Trusts are created by individual persons to protect and preserve income and assets and to distribute them to the trust beneficiaries. Trusts have the ability to earn income and this income may be subject to income tax.
The way a trust is taxed will generally depend on whether it is a revocable trust or an irrevocable trust. A revocable trust is one that can be amended or changed during the life of the grantor/creator. An irrevocable trust is one that, once created, cannot usually be amended or revoked.
The vast majority of trusts are revocable. However, all revocable trusts become irrevocable upon the death of the grantor.
How Revocable Trusts Are Taxed
Revocable trusts do not pay taxes because they are disregarded by the IRS. A Revocable Trust doesn’t even have a tax number because it is not required to file an income tax return.
Furthermore, when assets are moved in and out of a revocable trust, no tax consequences are triggered. What’s more, when the trust earns income, this income is reported on the grantor’s individual tax return.
For instance, if your revocable trust owns stock and that stock receives a dividend, you will need to report this income on your individual income tax return. However, there will be no tax consequences for the trust itself.
How Irrevocable Trusts Are Taxed
How a revocable trust is taxed is easy to understand, because it doesn’t pay any taxes. That said, a revocable trust will eventually become irrevocable.
When the grantor of a revocable the trust dies, the trust can no longer be amended. At that point, the trust becomes irrevocable, by definition, and the income tax consequences of an irrevocable trust come into play.
Similarly, if the trust is set up as an irrevocable trust from the start, you need to be aware that there might be income tax consequences. This is because an irrevocable trust must pay taxes on any income it generates and these taxes can be substantial.
An irrevocable trust must have a tax ID number, just like a corporation does when it is formed. And, the trustee of an irrevocable trust must file a separate income tax return for the trust using IRS Form 1041.
But, sometimes irrevocable trusts have no income to report. Furthermore, when the irrevocable trust does have income to report, the trustee may choose to distribute that income to the trust beneficiaries to be paid at a lower rate.
In this case, the trust beneficiaries will report the income on their individual income tax returns, where it will be taxed at the personal income tax rate, and the trust will again have no income to report.
Reporting income tax for an irrevocable trust can sometimes be complicated. As a result, you may need the help of a qualified tax professional to report the trust income properly.
To summarize, a revocable trust pays no taxes. Income earned by a revocable trust flows through to the grantor.
On the other hand, an irrevocable trust must pay taxes on any income it earns, unless that income is distributed to the trust beneficiaries. Reporting income tax for an irrevocable trust may require the help of a qualified tax professional.
To learn more about trusts and taxation, call us to schedule a free consultation with an experienced estate planning attorney.
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