A revocable trust isn't its own separate tax entity until its grantor, the individual who creates and funds the trust, dies. Until then, it’s an extension of the grantor, so no unique tax considerations come into play. However, once the grantor dies, things can become complicated.
During the Grantor's Lifetime
When you create a revocable trust and fund it by transferring your assets into it, you retain control of your assets. With this type of trust, you, as the grantor, typically also act as the trustee, the person who manages the trust, rather than appoint someone else to do it. This way, you can sell assets, buy and add new ones, or make bequests during your lifetime, either to others or to yourself. You can revoke or undo the trust if you choose. Therefore, the IRS considers that for tax purposes, you are your trust and your trust is you. It’s not necessary for your trust to file its own tax return during your lifetime. You report all income and losses on your own personal return under your Social Security number.
Your trust converts from revocable to irrevocable at your death because you can no longer make changes to it. It can't use your Social Security number anymore, so your successor trustee – the person you name to take over when you die – must apply for a tax ID number. Your trust documents might direct your successor trustee to form new, irrevocable trusts to continue holding your assets after your death, or to transfer everything to your beneficiaries immediately and close your estate. All trusts must pay taxes on income, and those that generate over $600 in income in a year must file a tax return. If the trust sells an asset and realizes capital gains, this is taxed on its own return as well, but only if your trustee adds the gains to the corpus or principal of the trust, meaning your trustee retains the money so he can reinvest it.
Tax Liability of Beneficiaries
If and when the trust makes distributions of income to your beneficiaries, they are taxed, not the trust. The trust can take deductions for these amounts on its tax return, so the liability is passed on. Your successor trustee sends each beneficiary a Form K-1 at the end of the year, showing the amount he received, and files a copy with the Internal Revenue Service as well. The beneficiary must report the income on his personal return. This only applies to trust income, however. The assets themselves are not taxed, so if you state in your trust documents that your son is to receive your vacation property when you pass away, he would not have to claim this value on his personal return. If he sells the property, he must pay capital gains tax on any profit, however. The property's basis is the value of the asset as of your date of death; he would typically pay capital gains tax on the difference between that amount and the sales price.
Revocable trusts are basically useless when it comes to protecting your assets from estate taxes. This stems from the fact that before your death, you and your trust were the same tax entity. You didn't give up control of your assets, as you would have with an irrevocable trust, so all the property you funded the trust with is usually part of your taxable estate. However, the value of your estate must exceed $5.34 million as of 2014 before estate taxes are due on the balance.
- The Law Offices of Craig E. Berman: Revocable Living Trusts
- The Florida Bar: The Revocable Trust in Florida Pamphlet
- Kristel K. Patton: Do I Have to Pay Income Tax on My Trust Distributions?
- Heritage Wealth Managers: Income Taxation of Trusts and Estates (PDF)
- Forbes: IRS Announces 2014 Tax Brackets, Standard Deduction Amounts and More
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