For some reason, there is some misconception about the role that living trusts play in the taxation of estates, and taxes in general. While some living trusts can provide certain tax benefits, it is important to distinctly note that they do not outright avoid taxes.
Taxes are still an important consideration for any living trust, both revocable and irrevocable, and they are a concern not only for the trust’s current grantor, but for successor trustees and beneficiaries as well. A living trust allows an individual to designate certain property and assets as held in-trust, as per a detailed trust document.
But for all intents and purposes, the contents of a revocable trust are still within the grantor’s possession, with all the necessary responsibilities and costs associated with that. While irrevocable trusts remove both ownership and responsibility, there are still taxes to pay.
Living Trusts Are Not Tax Havens
First and foremost, let us set the record straight – a living trust will not help you avoid taxes. An irrevocable living trust can help you avoid one tax. That tax is the estate tax, which has a very high federal exemption limit.
If, as of December 2019, the value of your total estate exceeds $11.4 million ($22.8 million if are married and use your spouse’s exemption limit), then you will be taxed for every dollar beyond that value. However, any and all assets and property placed in an irrevocable living trust is effectively cut off from you.
As such, you can place assets into an irrevocable living trust in order to reduce the total value of your estate, at the cost of no longer having any control over said assets, as they are irrevocably held in-trust until you pass away. The same goes for states that impose their own estate tax, which may have a much lower exemption limit. California does not have a state estate tax.
For most people, the federal estate tax exemption limit is more than enough to cover the entirety of their current estate’s value. That being said, trusts do not protect you from other costs and taxes. Anything funded into a revocable living trust which is the most common kind, still needs to be managed and held by the grantor.
As such, you will continue to effectively own and pay taxes on any property or assets held within a revocable living trust, and you maintain the right to live in/own/use said property and assets. Beyond simply paying for the upkeep and the usual taxes associated with owning and managing property, holding assets and property within a trust may also mean paying taxes on any income made through gained interest.
This is different from buying stock, for example. When the value of a trust’s contents increases due to appreciation or some other factor (for example, rental property, which produces a monthly income), the grantor must pay taxes on that income.
If the trust is irrevocable, then it is under the management of a successor trustee. Said trustee is in charge of ensuring that any income made by the trust is property reported in the appropriate tax report, using the appropriate tax form.
The tax rates for a living trust depend on the income reported. For example, if a trust reports an income of over $10,000 but under $12,751, then as of December 2019, the appropriate tax bracket is $1868 plus 35 percent over $9,300. Note that these income taxes are not the same as estate taxes, which are calculated when a person passes away.
Tax Forms to Keep in Mind
In a revocable living trust, the grantor must file an annual tax return on any income made through the trust. If the trust is irrevocable, it is an entity in and of itself, and must file its own annual tax return through a trustee.
As such, any irrevocable trust must obtain a Taxpayer Identification Number, and any assets held within an irrevocable trust do not count as part of the grantor’s estate upon passing away. If you are managing your trust (as a revocable living trust), any income it makes gets reported in your personal Form 1040.
However, if the trust is irrevocable, then it must fill out a Form 1041, which is the US Income Tax Return for Estates and Trusts. The same occurs if you become mentally incapacitated or pass away, at which point your revocable living trust becomes irrevocable and a trustee begins managing it.
Unless your instructions were to immediately distribute the trust, chances are that the trustee may have to continue managing the trust until the time is right for the appropriate beneficiaries to receive their portion. When the contents of the trust become the beneficiary’s assets, they are not immediately taxed. Instead, taxes are applied based on how the assets are distributed from the irrevocable living trust.
As assets are withdrawn, the beneficiaries are taxed through a Schedule K-1 tax form, which is also used in limited partnerships and ‘S corporations’. To avoid double taxation, the amount withdrawn by the beneficiaries is deducted by the trust via income distribution deduction.
Always Consult a Legal Professional
Tax laws are no simple matter, partially because they can fluctuate and change constantly. The US Tax Code is constantly being rewritten piece by piece and staying abreast of every minute detail is a job in and of itself – which is why tax attorneys and other financial advisors spend a lot of time staying informed.
Local and federal tax laws are nothing to take lightly, and if you have set up a trust, are a successor trustee, or are a beneficiary of a living trust, then informing yourself on your tax responsibilities is critical. Different circumstances call for different measures.
While the above information might help you, it is not legal advice. It is important to consult a professional for financial or legal advice. Not only can professional guidance help you avoid errors that might cost you a serious financial loss, but they can help ensure that you are not accidentally ignoring taxes that you should be paying.