A trust is a legal device that allows you to place assets, including money, under the care of a trustee you appoint. A trust fund is simply a sum of money kept in a trust. The tax treatment of a trust fund depends on the type of trust that holds it — a revocable trust or an irrevocable trust. An irrevocable trust offers more favorable tax treatment than a revocable trust.
The trust document that creates the trust should clearly state whether it is revocable or irrevocable. If the wording of the trust doesn't make this clear, the revocability of the trust will depend on state law. The trust law of some states presumes that the trust is revocable unless the trust document states otherwise, while the trust law of other states presumes the irrevocability unless stated otherwise. If the trust is irrevocable, it typically cannot even be amended without either a court order or the agreement of the trust grantor and all beneficiaries.
Trust Income Tax
If your trust is revocable, the Internal Revenue Service will ignore it for tax purposes, meaning that any income the trust property earns will be taxed to you just as if you had never established the trust in the first place. If the trust is irrevocable, the IRS will treat it as a separate taxpayer. The trustee must file a separate tax return from it, Form 1041, if the trust (i) earned any taxable income at all during the year or (ii) earned gross income of $600 or more during the year, even if the income wasn't taxable. Any taxes due for an irrevocable trust can only be taken out of trust assets — you cannot be held liable for them.
Estate tax is levied on the value of the estate of a deceased taxpayer. Since the estate tax exemption is so large ($5 million as of publication), only wealthy taxpayers need concern themselves with estate tax. If you establish a revocable trust, its assets are subject to estate tax after you die to the extent that their value exceeds the estate tax exemption. If the trust is irrevocable, however, it is considered a separate taxpayer and your death will not trigger estate tax liability based on trust assets.
If you contribute money to a trust fund, any amount exceeding $13,000 per year triggers gift tax liability. As of publication, the maximum gift tax rate is 35 percent of the amount exceeding $13,000. You can avoid paying this amount by reducing the amount of your lifetime unified credit by the amount of the gift tax you would otherwise owe. Doing this, however, will reduce your estate tax exemption. Even if you use the unified credit, however, you will still have to file a gift tax return, Form 709.
- Internal Revenue Service: Instructions for Form 1041 and Schedules A, B, G, J, and K-1
- Bankrate.com: How a Trust Is Taxed
- Internal Revenue Service: Abusive Trust Tax Evasion Schemes
- Maryland State Bar Association: Uniform Trust Code
- LawEasy.com: Revocable Trust and the Gift Tax
- Law Office of Kieth Codron: New Gift Tax Provision for Transfers to Irrevocable Trusts
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