Clients frequently ask me if they have to file a tax return for a trust they have created. The answer is no if it is a REVOCABLE Living Trust.
Income Tax Treatment of Revocable Trusts
A revocable trust is typically formed by husband and wife. Both are considered the initial trustees who manage the assets in the trust. The trust is usually revocable (i.e. can be changed or revoked) during the trustees lifetimes. It is not considered a taxable entity when it is formed. It is strictly a means of holding title for the beneficiaries of the trust who are at first the beneficiaries of the trust as well. Therefore because there is no separate tax entity, the assets of the trust and the related income are disregarded for tax purposes so long as the grantor(s) are alive. Any income, gains or losses are reported on the individual return. For example, all mortgage interest and property taxes are still reported on Schedule A, interest income and dividends on Schedule B and so on.
Of course, once the grantors die, then tax consequences may kick in. At that point, the trust generally becomes irrevocable, at least as to the person who died. The irrevocable trust must receive a tax identification number and needs to file its own tax returns.
Income Tax Treatment of Irrevocable Trusts
Unlike a revocable trust, an irrevocable trust is treated as an entity that is legally independent of its grantor for tax purposes. Accordingly, trust income is taxable, and the trustee must file a tax return on behalf of the trust. If income is distributed to trust beneficiaries or if a charitable deduction is claimed, additional tax documentation is required.The trustee of an irrevocable trust must complete and file Form 1041 to report trust income, as long as the trust earned more than $600 during the tax year. Irrevocable trusts are taxed on income in much the same way as individuals. Under present rules, the tax on the trust income can be very high if the income passes certain thresholds and is not distributed to the beneficiaries.
What about the Beneficiaries?
A beneficiary of a revocable trust does not have to pay income taxes on his distributions from the trust since the trust grantor has already paid these taxes. Distributions to beneficiaries of an irrevocable trust, however, are taxable to beneficiaries at ordinary income tax rates. Since the individual income tax rate is lower than the trust income tax rate, trusts normally distribute their income to their beneficiaries if they are individuals. If the trust distributes any of its income to beneficiaries, the trustee must prepare Schedule K-1 for each beneficiary who has received a distribution. The trust must also file Schedule K-1 with the IRS if it made any distributions to beneficiaries during the tax year. A beneficiary doesn't have to submit Schedule K-1 with Form 1040 but will need it to calculate his own tax liability.
If you have questions regarding your trust and taxes, please feel free to give me a call.