Living trust and a revocable trust are two terms you can hear about in nearly every estate planning meeting. These two trust forms are similar in that they may be set up to avoid probate after your death. However, there are several differences between them that can make one more suitable for your situation than the other. To simplify, this article will highlight the differences between living trusts and revocable trusts and provide you with information on how to file taxes for a living trust.
People have asked me how to file taxes for a living trust, or how I was able to file a living trust for my clients. Others had similar questions about creating a living trust and wanted to know how easy it would be once they signed one. They wanted to know what it would cost, too. After all, whenever you want to get something done, you need to know how much it’s going to cost you. The answer is pretty simple: Well, it depends…
How to file taxes for a living trust
If you have a living trust, you’ll need to file your taxes differently than if you did not have one. Here’s how:
- Check with your accountant or tax preparer about how to file taxes for a living trust. They will have the most up-to-date information on what forms are required, how they should be filled out, and how much money should be paid in taxes. You can also refer to IRS Publication 559: Survivors, Executors, and Administrators for more information about filing taxes if you’re an executor or administrator of an estate.
- If you’re not sure whether or not filing taxes as part of an estate is right for you, consult with an attorney who specializes in estate planning before proceeding further down this path; they will be able to advise on whether or not it’s appropriate given your particular circumstances and goals for your estate/trust (i.e., whether or not it makes sense from a tax perspective).
Living Trust Basics
A living trust is one of several varieties of trusts often used in estate planning. A living trust is an instrument that can be used to control where one’s assets go either before or after death. It can help heirs skip probate, avoid conservatorship in the event of incapacitation and specify how assets will be left to minor children, among other things.
To set up a living trust, an attorney draws up the documents creating the trust. Then assets are transferred to the control of a trustee overseeing the trust. The trustee can the original owner of the assets, called the grantor, or someone else appointed by the grantor. The trustee is charged with managing the assets for the benefit of the named beneficiaries.
Living trusts come in a number of varieties. Transfer of assets to irrevocable trusts can’t be reversed. Revocable trusts allow the grantor to change or cancel the terms of the trust. Marital trusts are a type of irrevocable living trust allowing transfer of assets to a surviving spouse without taxation. Grantor trusts, in which the grantor retains control of assets are treated like revocable trusts for tax purposes.
Living Trust Tax Filing Requirements
A trust with more than $600 in income during a tax year is required to file a federal income tax return. The trustee files out a Form 1041 reporting the trust’s income. Even if it does not report $600 income, a trust must file a return if it has a non-resident alien as a beneficiary. However, there are exceptions to this rule.
One exception to this rule is a grantor trust, one in which the grantor of the trust retains control over the assets in the trust. In the case of a grantor trust, the grantor has to report the trust’s income on his or her personal 1040. The grantor is also responsible for paying any taxes due on the trust’s income.
Another exception to the rule that living trusts must file tax returns is a revocable marital trust in which both spouses are living. In this case the income from the trust’s assets is reported on the spouses’ personal returns and the trust does not file a Form 1041.
When one spouse dies, however, things change. At that point, the portion of that spouse’s assets in a revocable living trust become irrevocable. The trust must file a Form 1041 for that year, reporting and paying taxes on the income from the deceased spouse’s portion of the assets. This is typically half the trust’s assets. Afterward, the irrevocable trust will file a return, subject to the income level requirements, every year.
Trusts also must provide a tax form called a Schedule K-1 and supply it to beneficiaries of the trust. This will sum up any funds the trust distributed to beneficiaries. The beneficiaries of the trust have to report any receipts from the trust on their own personal returns.
Living trusts have to file tax returns in most cases if they have $600 or more in income for a given tax year. They may also have to file if the living trust is a grantor-controlled trust or a revocable marital trust and both spouses are still living. Trusts that file tax returns do so using Form 1041. However, the grantors of grantor-controlled and revocable trusts report the trust’s income on their own personal returns. Living trusts also supply Schedule K-1 forms to beneficiaries outlining and funds paid to them during the year as benefits.
Estate Planning Tips
- Living trusts can be effective tools for estate planning, but they are best used with the help of a financial advisor. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals.
- Estate planning can be complex, and that’s especially true if you’re someone with significant wealth. To make sure you have everything you need, read up on the essential estate planning tools for wealthy investors.
