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January 7, 2019
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Most trusts are revocable which means that a grantor can make changes to it during his or her lifetime. Revocable trusts are frequently used in estate planning as a means of avoiding probate court by placing valuable assets under the ownership of a sole entity.
However, this brings up an important question. If you transfer property under your name to a trust, are you still responsible for taxes? Does the trust need to file its own tax return? If so, who is responsible for paying those taxes?
If you’re in the process of setting up a trust or considering setting one up, you may be wondering what kind of impact taxes will have on you and your heirs. The short answer is, you probably saw this coming, no, you don’t get to avoid tax altogether. One way or another, Uncle Sam will find a way to collect his share. But that does not mean that a living trust is not worth the effort and that it can’t save you money. So what kind of impact will taxes have on you, the trust, and its beneficiaries? Let’s take a look at how taxable income affects two phases of a trust: during the life of the grantor and after the death of the grantor.
During the Life of the Grantor: Grantor Trust Taxation
A grantor is a person that creates and funds a living trust. Revocable trusts are the most common as these allow the grantor to modify or dismantle it altogether. Essentially, a grantor has the power to move assets in and out of the trust or terminate it. If you’re the grantor, you can also collect income and principal from trust assets. But like any income, whether it’s from employment, rent, or other sources, the IRS will tax it at the standard rate.
If you establish a trust, the IRS identifies it through your social security number. You are not required to file a separate tax return. If you receive income from trust assets, you would report this on your individual return. The assets, however, remain under the ownership of the trust.
Special Circumstances when a Trust does have to File a Separate Tax Return
When a grantor dies, a trust is responsible for filing its own tax return. In this case, the trust would be identified through a separate tax ID number. However, there may be unique situations that could require using a different tax ID while the grantor is still alive. For example, if you become mentally incapacitated, the individual you have named as a successor will have to file under a different tax ID from your social security number. Your successor would apply for an EIN, an Employer Identification Number. Through the setup of EIN, a successor can protect themselves from paying income taxes while still carrying out their duties set forth by the grantor. A trust with an EIN has to file its own tax return on an annual basis.
Can you still establish an EIN for a trust even without special circumstances?
Yes, you can still establish an EIN without special circumstances like incapacitation. For example, if a grantor has personal taxes that are highly complicated and wishes to keep those items separate, establishing an EIN can simplify reporting. In doing so, a grantor wouldn’t have to report personal income and losses on the trust. However, he is still responsible for paying taxes on any income.
After the Death of the Grantor: Living Trust Taxation
After a grantor’s death, a trust becomes irrevocable and continues as its own entity responsible for its taxes. An executor files the final tax return for any income that was earned during the final moments of the grantor’s life. For any income earned after the death of the grantor, an individual tax return must be filed.
Once trust assets are distributed to its beneficiaries, any income that these assets earned would be reported on the beneficiaries individual tax returns. It is important to note that this only applies to any earned income, like interest, and not principal. Principal balance from a trust is non-taxable. If no distributions are made, then the living trust must continue filing its own taxes on a yearly basis.
In Summary
Establishing a living trust is a powerful and popular estate planning strategy. It can save you and your heirs a considerable amount of money. Of course, establishing one requires effort and a great deal of organization and understanding about probate law and other issues, including tax implications. Every family’s situation is unique. An estate planning attorney can help you and your family determine the right course of action for your wealth management needs.
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