How Are Revocable and Irrevocable Trusts Taxed?

 In Revocable Trusts, Trustee

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For the most part, trusts don’t pay taxes on their income, instead passing the income through to the trust beneficiaries. But when they do pay taxes, the tax rates are often higher than those for individual taxpayers. Here’s how this works.

Revocable Trusts

If you are the trustee of your own revocable trust, you use your own Social Security number for your accounts and report the trust income just like your own. If you are not the trustee, some tax specialists advise that the trust should have its own tax identification number (sometimes referred to as an 04 number), but few trustees take this step, since even if they did, the trust grantor would pay taxes on any income.

Irrevocable Trusts

All irrevocable trusts must obtain their own tax ID number and file their own 1041 tax return to report any income earned. Irrevocable trusts are divided into two types for tax purposes—grantor trusts and non-grantor trusts. Grantor trusts are those in which the creator of the trust—the grantor—retains significant benefits or rights, such as the right to receive all the trust income or change trustees. Grantor trusts file their own informational returns, reporting the trust income, but do not pay any income tax. Instead, they issue a k-1 form to the grantor, akin to a 1099, telling the grantor how much to report on her tax return. (There are arguments that some grantor trusts do not need their own tax ID number or have to file a return, but the standard practice is to do so with all irrevocable trusts.)

Non-grantor trusts, those in which the grantor does not retain significant rights or benefits, still often do not pay income taxes. Like grantor trusts, they must file an annual 1041 tax return, but they only deduct income actually distributed to or used on behalf of any beneficiaries. To the extent they do distribute income, they issue k-1s to the beneficiaries who received the income, who must report it on their income tax returns, whether or not they are the grantor of the trust. The trust then pays taxes on any undistributed income.

By way of example, let’s assume that a trust earns $10,000 in interest and dividends in a year and distributes $1,000 each to five beneficiaries. It will report the full $10,000 of income on its tax return, but deduct the $5,000 it distributed, paying taxes on the remaining $5,000 of income (less certain deductions). It will issue five k-1s, one each to the five beneficiaries, reporting the $1,000 each that they received.

Trust Tax Rates

Trust tax rates follow similar rates to those paid by individuals, but reach those rates at much lower thresholds. Here are the rates and thresholds for 2020:

Taxable Income            Tax Rate

$0 – $2,600                         10%

$2,601 – $9,450                  24%

$9,541 – $12,950                35%

$12,951 and above             37%

As you can see, trusts reach the top rate at just under $13,000 of income. Except for the best heeled trust beneficiaries, their own marginal rates are likely to be much lower, since individuals need more than $500,000 of income and married couples more than $600,000 of income to reach this rate. This means that trusts can usually save taxes by distributing all but minimal income to beneficiaries. Of course, taxes paid is only one consideration in determining whether it’s appropriate to make distributions.

Related Articles

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How Are My Trust Distributions Taxed?

 

Showing 23 comments
  • Elvis
    Reply

    If an irrevocable Trust is formed in FL (settlor residing in NY grants money into the FL trust and to the trustee, who is a FL resident), and if the trust is a non-grantor trust (settlor gives up all rights & claims to the money given to the trust, and cannot alter or amend the trust in any way)….. are the trust taxes paid federal and Florida income taxes or federal and NY state income taxes? Thank you for your thoughts and insights.

      • Harry Margolis
        Reply

        Elvis,
        I believe the trust would be taxed in Florida and not in New York since it’s only New York connection would be the residence of the grantor. He or she should be sure to file a gift tax return as further evidence of intent to give up all control.

      • Victoria
        Reply

        A Revocable Grantor Trust set up by a parent became an irrevocable trust when the parent died, in 2020. The two surviving children are were co trustees with with grantor and are now co-trustees of the trust which now has it’s own EIN. The trust, when all properties are liquidated will have a value close to $1,000,000. These properties, because of the currant situation, will not be liquidated until the trustees can safely travel. The trust has income from one rental property, and increases in investments. Is it a correct understanding it will be liable for 37% of this income assuming it is over $12,951? The trustee’s however, would not have a tax liability? We are trying to budget accordingly.