- Inheritance isn’t usually considered income, but certain types of inherited assets can have tax implications. Before you spend or invest your inheritance, read more inheritance taxes and exemptions.
Two Categories of Trusts: Revocable and Irrevocable
Revocable Trusts
A revocable trust is a trust which can be revoked or amended by its creator at any time and without anyone’s consent. Of course, the creator of the trust retains the unrestricted control of the trust assets so long as he or she is competent. After the creator’s death, the trust usually continues for traditional estate planning purposes.
When planning for a family member with special needs, his or her parent(s) or other relatives often create a revocable special needs trust but expect to delay funding until the creator’s death. The trust creator may declare the trust irrevocable at any time and may even provide for an automatic shift to irrevocable status under a specific circumstance, such as funding by someone other than the trust creator. Revocable trusts give the creator significant flexibility to address changes in the lives of those expected to be involved in the future administration of the trust.
Irrevocable Trusts
Irrevocable trusts are the other (and more commonly used) category of trusts used in special needs estate planning. The primary characteristics of an irrevocable trust are that the creator cannot amend the provisions of the trust and cannot spend trust funds for the benefit of anyone other than the beneficiary unless the terms of the trust document specifically authorize it. Sometimes the trust document grants the trustee a limited right to amend certain provisions if changes in the beneficiary’s life justify or require an amendment. For example, this need could be triggered by the beneficiary moving to another state with different laws or policies, or by changes in trust, tax, or public benefits law.
SNTs created by and funded with the assets of the parents, grandparents or other relatives are called “third-party” SNTs, whether they are irrevocable at the time of creation or become irrevocable later. SNTs funded with assets of the beneficiary are called “first-party,” “self-settled” or “Medicaid payback” trusts and must be irrevocable from the beginning. First-party trusts can receive and hold any assets of the beneficiary, such as his or her injury settlement funds and gifts and inheritances left directly to the beneficiary.
Whether a first- or third-party irrevocable SNT, the creator is prevented from accessing the funds unless those funds are to be spent for the benefit of the trust beneficiary according to the trust’s terms.
Trust Taxation
Family members should have a general understanding of the basic income tax rules that will apply to the trusts they create for their loved ones. Where is the trust’s income reported? Who is responsible for the payment of tax on the trust’s income? The remainder of this article addresses questions like these.
Revocable Trusts
Revocable trusts are the simplest of all trust arrangements from an income tax standpoint. Any income generated by a revocable trust is taxable to the trust’s creator (who is often also referred to as a settlor, trustor, or grantor) during the trust creator’s lifetime. This is because the trust’s creator retains full control over the terms of the trust and the assets contained within it. Typically during the creator’s lifetime, the taxpayer identification number of the trust will be the creator’s Social Security number. All items of income, deduction and credit will be reported on the creator’s personal income tax return, and no return will be filed for the trust itself. Revocable trusts are considered “grantor” trusts for income tax purposes. One could think of them as being invisible to the IRS and state taxing authorities. Grantor trusts are discussed in more detail below.
Irrevocable Trusts
Most irrevocable trusts have their own separate tax identification numbers, which means that the IRS and state taxing authorities have a record of the existence of these trusts. Income of a trust that has a tax identification number is reported to that tax identification number with a Form 1099, and a trust reports its income and deductions for federal income tax purposes annually on Form 1041. There are two primary taxation categories of irrevocable SNTs: (1) grantor trusts and (2) non-grantor trusts.
Grantor Trusts
If a trust is considered a grantor trust for income tax purposes, all items of income, deduction and credit are not taxed at the trust level, but rather are reported on the personal income tax return of the individual who is considered the grantor of the trust for income tax purposes.
The concept of who is the grantor can sometimes be confusing, especially in the context of a first-party SNT. For income tax purposes, the grantor is the individual who contributed the funds to the trust, not necessarily the person who signs the trust as the creator. Generally all first-party trusts (those funded established with the beneficiary’s own assets) are considered grantor trusts for income tax purposes and so all of the items of income, deduction and credit will be reportable on the beneficiary’s personal income tax return.
Third-party SNTs can also be created as grantor trusts, as sometimes the creator of the third-party SNT wants to remain responsible for payment of the income taxes during his or her lifetime. In those instances the creator of the trust retains certain rights which cause the trust to be treated as a grantor trust for income tax purposes. At the time the creator of the trust passes away or otherwise relinquishes the rights causing the trust to be a grantor trust, the trust’s income will no longer be taxable to the grantor, and the trust will no longer be considered a grantor trust.
