Living Trust and Taxes: What You and Your Beneficiaries Need to Know

By Michelle Kaminsky, J.D.

Living Trust and Taxes: What You and Your Beneficiaries Need to Know

By Michelle Kaminsky, J.D.

A living trust, also called a revocable trust, is a legal document through which you can place assets to be distributed to chosen beneficiaries upon your death. The major advantage of a living trust is that when the creator or grantor of the trust dies, the assets avoid going through the probate process, which can be costly and delay distribution to beneficiaries.

Generally, potential tax advantages of a living trust aren't the primary reason for creating one. But knowing how a living trust and taxes work together is crucial to making sure you receive the most benefits from creating and maintaining a living trust.

Here's everything you need to know about how taxes affect a living trust and its beneficiaries.

Filing Taxes for a Living Trust

Through the grantor's life and through the life of the trust, the trust grantor remains in control of the assets placed in the trust. The grantor can add and remove assets and is also entitled to the income and principal of the trust. Because of these basic principles, the Internal Revenue Service (IRS) taxes the grantor on the trust's income.

However, no one needs to file a separate income tax return for the living trust. The grantor can report all trust-related income on their own personal tax return.

One potential exception to this general principle would be if the grantor becomes incapacitated and cannot manage the assets of the trust. In this situation, the successor trustee, who is named in the trust deed that created the trust, may elect to obtain a separate tax identification number for the trust in order to file a separate return. This separate number is called an Employee Identification Number (EIN), and the successor trustee would be required to file the trust's taxes on Form 1041 along with the grantor's personal taxes.

Notably, the grantor may choose to have an EIN and file separate taxes even without the issue of incapacitation. A grantor may choose to do this to simply file personal tax returns, though the grantor is still responsible for paying taxes on the trust's income.

Living Trust Distributions and Taxes

During the life of the trust, beneficiaries may be entitled to living trust distributions, which are usually deducted from the trust's income on its tax return. These distributions may be taxable for the beneficiaries, depending on several factors, including the amount and type as well as whether the trust is simple or complex. If the distributions derive from the non-income portion of the trust's principal, the beneficiary would probably not have to pay taxes on them.

In any event, beneficiaries should receive an annual report that indicates whether they owe any taxes on distributions derived from trust income. If they have received no distributions, beneficiaries are not responsible for any taxes regarding the living trust.

Death of Living Trust Grantor and Taxes

Upon the grantor's death, the living trust's assets are distributed to beneficiaries as provided for in the trust deed. We already know that these distributions do not enter the probate process. As the assets are not considered part of the grantor's estate, they are also not subject to estate tax.

At this point, another key question surrounding living trusts arises, which is whether beneficiaries owe taxes on trust assets. A recipient of an inherited trust may, indeed, owe inheritance taxes and may also be responsible for capital gains and income taxes as well.

It is important to note that a living trust remains valid after the grantor's death and retains ownership of trust assets. The successor trustee must file a final tax return on behalf of the trust, and this must be filed on a separate tax return as the trust becomes irrevocable once the grantor is deceased, i.e., the grantor can no longer change terms in the trust or revoke it entirely.

Overall, there are several considerations to keep in mind regarding living trusts and taxes, and some issues could get quite complicated depending on your circumstances. You should strongly consider seeking professional legal advice on issues concerning living trusts and taxes to make sure you're maximizing the benefits of having one for both you and your beneficiaries.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.

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