          • Harry Margolis
            Reply

            Victoria,
            The trust must report the rental income, but it may or may not have to pay any taxes. First, it can deduct any expenses attributable to the rental properties. Second, it can deduct trust expenses, such as trustee fees and legal or accounting fees. Finally, third, to the extent the income is distributed to the beneficiaries, such distributions can also be deducted. In this case, the trust would issue k-1s to the beneficiaries and they would report the income on their returns and pay taxes at their marginal rates.

          • Kris
            Reply

            My wife has a irrevocable trust with around 30k in it. We are hoping to pull 25k out of it to help with the construction of our new house. What would be the tax implications of such a action? Thanks.

              • Harry Margolis
                Reply

                Kris,
                It depends on how the $30k is invested. If it’s in a money market account, there would be no tax consequences. If it’s in appreciated stock that has to be sold, doing so would trigger the realization of capital gains and a tax on those gains. In all likelihood whatever tax liability there may be would have to be paid by your wife rather than the trust, since the trust could take a deduction for the distribution.

              • Randi
                Reply

                Hi Harry,
                I love your website, by the way!
                I have a question that is the opposite of Elvis’s above.
                We have an Irrevocable Trust for dad. It was signed/formed in NY 2019, with a Tax ID, after he became incapacitated from a brain tumor. At the time dad was a resident of NY. Dad had two homes, one in NY – owned by the trust and one in FL – not owned by the trust. We have sold both homes and now dad is a FL resident in an assisted living facility. I am the healthcare proxy. I live in FL and my brother is the POA and Trustee who lives in NY. We are both equal beneficiaries.
                The question is, if dad is now a FL resident and the trust was formed in NY, with the POA and Trustee residing in NY, do we need to file NYS taxes. This is a non-income producing trust, but there may be some income this year since we have to change all the investments (it was not properly invested). Do you recommend we have an addendum to the Trust to change the address to FL? Can the Trustee and POA reside in NY with dad as a FL resident? How does this affect the trust and taxes? Thank you in advance for your response.

                • Randi
                  Reply

                  I forgot to add, it is a Grantor’s Trust. 🙂

                    • Harry Margolis
                      Reply

                      Randi,
                      Thank you for your comment.
                      Your addendum that this is a grantor trust is very important. It means that all the trust income should pass through to your father and should be taxed to him based on his residence. Upon your father’s death, however, the trust will no longer be a grantor trust and will probably have to pay taxes in New York in part due to your brother’s residence there. I’m not sure whether changing the trust’s jurisdiction to Florida would change that given the strong nexus with New York.
                      To be absolutely certain about all the above, I’d consult with an accountant or tax attorney in New York.
                      Harry

                        • Randi Glazer
                          Reply

                          Hi Harry!
                          Thank you for responding and for confirming the state income tax is based on dad’s residence. Just to make this a little more interesting, my brother and I have inheritance trusts set up for each of us (50/50) upon dad’s passing. We hope that won’t be for quite a while. Once the assets are split between us, my brother would need to pay any NYS taxes after the step up basis, if he is still a NYS resident?

                          By the way, I read your sample chapter on ‘Durable Power of Attorney’. Excellent advice! The Case Study you site about the accountant is very similar to what happened with dad. I shared it with my brother. We are so grateful dad had a Durable POA and Health Care Proxy in place for us. NYS was going to start Guardianship until we advised we had taken care of everything. Ironically, we had the trust was set up 24 hours before they hospital was going to do start the process.

                          I have told many friends my age to make sure their parents have a POA, Health Care Proxy and will in place; for disability, not just for death. We’ve put all these in place for ourselves, as well. Dad having Long Term Care Insurance (LTCI) has been a life saver. I encouraged my in laws to buy this and they were able to convert their Life Insurance into a LTCI policy. 🙂

                            • Harry Margolis
                              Reply

                              Randi,
                              All great advice. Everyone should have a durable power of attorney and health care directive. I’m also a big proponent of revocable trusts for asset management. Those who can afford to, should also consider buying long-term care insurance.
                              With respect to your father’s grantor trust, your brother in New York would have to pay any New York State taxes due on income from the trust as well as capital gains, though the latter should be minimal given the step-up in basis upon your father’s death.

                        • sree srch
                          Reply

                          I have ILIT where I gift some amount every year much less than gift limit. Will the Gift amount become income for ILIT trust for IRS purpose tax filing?

