Irrevocable and revocable trusts are taxed differently, which makes sense since they are different entities.
An irrevocable trust is a trust that “cannot be modified, amended or terminated without the permission of the grantor’s named beneficiary or beneficiaries.” In contrast, as indicated in our previous blog, a grantor in a revocable trust can alter or cancel it.
Senior Couple Planning Their Trust. Be Sure You Understand the Tax Consequences in Different Types of Trusts.
The government considers their assets differently. That is the major reason for the difference in tax treatments. On the one hand, the IRS considers the assets of a revocable trust to be the explicit property of the grantor. Therefore, the IRS calls the revocable trust by the term “grantor trust.” On the other hand, the government and the law treats an irrevocable trust as “an independent legal entity that owns its assets.”
Thus, you can see the dilemma. The type of trust you create can have some serious taxation consequences. Some might be good and some not-so-good.
Revocable Trusts and Your Income Tax
According to the letter of the law, “A revocable trust may earn income in the form of interest on funds held in a bank account.” Therefore, if a trust owns a house, it can collect and bank rent on it.
- Principal Law wants you to know and understand this fact. When you create a revocable trust, all income from it will be taxed as part of your personal income.
- Yes, you must report trust dollars on your form 1040. Without exception, the IRS must tax money left in the trust. And they will tax money moved to a different account, but earned by the trust.
A Special Tip from Principal Law: Register the Trust
Don’t neglect the little section of ID information specifically concerning the trust on your 1040. To do this properly, you, if “you” are the trustee, You will have registered the trust for an EIN number. “The trust must have an employer identification number. This allows the Internal Revenue Service to identify it for tax purposes. You can apply for an EIN on the IRS website or by filing Form SS-4.”
Within the registration process, you simply submit the name of the trust and the name of the trustee. Additionally, you include an address and phone number.
Thus you register a representative of the trust. And last but not least, “note the type of business activity that the trust conducts if any.”
Irrevocable Trusts and Your Special Income Tax Treatment
In the case of an irrevocable trust, the person designated to complete and file Form 1041 is the trustee. You will find a number of details to complete:
1. In the first place, Form 1041 requires the trust to report its identification information, as stated above.
2. Likewise, you must record the “details of its income and deductions and tax payments.”
For the Irrevocable Trust: A Few Prized Legal Tax Deductions and Changes are Coming
As we mentioned, be sure you seek the advice of your financial planner or accountant before you open a trust. However, for your legal information, we present an abbreviated list of allowable trust tax deductions for an irrevocable trust. Deductions might include expenses for attorney’s fees, accountant’s fees, and trustee compensation. Deductions may also include some interest, as well as state and local taxes.
Also, be aware. New tax deduction changes are coming. They begin with the 2018 tax season and continue to 2025. These changes are due to the Tax Cuts and the Jobs Act. The IRS will not allow certain miscellaneous itemized deductions. “The law amends Sec. 67 by suspending all miscellaneous itemized deductions. Trusts and estates will not be permitted to deduct investment fees and expenses and reimbursed business expenses, among others.” Look for more information on changes to income tax laws in this area, in our upcoming blogs.
The trust might have deductions because of certain investment losses or bad debts. Likewise, the trust might be able to deduct payment to beneficiaries. Plus, deductions include expenses for the production or collection of income. The expense must exceed 2 percent of the trust’s adjusted gross income to be eligible. Certain additional deductions might apply to special types of trusts. Again, Principal Law advises that you check with your accountant or financial adviser.
Irrevocable Trust: Details of the Trustee’s Income Tax Report
The trustee of an irrevocable trust is obligated to report the income from the trust income if it has earned more than $600.00 total, over the tax year. (“You” in the comments below refers directly to the trustee.)
- Remember if you distribute income to trust beneficiaries, then the IRS requires more tax documentation.
- Likewise, if you claim a charitable deduction, you must include additional tax documentation.
- Additionally, “the trustee must also file Schedule K-1 and deliver copies of it to each beneficiary who received a distribution from the trust during the tax year.”
Gifts Require Taxation
Many Roads Lead To a Well Planned Legacy. Principal Law Can Help You Avoid the Pitfalls.
If you transfer assets to an irrevocable trust, or to the beneficiary of a revocable trust, be aware. It “is a taxable event resulting in gift tax liability.” You, as the trustee, must file the gift tax return, Form 709, but only if you actually owe a gift tax. Principal Law reminds you that “the recipient of a gift is never liable for gift tax.”
Thank you for visiting the blog at Principal Law. In our next blog, Principal Law will bring you more news you can use about irrevocable and revocable trusts and taxes. Obviously, this topic is too extensive for one blog which is why you will soon see our next blog, Part II of our coverage of this topic.
