, this could be very high, often as much as 48% of the amount over the allowable limit.

There are ways that you can avoid having to pay the government a lot of money in estate taxes. During your lifetime, you are allowed to give gifts totalling $1 million to family and friends to avoid paying taxes on them. You can set up an irrevocable life insurance trust that owns the policies on your life. If you die within three years of setting up this trust, it is considered part of the estate. You are allowed to transfer unlimited amounts of money to your spouse tax-free, provided that your spouse is an American citizen.

You can give gifts of up to $11,000 to an individual every year, if you wish, without paying federal tax on it or having it come off the allowable gift limit of a million dollars. If you and your spouse want to make joint gifts and file joint taxes, then this amount rises to $22,000 a year. This is just one example of how you can pass along inheritances to your children and friends without incurring them any stress of taxes after you die and it also frees your estate from having to pay out a lot of taxes on the value.
 

http://www.state.tn.us/revenue/tntaxes/inherit.htm

Inheritance and estate taxes are imposed on decedents' estates that exceed the maximum single exemption. Inheritance tax is due on the net estate as defined in Tennessee Code Annotated. Estate tax is based on the difference between the inheritance tax and the “state death tax credit” allowed on the federal estate tax return.

Exemptions:
Date of Death
Amount
1999
$650,000
2000 & 2001
$675,000
2002 & 2003
$700,000
2004
$850,000
2005
$950,000
2006 and after
$1,000,000

DUE DATE
Nine months after death of the decedent

Extension: An extension of up to one year may be granted upon written request.

TAX RATES
Note the statutory exemptions listed above. Anything over the exemptions are taxed at the following rates:

First $40,000
5.5%
Next $40,000 - $240,000
6.5%
Next $240,000 - $440,000
7.5%
$440,000 and over
9.5%
 

http://www.retirementliving.com/RLtaxes.html

Inheritance and Estate Taxes
An inheritance tax is an assessment made on the portion of an estate received by an individual. It differs from an estate tax which is a tax levied on an entire estate before it is distributed to individuals. It is strictly a state tax. Eleven states still collect an inheritance tax. They are: Connecticut, Indiana, Iowa, Kansas, Kentucky, Maryland, Nebraska, New Jersey, Oregon, Pennsylvania and Tennessee. Connecticut will be phased out after 2005. In all states, transfers of assets to a spouse are exempt from the tax. In some states, transfers to children and close relatives are also exempt.

As for estate taxes, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) phases out the federal estate tax that culminates in full repeal in 2010. On a much faster track, the legislation repeals over four years -- 2002 through 2005 -- the federal estate tax credit to which state estate taxes are tied. In most states, estate and inheritance taxes are designed in such a way that states face either a full or partial loss of estate tax revenues as this credit is phased out. States can avert this loss of revenue by "decoupling." Decoupling means protecting the relevant parts of their tax code from the changes in the federal tax code, in most cases by remaining linked to federal law as it existed prior to the change.

Seventeen states and the District of Columbia have retained their estate taxes after the federal changes. Of these, 15 states -- Illinois, Kansas, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Ohio, Oregon, Rhode Island, Vermont, Virginia, and Wisconsin -- and the District of Columbia decoupled from the federal changes. Two states -- Nebraska and Washington -- retained their tax by enacting similar but separate estate taxes.

Of these, 12 states acted to decouple from the federal changes. Illinois, Maine, Maryland, Massachusetts, New Jersey, Rhode Island, and Vermont enacted legislation linking their estate taxes to the federal estate tax as in effect before the 2001 tax bill. Minnesota, which passes a tax conformity package each year, explicitly elected not to change its estate tax to conform to the federal changes. North Carolina elected to decouple at least through 2005, and Wisconsin has decoupled through 2007. Nebraska decoupled by creating a separate state estate tax on estates that exceed $1 million based on the federal law before the 2001 changes. In 2005, Washington enacted a separate tax with a somewhat different rate structure that applies to estates that exceed $2 million after the state's original decoupling was nullified in court.

In addition, five states and the District of Columbia will remain decoupled unless they take legislative action. In five states -- Kansas, New York, Ohio, Oregon, and Virginia -- and the District of Columbia, estate tax laws are written in such a way that the state will not conform to the federal changes unless it takes legislative action.
Sources: http://www.1800probate.com/resources/difference-between-an-estate-tax-and-an-inheritance-tax.html

The Family Trust

Another trust which can be used to save income taxes is the family trust. Where the trust owns income producing assets (for example a management company which supplies staff to a business or a leasing company which leases equipment to a business), the income earned by the trust can be allocated to the beneficiaries of the trust. If those beneficiaries are children or a spouse with little or no income, then the beneficiaries will not be taxed on that income. Such beneficiaries can receive tax-free income of approximately $21,000 each annually, saving an individual with a 39 percent marginal rate (in Alberta) about $8,190 each year.

The income earned by the trust need not be paid to the beneficiaries each year, but must be allocated to them and declared in their individual tax returns. Because parents are responsible for the basic needs of their children, including shelter, clothing and food, the Canada Revenue Agency has taken the position that the children's trust income cannot be used for these purposes; however, such trust income can be used to pay for the children's non-essentials, such as sporting activities, vacations and education. Where possible, these activities should be paid for directly by the trust on behalf of the children, rather than just reimbursing the parent.

The costs of starting up and administering such a trust are much lower than the annual tax savings.

In the normal course, you will incur these "non-essential" expenditures for your children in any event. Why not take advantage of the tax saving made available to you by our current tax legislation? You are encouraged to contact us to obtain more information or discuss this matter.
Sources: http://carrlaw.com/family-trusts-income-taxes.asp

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