Hyden, Miron & Foster, PLLC Law Blog

Thursday, January 21, 2021

How Are Irrevocable Trusts Taxed?

An irrevocable trust is a type of trust that cannot be changed without the permission of the beneficiaries. This means that, once the terms of the trust are established, it can be very difficult to modify or amend. It is also important to note that the grantor of the trust, the one who owned the assets which funded the trust, has relinquished ownership over the assets as the ownership has been transferred to the trust. An irrevocable trust can serve an important role in estate planning. One often overlooked aspect of using trusts in estate planning, however, is how they are taxed. The tax consequences of establishing an irrevocable trust definitely merit some reflection.

How are Irrevocable Trusts Taxed?

Many people establish irrevocable trusts for tax reasons. This, however, has to do primarily with estate taxes. Once assets are placed into the irrevocable trust, the grantor no longer owns them. This, in turn, means that the assets have essentially been removed from the grantor’s taxable estate. When assets are removed from the taxable estate, the estate tax burden is eased.

Income tax consequences, however, are a different story. While estate taxes may be lowered, income taxes can be raised quite significantly. This is due, in part, to the fact that income generated from the irrevocable trust is often taxed at a higher rate than personal income taxes. The income tax consequences of the irrevocable trust will, however, largely depend on whether the irrevocable trust is classified as a grantor or non-grantor trust.

A grantor trust is one where the individual creating the trust is also the owner of the assets and property put into the trust. For grantor trusts, the grantor is considered to be the owner of the assets for income tax purposes. This means that the income generated from a grantor trust will generally be taxed on the tax return of the grantor.

For non-grantor trusts, however, get even more complex. A non-grantor trust is considered to be separate from the grantor for tax purposes. The trustee of a non-grantor irrevocable trust will need to file IRS Form 1041 in order to both report the taxable income of the trust for the year as well as allocate who will pay the tax on that income. When the non-grantor trust is a simple trust, one where the trustee is required to distribute all of the trust’s income to the beneficiary, then the beneficiary is taxed on the income of the trust. When the non-grantor trust is a complex trust, one where the trustee has discretion over how much to distribute to the beneficiary, the number of distributions made will dictate tax consequences. If the taxable income of the trust is greater than the distributions made, then the trust will pay taxes on the undistributed portion of the income.

Estate Planning Attorneys

While often overlooked, there are important tax considerations to take into account when estate planning. For help developing a strong estate plan that considers the important implications associated with such a plan, talk to the knowledgeable attorneys at Hyden, Miron & Foster, Contact us today.

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