Dear Harry,
I’m interested in setting up a revocable life insurance trust. I’d like to know if any money given to grandchildren as a loan by the trust is taxable, since it’s not a gift. For instance, if they need $40,00 for education, a down payment on a house or to buy a car, would they be better off receiving this as a loan rather than as a trust distribution?
Dear reader,
Allow me to clarify one issue before getting to your question. You talk about setting up a “revocable” life insurance trust. Most life insurance trusts are, in fact, “irrevocable” and are generally used to shelter the life insurance proceeds from estate taxation. However, since only very large estates (those over $13 million for those dying in 2023, a threshold which is slated to be cut in half for those dying in 2026 or later) are subject to federal estate taxes, such trusts are only of benefit to few individuals these days (though they can help reduce state estate taxes if you live in one of the few states with such taxes and your estate exceeds its limits, which may be significantly lower than the federal threshold).
If your estate is not taxable, you can, as you suggest, create a revocable trust to hold the life insurance proceeds paid out at your death. Such a trust will, in fact, become irrevocable upon your death, but you will be free to make any changes to it that you chose during your life.
The trust, once funded, will be able to make loans to your grandchildren and such loans would not be taxable. But it’s also unlikely that your grandchildren would have to pay any significant taxes on distributions from the trust and such distributions would be much simpler to administer than loans. In fact, the ultimate taxes for distributions are likely to be lower than those from loans.
Here’s why: Any loans from the trust to your grandchildren must be real. Your grandchildren should sign promissory notes for such loans and pay interest while the loans are outstanding. The IRS sets the so-called Applicable Federal Rate (AFR) as the interest rate that should be charged and adjusts it each month based on prevailing market interest rates. The trust will pay taxes on such interest it receives at the tax rate for trusts, which accelerate much more quickly than individual income-tax rate.
Irrevocable trusts must file annual 1041 tax returns on which they report their income, usually from dividends and interest. If they hold on to the money, then they pay the taxes on the income at the trust income-tax rates.
If, instead, they distribute the income to the trust beneficiaries, then it passes through to recipients. The trust issues them K-1s (like 1099s) so they know what to report on their income tax returns. This often results in lower ultimate taxes because trust taxes accelerate into higher rates more quickly than individuals, reaching the top rate of 37% at just $14,450 on income (in 2023).
Your grandchildren, especially while they are young, are likely to be subject much lower marginal tax rates. As a result, the ultimate taxes paid on trust income, whether from personal loans or investment income, may be substantially lower if it is distributed.
If you would like to relieve your grandchildren of the burden of such taxes, the trustee could make further distributions to them based on their reports of the taxes they pay on the trust income that passes through to them.
Given the necessity of executing promissory notes, the burden on your grandchildren as trust beneficiaries of paying the interest and ultimately the principal on the loans, and the taxes the trust would have to pay on that interest (and its other income), it would be much simpler for the trust to simply make distributions to your grandchildren. And the ultimate taxes are likely to be lower.
