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

By Jeff Franco J.D./M.A./M.B.A.

As the beneficiary of an irrevocable trust, you may receive periodic payments of money from the trustee. When you do, there usually aren’t immediate legal implications you need to deal with. However, when it comes time to file your state and federal tax returns, you may need to report the payments and pay tax on the income.

Irrevocable Trust Basics

Irrevocable trusts are commonly created as part of a person’s overall estate plan. The property in the trust isn’t subject to probate by a state court, which minimizes the chances someone other than the intended beneficiaries will receive money from the trust. The trust is created when a person, called the “grantor,” establishes the terms of the trust in accordance with state law, such as naming beneficiaries and funding the trust with money or property. What distinguishes an irrevocable trust from a revocable one is that once the grantor transfers money and property, he no longer has any control over it. As a result, either the trust or its beneficiaries are responsible for paying income tax on any income generated by the cash and other assets in the trust.

Tax Implications for Beneficiaries

The fact you receive money from an irrevocable trust isn’t sufficient to determine whether you are responsible for reporting the payments on your state and federal tax returns. Instead, it depends on the terms of the trust. If the grantor requires all trust income distributed to beneficiaries, you will be responsible for paying tax on your share, regardless of when you receive the money. On the other hand, if the money you receive represents a portion of the trust principal, or income the trust has already paid taxes on, you receive the distribution without any tax consequences.

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Trust Tax Implications

An irrevocable trust is treated as a separate taxpayer and must file a federal income tax return on Form 1041 each year. The trustee is responsible for reporting all income the trust earns, even if the terms of the trust require beneficiaries to receive all of that income. However, if the trustee has no obligation to distribute earnings to beneficiaries and accumulates income within the trust, she must pay tax on those earnings using money from the trust. Then, when the trust distributes income to you and other beneficiaries, the trustee reports those earnings on the 1041 but takes a deduction, known as an income distribution deduction, for all payments to beneficiaries. This is done so that income tax is paid only once by beneficiaries.

Beneficiary K-1s

If you receive payments of money from an irrevocable trust during the year, it isn’t necessary for you to make the determination of whether to report the payments on your tax return. The IRS requires the trustee to prepare a Schedule K-1 for each beneficiary when filing the trust’s 1041. The K-1 reports the payments you received for which you have a tax liability. You will receive a copy of the K-1 before the due date of your tax returns, so you should always know what the tax implications are before you file.

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Tax Treatment of Living Trust Distributions
 

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