Non-Grantor Trusts
When a trust doesn’t qualify as a grantor trust for income tax purposes, how is the trust taxed and who pays the taxes on the income?
To the extent the trustee of a non-grantor trust pays expenditures on behalf of the beneficiary of the trust, the trust receives a deduction, and all or a portion of the trust’s income will be taxed to the beneficiary. This relates to a provision in the Internal Revenue Code that states distributions to or for the benefit of a non-grantor trust beneficiary carry out income to that beneficiary. For example, if in 2012 a taxable trust generated $3,000 of interest and dividend income, and the trustee made distributions of $5,000 for the benefit of the beneficiary in 2012, all of the $3,000 of income would be treated as having been passed out to the beneficiary and thus taxable to the beneficiary on his or her personal income tax return.
Though at first blush this may not seem ideal, in many cases the result is good because the beneficiary, earning little or no income, is in a low income tax bracket. The beneficiary will often have his or her own personal exemption ($3,800 for federal income tax purposes in 2012), and in many cases the standard deduction available for individual taxpayers ($5,950 in 2012). Unless the beneficiary has other sources of taxable income, the only trust income ultimately taxable to the beneficiary will be the amount of income that exceeds the total of the beneficiary’s standard deduction and personal exemption.
By contrast, to the extent that trust income is not distributed to or expended on behalf of the beneficiary in a given year (or by March 5th of the following year), that retained income is taxed to the trust. Using the same example above, if a taxable trust generated $3,000 of income in 2012, and only $1,000 was expended on the trust beneficiary in 2012, $1,000 of income will be passed out and taxable to the trust beneficiary, but the remaining $2,000 of income will be taxable at the trust level.
Dramatic Differences in Tax Rates
Understanding the income tax treatment of taxable trusts is important because trusts have highly compressed tax brackets. For 2012, trusts reach the highest federal tax bracket of 35% at taxable income of $11,650 (except for capital gains, which are taxable at a lower rate). By comparison, the tax rate for single taxpayers on taxable income of $11,650 is only 15%. The highest federal tax bracket of 35% does not apply to most individual taxpayers until their taxable income reaches $388,350. In addition, many states also tax the income of trusts.
Exemptions
Taxable trusts have a very small exemption of only $100. (If the trust requires that all income be distributed annually, the exemption is $300, but a SNT should not have such a requirement.) If the third-party SNT and its beneficiary meet certain requirements, the trust can be considered a Qualified Disability Trust (QDT) for federal income tax purposes and allowed a larger exemption. The next issue of The Voice will discuss the QDT, the higher federal income exemption QDTs are allowed, and when a third-party SNT can or should be drafted as a QDT.
Conclusion
Family members and the professionals helping them often fail to consider and discuss the various options available in establishing a SNT and how choices affect the taxation of the trust. Being aware of the income tax aspects of these commonly used estate planning tools can help the attorney and client make choices that can minimize the federal and state income taxes payable at different stages of the trust’s existence. Failing to consider these consequences may result in unintended contributions being made to the IRS. As one can glean from this article, trust taxation is a complex but very important topic. Families and trustees need to work with a practitioner who has both knowledge and experience with SNTs and trust taxation.
How is a living trust taxed after the death of the grantor
Interplay with the decedent’s final return, fiduciary income tax, and Form 706
Upon the death of the grantor, grantor trust status terminates, and all pre-death trust activity must be reported on the grantor’s final income tax return. As mentioned earlier, the once-revocable grantor trust will now be considered a separate taxpayer, with its own income tax reporting responsibility. Sec. 644(a) states that the tax year of any trust (other than trusts exempt from tax and charitable trusts) must be the calendar year.
Depending on the language and directives embodied in the trust document, the trust may be considered a simple trust (one required to distribute all its income annually and which does not also distribute corpus or principal) or a complex trust. Concurrently, the deceased grantor’s estate will come into existence and also be considered a separate taxpayer for income tax purposes. The estate will have its own tax reporting responsibility and be required to obtain a TIN.