                            • Harry Margolis
                              Reply

                              Sree,
                              No, gifts are never considered income to the recipient. However, remember to provide the beneficiary or beneficiaries of the ILIT a Crummey letter whenever you transfer funds to the trust. It’s the Crummey letter that qualifies the gifts for the $15,000 gift tax exclusion. Without the letters, each contribution is a taxable gift.

                            • Larry Olson
                              Reply

                              Hi Harry,

                              Great advice and info!
                              Is there any reason that I can’t have an irrevocable trust that is owned by my Roth IRA? Would that asset be taxable to my kid at the time I give it to her (as beneficiary)?

                                • Harry Margolis
                                  Reply

                                  Larry,
                                  I actually don’t know a lot about Roth IRAs, partly because they haven’t come up in my practice and partly because I’m not a great fan. They seem like one more financial product to complicate our lives. That all said, I don’t know of any reason an irrevocable trust can’t own a Roth IRA (rather than the Roth IRA owning the trust).

                                • Chris Androulakis
                                  Reply

                                  If a irrevocable trust is created 1/1/2021 and a property in that trust is sold 1 year later, how would the cost basis be calculated on that property for capital gains? Does it use the value of the house when put into the trust or the value of the house when it was originally purchased 50yrs ago?

                                  If it uses the 50yr cost basis, i assume the 250k/500k exception cant be used anymore since its no longer owned by my parents?

                                    • Harry Margolis
                                      Reply

                                      Chris,
                                      Assuming the grantor of the trust does not die before the property is sold, the house will have the same basis as it had when it was transferred into the trust, its purchase price from 50 years ago plus the value of any improvements. If the grantor dies before the house is sold, it might receive a step-up in basis depending on how the trust is written. In terms of taking the homeowner’s exclusion, that too depends on how the trust is written. If it’s a grantor trust with respect to both income and principle, it can qualify for the capital gains exclusion, but the trust has to be specifically written for this purpose, which sometimes can undermine other purposes of trusts.

                                    • Donna M Lynne
                                      Reply

                                      Sorry if I got70,000 in trust bank account and got 60$ interest. Do I claim anything. Just that an life insurance policies irrevocable trust three children never took anything out

                                        • Harry Margolis
                                          Reply

                                          Donna,
                                          I’m not sure if I totally understand, but it sounds like you received $70,000 of which $60 was interest. If that’s the case, you would report the $60 on your income tax return, but not the $70,000. But please clarify whether this is the situation and your question.

                                        • Donna M Lynne
                                          Reply

                                          I have insurance policies in my irrevocable trust. I also started a bank account of $60,000 irrevocable trust. Can I add to the bank??? Being I don’t own the trust anymore .Do my beneficiaries get the money tax free ? Nothing has been distributed. Does trustee just follow the will?? Do you have to report it to anyone I know it does not go through probate.

                                          • Donna M Lynne
                                            Reply

                                            Should I name irrevocable trust as beneficiary of my savings and checking account?

                                            In which my children are in the trust. Or name separate beneficiaries on saving and checking? Which would still be my children?? Once in trust I know life insurance policy are tax free. Do they fill out a form for trust.
                                            Or individual when money is received. This does not go there probate correct? Just follow the wishes of trust?

                                            • Sonia
                                              Reply

                                              Hi Harry – great info.
                                              I have a quick question about tax filing and revocable trust if it does not distribute anything to anyone. For example, a revocable trust contains only stocks and receives dividends every year. If the trust does NOT distribute any money to anyone and retains all the dividends (can it do that?), whose tax return will the dividend income show up? The trust itself (the trust’s tax returns), or the trustee (personal tax returns)?
                                              Anyway to keep these dividends OFF of personal tax returns?

                                                • Harry Margolis
                                                  Reply

                                                  Sonia,
                                                  No, revocable trusts are always grantor trusts, meaning that the income is taxed to the grantor. The trust may or may not have its own tax ID number. If the grantor is a trustee, then revocable trusts generally use her Social Security number, but if other’s are trustees it may have it’s own tax ID number and have to file its own return. But even in that case, it pays no tax at the trust level. For tax purposes, all the income flows through to the taxpayer even if it’s not actually distributed and remains in the trust.

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