The tax treatment of a trust depends on the type of trust and the type of tax. While it is generally inaccurate to state that trust funds are tax-free, setting up a trust can bring certain tax advantages. It can also bring tax liability to the grantor and to trust beneficiaries.
A revocable trust is, as its name suggests, a trust that you have the power to revoke at any time. Revocability is generally stated in the trust document that you sign when you create the trust. The IRS completely ignores revocable trusts for tax purposes. All trust income is taxed as your personal income. Although assets contributed to a revocable trust are not subject to probate, the IRS still considers trust assets part of your estate when you die for the purpose of assessing estate taxes. Although you can draft the trust document to have the trust expire upon your death, if the trust survives your death it becomes irrevocable automatically and is taxed as such.
A trust is irrevocable if the trust document deprives you of the power to unilaterally revoke it. Since the assets of an irrevocable trust are not legally yours anymore, the IRS treats an irrevocable trust as an independent taxpayer. Irrevocable trust income, such as interest earned on trust-owned funds, is taxed in much the same way as individuals are, although the trustee must file Form 1041 instead of Form 1040. An irrevocable trust may earn up to $600 per year tax-free.
Estate tax is levied on the value of a deceased taxpayer’s estate to the extent that its taxable value exceeds $5.25 million, as of 2013. Any assets, including cash that you contribute to an irrevocable trust before you die are not counted as part of your estate for the purpose of assessing estate tax. Moreover, since trusts do not physically die, estate tax will not be assessed against the trust itself even if it terminates according to the trust document as soon as you die. You can avoid estate tax by contributing enough to an irrevocable trust to bring the taxable value of your estate below $5.25 million.
Taxation of the Grantor
Even though you can shield your assets from estate tax by contributing to an irrevocable trust, you may be assessed gift tax on your contributions to the trust while you are still alive. You are allowed to contribute up to $14,000 per year, as of 2013, to any person or to an irrevocable trust without triggering gift tax liability. It is possible to structure a trust to multiply the gift tax exemption by contributing up to $14,000 to multiple beneficiaries through the trust.
Taxation of Beneficiaries
Beneficiaries are generally not taxed on trust assets until the assets are actually distributed to them, regardless of whether the trust is revocable or irrevocable. Once trust assets are distributed, however, the beneficiary is taxed on the distribution as his personal income. The trustee will distribute Schedule K-1 to the beneficiary, and the beneficiary must use the information in Schedule K-1 to report trust income by completing Schedule E and Form 1040.
- TurboTax: Estates and Trusts
- Internal Revenue Service: Instructions for Form 1041
- Bankrate.com: How a Trust is Taxed
- Internal Revenue Service: Abusive Trust Tax Evasion Schemes
- Maryland State Bar Association: Uniform Trust Code
- Law Offices of Keith Codron: New Gift Tax Provision for Transfers to Irrevocable Trusts
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