An often overlooked yet important distinguishing factor applicable to an estate is its ability to elect a fiscal year other than a calendar year. Electing a fiscal year end may afford the estate or beneficiaries a tax-deferral opportunity and provide the executor with additional time to organize the estate’s affairs. This can be especially advantageous when the decedent dies during the latter part of the calendar year.
To reduce the number of separate income tax returns that may be required after the death of the grantor, the trustee of a former revocable trust and the estate’s executor may consider a Sec. 645 election to treat certain revocable trusts as part of the estate. A trust will be considered a qualified revocable trust (QRT) if it was treated under Sec. 676 as owned by the decedent of the estate by reason of a power in the grantor. The election, which is irrevocable, is made by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate, no later than the time prescribed for filing the return for the first tax year of the estate, including extensions, or, where no probate estate exists, the due date of the QRT’s income tax return, including extensions. A Sec. 645 election makes available a number of income tax advantages that would not otherwise be available in a separate trust tax filing, including:
- Use of a fiscal year;
- A larger exemption amount ($600 versus $300 for a simple trust versus $100 for all other trusts);
- No requirement to make estimated tax payments until after the second tax year following the decedent’s death;
- Deducting medical expenses paid by the trust on the decedent’s final income tax return;
- A potentially longer time frame for owning S corporation stock (period of administration versus two-year period for former revocable trusts);
- Claiming a charitable deduction for amounts permanently set aside for charitable purposes but not yet paid;
- Ability to deduct losses for in-kind pecuniary bequests otherwise nondeductible under the related-party rules for trusts; and
- Two-year waiver of the active participation requirement under the passive activity rules.
A Sec. 645 election will remain in force for (1) two years if no estate tax return is required to be filed, or (2) the earlier of the date the trust and estate have distributed all of their assets or the day before the later of (a) two years following the date of the decedent’s death or (b) six months after determination of the estate’s final estate tax liability, if an estate tax return is required to be filed (Reg. Sec. 1.645-1(f)). During the election period, income and deductions are reported on a combined basis, but distributable net income must be computed separately for the estate and trust. Upon termination of the election, the electing trust component is deemed to have been distributed to a new trust. The new trust will be required to report on a calendar year, which may cause beneficiaries to receive two Schedule K-1s, Beneficiary’s Share of Income, Deductions, Credits, etc., in instances where the co-electing estate files on a fiscal year.
If Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, is required, the assets held in the revocable trust should be aggregated and reported on Schedule G, Transfers During Decedent’s Life, rather than listed separately (e.g., stocks and bonds, real estate, mortgages, notes, cash, etc.). Additionally, the Part 4, General Information, questions dealing with lifetime transfers (Q12) and the establishment of trusts (Q13) should be answered “yes.” A verified copy of the written trust instrument should also be attached.
Practitioners should know the tax implications when a grantor dies
In summary, the use of revocable trusts has become increasing widespread in recent years. In many instances, the grantor, trustee, and executor have focused their attention on the nontax advantages of using revocable trusts, particularly in jurisdictions where probate is costly and protracted. Practitioners must be aware of the tax issues and nuances that will ensue upon the death of the grantor, so they can provide before-the-fact, valued-added advice to their clients.
Tax Consequences of a Living Trust
Income Tax Consequences
Irrevocable Trusts: When the grantor or the grantor’s spouse is the trustee or co-trustee of the Living Trust, the grantor of the Living Trust continues to be treated as the owner of the assets that are now part of the trust. Thus, if you are the grantor of your Living Trust, you must report the income from the Living Trust assets on your individual income tax return in the same manner as you did prior to transferring the assets into your trust. If some other party is the trustee, the grantor is not responsible for paying income taxes generated by trust assets; instead, the trustee has additional tax reporting requirements.
Revocable Trusts: For income tax purposes, the grantor of a Living Trust continues to be treated as the owner of the assets that are now part of the trust no matter who is the trustee.
Gift Tax Consequences
The grantor must pay gift taxes whenever assets are transferred into an irrevocable trust. Revocable trusts are not subject to gift taxes, but will be included in the grantor’s estate for estate tax purposes.
Estate Tax Consequences
Estate tax savings provisions can be included in a Living Trust, but a Living Trust has no more estate tax savings potential than a traditional Will. The key cost saving difference between the two is the Living Trust’s avoidance of probate.
Because there are several kinds of Living Trust that help you avoid, reduce or postpone federal estate and income taxes, if you are interested in creating a Living Trust, contact an attorney.