What Happens When a Beneficiary of an Irrevocable Trust Receives Money?

By Laura Payet

What Happens When a Beneficiary of an Irrevocable Trust Receives Money?

By Laura Payet

If you're the beneficiary of an irrevocable trust and you receive a distribution from it, congratulations! That money is yours to do with as you please. When distributions are paid out of trust income, as is often the case, the original assets put into the trust, called the principal, continue to generate income to support future distributions. One caveat to remember, however, is that when tax time comes around, you may have to pay income tax on what you received.

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Irrevocable vs. Revocable Trust

A trust is a legal entity created when an individual gives money or property over to a trustee to manage on behalf of named beneficiaries. The person who creates the trust is called the grantor. Trusts are created and governed under state law, usually by a detailed written instrument called a trust instrument or trust agreement. Trusts can be a valuable tool for protecting assets and are common in estate plans.

An irrevocable trust is an independent, tax-paying entity. The grantor of an irrevocable trust can neither change its terms nor revoke it and repossess its property. Property transferred to an irrevocable trust no longer belongs to the grantor. Therefore, when the grantor passes away, the property isn't included in her estate for probate or estate tax purposes. This means that the property isn't subject to estate tax and does not need to go through the probate process. Similarly, neither the grantor's nor the beneficiary's creditors can reach the trust property to satisfy any debts because neither the grantor nor the beneficiary has ownership rights to it. An irrevocable trust pays income taxes on accumulated income that isn't distributed to beneficiaries.

With a revocable trust, on the other hand, the grantor may revoke it or change the terms at any time. The trust still protects its property from the estate tax and creditors, but the grantor herself pays income tax on trust income because she can still choose to access its property. A revocable trust becomes irrevocable when the grantor passes away.

Tax Consequences of Trust Distributions

As noted above, an irrevocable trust must pay income tax on its earnings. However, a trust is also entitled to take a deduction for income distributions made to a beneficiary. Therefore, if the trust instrument requires the trust to distribute all its income to its beneficiaries, as is common, it is entitled to deduct the amount distributed, which would bring its total taxable income to zero. In this case, the tax obligation passes to the beneficiary to declare and pay taxes on payments received as a distribution from trust income.

Some more complex trusts, however, are permitted to make payments to their beneficiaries out of the trust principal. Typically, the beneficiary isn't required to pay income taxes on distributions that come from principal because tax law presumes that the grantor already paid income taxes on it when he placed it in the trust and tries to avoid double taxation.

As a trust beneficiary, then, you would owe income tax on distributions made from trust income but not from the principal. Additionally, some forms of trust income, such as interest from state or local bonds, may be tax-exempt. This income retains its tax-free characteristics when passed on to beneficiaries. Although the tax consequences may seem confusing, rest assured that the trustee is responsible for sending you a form known as a Partner's Share of Income, Deductions, Credits, etc. (Form 1065, Schedule K-1), which reports payments made to you that you owe taxes on. You can rely on the Schedule K-1 when completing your own income tax return.

A trust can be an essential element of a good estate plan. Consult an online service provider to find out how a trust can protect your assets and help you give your loved ones faster access to their inheritance.

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.