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Monday, January 25, 2021

How Are Irrevocable Trusts Taxed?

While trusts may be often discussed as being included in an estate plan, the tax consequences of a trust are not always addressed. This is unfortunate because trusts can have significant tax implications for both grantors and beneficiaries. Here, we will address how irrevocable trusts are taxed.

How Are Irrevocable Trusts Taxed?

An irrevocable trust may be established during the grantor’s lifetime. The grantor, the owner of the assets, will place the assets and transfer ownership of the assets into the trust. In the alternative, an irrevocable trust may be established upon the death of the grantor. When an irrevocable trust is established upon the death of the grantor, control of the assets held within the trust is dictated by the terms set forth by the grantor prior to his or her death.

Every irrevocable trust has to get its own tax ID number as well as file a 1041 tax return in order to report any income earned on trust assets. How an irrevocable trust will be taxed will come down to whether it is considered to be a grantor trust or a non-grantor trust. A grantor trust is established when the grantor transfers his or her own assets into the trust to establish it. With a grantor trust, the grantor retains certain benefits or rights. For example, the grantor may retain the right to receive all trust income or to change the acting trustee. Because the grantor retains such rights, he or she is required to file information returns to report trust income, but he or she is not required to pay income tax. Instead of paying income tax, the grantor is issued a k-1 form, comparable to a 1099, which instructs the grantor on how much must be reported on his or her income tax.

With a non-grantor trust, the grantor does not retain any significant rights or benefits to the trust property or income generated therein. The grantor of a non-grantor trust must still file a 1041 tax return, but only deducts income that has actually been distributed to trust beneficiaries. When income has been distributed to beneficiaries, k-1s are issued to beneficiaries who have received income and these beneficiaries must report the income on their personal income tax returns. The trust is responsible for paying taxes on undistributed income.

As a beneficiary, it is important to be aware of what will happen should you assume ownership of assets held within an irrevocable trust. You will not be immediately forced to pay taxes. Tax consequences will only happen once distribution from the trust begins. Should you choose to withdraw assets from the trust, you will need to pay taxes on an adjusted cost basis. This is because taxes have already been paid by the original grantor on the assets placed in the trust.

Elder Law Attorney

Estate planning has more complexities that can have significant impacts on a person and their loved ones. Tax consequences are definitely complex to unravel, but the dedicated team at Monk Law is here to help explain your estate planning options as well as how it can impact you and your loved ones. Contact Monk Law today.


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