This article has been reviewed by a practicing attorney in 2020
This content is not intended to be a substitute for professional legal advice. Always seek the advice of an attorney or another qualified legal professional with any questions you may have regarding your situation.
The irrevocable trust is a common estate planning tool. While irrevocable trusts have their advantages, it is important to understand that they also come with tax liabilities. Below is a brief overview of how irrevocable trusts are taxed and the potential tax consequences for an irrevocable trust’s beneficiaries.
To better understand the tax consequences surrounding irrevocable trusts, it is important to understand some basic trust terminology and concepts. All trusts are formed with assets or income from a grantor, the trust’s creator. The grantor designates a trustee to administer the trust in accordance with the trust terms. Finally, the trust is created for the benefit of the trust beneficiaries. Trusts fall into two categories: revocable and irrevocable. As the name suggests, a revocable trust may be changed, modified, or even dissolved during the lifetime of the trust. Conversely, generally, an irrevocable trust cannot be changed or modified.
Who Pays Taxes on Irrevocable Trust Income?
Because the revocable trust may be freely modified, the Internal Revenue Service (“IRS”) treats the property in a revocable trust as if it were the grantor’s own property for income tax purposes. The grantor of a revocable trust reports the trust property on his or her tax return, using his or her own social security number.
The IRS treats irrevocable trusts differently. Because an irrevocable trust may not be changed or modified, the IRS views the property in the trust as belonging solely to the trust, which is its own entity, separate from the grantor. For this reason, all irrevocable trusts must obtain their own tax identification number and file their own income tax return.
Importantly, there are two types of irrevocable trusts for tax purposes: grantor (not to be confused with a revocable trust) and non-grantor. In a grantor trust, the grantor (the trust’s creator) retains significant benefits or rights in the trust, such as the right to receive all trust income or change trustees. In a non-grantor trust, the grantor does not have these rights. These trusts are usually for the benefit of third-party beneficiaries. While all irrevocable trusts must file their own tax returns, we discuss below who may be liable for those taxes.
Do I Have to Pay Taxes on Money from an Irrevocable Trust?
An irrevocable trust is not alone with its tax burden. Trust beneficiaries of irrevocable trusts must also pay taxes on certain trust distributions. Whether a beneficiary of or the irrevocable trust itself is required to pay taxes depends on: (1) the character of the distribution or money; and (2) the type of irrevocable trust.
When a beneficiary receives a distribution from the trust’s principal balance, the beneficiary is not required to pay tax on the distribution; neither is the trust. This is because the IRS assumes this money was taxed before being placed into the trust. However, if the money originally placed into the trust begins accruing interest, that interest becomes taxable income, for which either the beneficiary or the trust is liable.
As an initial matter, there are two types of documents associated with trusts and taxes: a Form 1041 and K-1. A Form 1041, is an irrevocable trust’s tax return that the trust is required to file every year with the IRS. A 1041 reports how much income the trust earns in a given year. A K-1 is a document the trust distributes to its beneficiaries, which explains each distribution to each beneficiary, specifically the amount distributed that was principal versus the amount distributed that was interest or income. The importance of this is explained below.
While irrevocable grantor trusts file their own 1041 tax returns, the trust itself does not pay tax on any earned income. Rather, the trust issues a K-1 to the grantor, reporting the amount of income earned. The grantor must then report, on his or her individual income tax return, the income earned, and the grantor is liable for tax on the same.
Like a grantor trust, a non-grantor trust also files a 1041 return reporting the trust income earned. Whether the trust is liable for a tax on the earned income depends on the distributions made to beneficiaries for the year. If the trust holds onto the earned income through the end of the year, the trust must pay taxes on it. However, any earned income the trust distributes to its beneficiaries is deducted from the trust’s own taxable income on the 1041. Therefore, if the trust distributes the earned income to its beneficiaries, the trust takes the amount distributed as a deduction, and the beneficiaries are liable for taxes on the same. Generally, distributions to beneficiaries are from the income earned rather than the trust principal.
