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Question:

The beneficiaries want our trustee to petition the probate court to dissolve an irrevocable trust in Texas because we believe it has served it purpose. The trustee would agree. I read on another forum that “dissolving the trust would eliminate the generation-skipping feature so the assets would be included in the estate of the beneficiaries and then subject to the estate tax in the future.” Can you explain how that works and can you point to anything specific to clarify the tax liability difference versus the normal termination the trust on a persons death, per the trust rules. And won’t the assets be in the beneficiaries estate in the future away?

Response:

The comment about the generation-skipping feature may or may not apply to your trust, but it’s probably irrelevant given the current estate tax threshold. The federal estate tax threshold is just over $12 million (slated to go up to almost $13 million in 2023, but then be cut in half for people dying after 2025). But even at $6.5 million very few estates will be subject to estate tax, especially since married couples together will still be able to exclude $13 million.

Many trusts that are created by a third party, for instance by parents for the benefit of their children, are not subject to tax when the beneficiaries die. So, continuing our example, if parents create a trust for the benefit of their children which is distributed to the grandchildren when the members of the intervening generation die, it won’t be subject to tax when distributed to the grandchildren. This is why it’s called a generation-skipping trust. (Large generation-skipping trusts may be subject to a separate generation-skipping tax, but let’s not get into that.) As you suggest, by distributing the trust assets to the children they will then be in their estates and subject to estate taxation when they die, forfeiting the generation-skipping tax benefits. But that’s only an issue if such beneficiaries have taxable estates in the first place or the trust distribution pushes them over the threshold.

In short, it’s unlikely that dissolving the trust early will have any tax implications, but I couldn’t be certain without seeing the trust or knowing about the beneficiaries’ estates. But be aware that generation-skipping trusts also offer other benefits, primarily asset protection. In most cases, the funds in trust are not subject to claim by creditors of the beneficiaries which means they are protected in the event of bankruptcy. In addition, these trusts often offer divorce protection so that they funds in trust do not have to be included in the marital estate when there’s a split of assets. Both protections would be lost if the trust were dissolved.

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