Irrevocable trusts introduce a layer that disconnects assets the trust owns from the control of the trust’s creator. Because the donor gives up the rights of ownership to any assets placed in an irrevocable trust, any income those assets generate belongs to the trust. To avoid double taxation, trusts pay taxes on any income they hang onto, while income distributed shows up on the tax return of the recipient. Some distributions can be made tax free.
Tax Exempt Income
Certain types of income receive special treatment under tax laws, exempting them from federal taxation. State and local bond interest, for example, is specifically excluded from taxable income under Section 103 of the federal tax code. When a trust distributes current year income, the characteristics of the income are passed on to the recipient. Paying out tax-exempt income to a beneficiary results in the beneficiary reporting tax-exempt income on her taxes.
Income Already Taxed to Trust
Some trusts might hang onto income from year to year. When a trust earns income and doesn’t distribute it, the trust must pay taxes on the undistributed amount. If the trust later pays that income out in subsequent years, the recipient doesn’t have to include it on his taxes again. This ensures that income earned by a trust is only taxed once.
Distribution of Corpus
The assets put into a trust form the trust’s corpus. Tax laws allow trusts to recover the after-tax money locked up in the corpus as tax-free return of principal. Trusts pass this benefit along to their beneficiaries in the form of tax-free distributions. Any amount distributed over the trust’s distributable net income comes from the trust’s corpus, and the recipient doesn’t report it as taxable income.
Crummey Trust Gifts
While gifts in excess of a certain amount are subject to a transfer tax, it’s the responsibility of the person making the gift to pay the tax. Trusts are commonly used to facilitate large, long-term gifts. For example, a small-business owner might use a trust to break up each individual gift to take advantage of the gift exemptions. To qualify for this tax treatment, the beneficiaries need some ability to access the gift in the year it is made. That ability, referred to as "Crummey powers," allows donors to avoid gift taxes on contributions made to an irrevocable trust.
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