Taxation of a Revocable Trust

by Beverly Bird

    The primary purpose of creating a revocable trust is to allow your estate to avoid the probate process. Beyond that, such a trust can't do much else. It doesn't escape estate taxation and it can't protect your assets from creditors. If you do elect to form a revocable trust, tax issues will typically proceed as though you had never created a trust at all.

    Nature of Trust

    The greatest difference between a revocable trust and an irrevocable trust is that with the former, you retain control of the assets you transfer to it. Assuming you name yourself as the trustee – and this is the norm – you can change the terms of the trust, sell its assets, use it to purchase new assets, or even revoke and undo it. An irrevocable trust doesn't allow you this freedom. When you transfer ownership of your assets into an irrevocable trust, you typically can't act as the trustee and you lose control of them forever. This is a pivotal issue for tax purposes because it means you still control -- and technically still own -- the assets you place in a revocable trust.

    Income Tax

    If the assets placed in your revocable trust earn interest, you must report it as unearned income on your personal return. If your revocable trust sells assets for a profit, you must report capital gains. The Internal Revenue Service does not automatically recognize your revocable trust as a separate tax entity. An exception exists if you name someone else as trustee. In this case, your trust must apply for a federal employer identification number or EIN and file a return of its own, reporting income, capital gains or losses. If your trust makes distributions to beneficiaries, they must report them on their own returns.

    Estate Tax

    Federal estate tax laws change considerably in 2013 unless Congress takes steps to prevent it. Through 2012, the IRS only taxes estates whose values exceed $5.2 million and only the excess over $5.2 million is subject to tax. This drops to $1 million in 2013, however, and the estate tax rate increases as well. Because you still own the assets you place in a revocable trust, they contribute to this $1 million threshold and your estate must pay taxes on any value over this amount.

    Portability

    With or without a revocable trust, a decedent can leave the entirety of his estate to his spouse without incurring an estate tax. When the second spouse dies, however, the tax comes due, so this option is more of a deferral than a means to avoid the estate tax entirely. A concept called "portability" allows a decedent to transfer to his spouse any unused portion of his $5.2 estate tax exclusion so she can use this to shield the inherited assets from taxation at the time of her own death. Unfortunately, the 2013 estate tax changes also eliminate portability.

    A-B Trusts

    Creating an A-B trust can sidestep the problem created by the loss of portability. An A-B trust is typically used by husband and wife, and it is revocable during their lifetimes. When one of them dies, it splits into two trusts -- thus the name "A-B" trust. One is called the decedent's trust, which is now irrevocable, and the other is called the survivor's trust. Although the survivor has only limited access to the assets in the decedent's trust, it is possible for her to use them in certain circumstances. After the surviving spouse dies, the assets pass to the couple's beneficiaries -- typically their children -- and because the assets come from the estates of two different people, two estate tax exemptions apply rather than one. Had the A-B trust not existed and the surviving spouse inherited everything, she would have only one estate tax exemption to pass to her beneficiaries.

    About the Author

    Beverly Bird has been writing professionally since 1983. She is the author of several novels including the bestselling "Comes the Rain" and "With Every Breath." Bird also has extensive experience as a paralegal, primarily in the areas of divorce and family law, bankruptcy and estate law. She covers many legal topics in her articles.

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