For example, Alice formed an irrevocable trust for her grandchild, Bella. The trust was funded with $500,000, which is the trust principal. Last year, the trust earned $30,000 in interest and distributed $15,000 of this interest to Bella. The IRS treats the $30,000 in interest as taxable income. Therefore, the trust will report the $30,000 on its tax return, but it will deduct the $15,000 it distributed to Bella, and it will pay tax only on the remaining $15,000. The trust will issue Bella a K-1 reporting the $15,000 that she received, and Bella will be liable for the tax on her $15,000. She will report this amount on her individual tax return.
2021 Tax Brackets
Like individuals, trusts are also taxed for their income earned within certain brackets. For 2021, trusts are taxed as follows:
- $0 to $2,650 in income: 10% of taxable income
- $2,650 to $9,550 in income: $265 + 24% of taxable income over $2,650
- $9,550 to $13,050 in income: $1,921 + 35% of taxable income over $9,550
- Over $13,050 in income: $3,146 + 37% of taxable income over $13,050
Tax rates for individuals for 2021 are:
- $0 to $9,950 in income ($19,900 for married couples filing jointly): 10%
- $9,951 to $40,525 in income ($19,900 for married couples filing jointly): 12%
- $40,526 to $86,375 in income ($81,050 for married couples filing jointly): 22%
- $86,376 to $164,925 in income ($172,750 for married couples filing jointly): 24%
- $164,926 to $209,425 in income ($329,850 for married couples filing jointly): 32%
- $209,426 to $523,600 in income ($418,850 for married couples filing jointly): 35%
- Over $523,601 in income ($628,300 for married couples filing jointly): 37%
Irrevocable Trust Capital Gains Tax
The above discussion concerned taxes on trust income earned. It is also important to be aware of how the capital gains tax could affect an irrevocable trust. Capital gains is the amount earned on an asset in between the time the asset was purchased and when the asset was sold. For example, if a person bought a house in 2010 for $100,000 and sold it in 2020 for $200,000, the capital gain on the house is $100,000. Capital gains are only paid once the asset is sold. Importantly, the capital gains tax only applies to “capital assets” such as stocks, bonds, jewelry, collectables, and real estate property.
Also, of importance, the capital gains tax applies only to profits from the sales of assets held for more than one year, also called “long-term capital gains.” The tax brackets for long term capital gains are 0% if your income is less than $40,400 (as a single filer), 15% if your income is between $40,401 and $445,850 (as single filer), or 20% for single filers with gains greater than $445,851. “Short-term capital gains,” assets sold less than one year after purchase, are taxed as ordinary income.
Like taxes on trust income earned, who pays the capital gains tax for a trust asset first depends on the type of irrevocable trust. If the trust is a grantor trust, because the grantor retains significant benefits or rights in the trust, the grantor must report the trust’s capital gains tax obligation on his or her personal tax return. In a non-grantor trust, capital gains are generally not treated as income. Rather, the capital gain is viewed as a contribution to the trust principal. Therefore, if a trust realizes a capital gain from a sold trust asset, that gain is not distributed to beneficiaries, and the trust would be required to pay taxes on the gain as a profit to the trust. If the non-grantor irrevocable trust transfers a trust asset to a beneficiary, the beneficiary becomes responsible for any capital gains taxes due when the asset is sold.
Consulting an Estate Planning or Tax Professional
The above information is intended to provide only a brief overview of the possible tax consequences associated with irrevocable trusts and is not a substitute for tax advice. The tax code is lengthy, complicated, and ever changing. If you are considering an irrevocable trust for your estate plan, or if you are currently the beneficiary of an irrevocable trust, it is important that you consult an estate planning attorney, tax attorney, or other financial planner for tax advice. A qualified professional may be able to limit your tax exposure through various legal instruments, such as a Crummey Trust.
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