Filing taxes on revocable living trusts

Income earned through and distributed from a revocable living trust is taxable and may be taxed at higher amounts than regular income if income is reported on an IRS form 1041. Revocable living trusts are legal documents that define heirs and trustees of a person's assets in the event of death. These documents can be changed to remove, add or adjust heirs, trustees, and terms of distribution during the life of the primary trustee who is the creator of the trust. The purpose of a living trust is to avoid the lengthy probate court process after the death of a loved one.

Taxation of trust income during life of the trustee

The Internal Revenue Service considers revocable living trusts to be a "grantor trust" because the primary trustee i.e. the owner and creator has the ability to retain, recall and revoke the trust. Income earned from these trusts during the life of the primary trustee is taxable as income and reportable through an IRS form 1041. The form 1041 instructions and guidelines for reporting income in a revocable living trust can be found through the U.S. Internal Revenue Service. Depending on the type of assets held within a trust, different tax forms and procedures may be necessary.

To illustrate the above, charitable contributions made through a trust are reported on Schedule A of the form 1041. The form 1041 instructions published by the U.S. internal revenue service indicate higher taxation rates on income earned through a living trust than through a normal taxable income. For example, income over $10.450 is taxable at a rate of 35% , any amount under which is taxable at 25.8%. The same amount of income taxed as regular income would be taxable at a 15% rate , $7550.00 of which is currently taxable at 10%.

Taxation of trust distributions after death of primary trustee

Once the secondary trustee has distributed trust funds to beneficiaries listed in the revocable living trust, the assets, assuming no liabilities, become taxable as estate property. To be taxable as an estate, the value of the trust must exceed a government determined minimum amount, which is currently over $1million.

If, after the death of the primary trustee, income is still generated within the trust before distribution of the assets within the trust takes place, the trust is taxable as income i.e. tax filings for the deceases must be filed and any taxes due will be paid for either from assets within the trust or from assets within the deceased's estate.

Tax avoidance, and tax fraud in revocable living trusts

According to the U.S. Internal Revenue Service, income within a revocable trust may be "distributed to other trusts so long as they are named as beneficiaries within the trust". In other words, to lower taxable income of a trust, the income can be spread around to a life insurance trust or an AB Trust. What is not considered legal by the IRS is the illegitimate reduction of trust income through false expense deductions.

Legitimate ways to lower taxation of living trusts include the above, optional tax reporting methods that do not use a form 1041 and selective allocation of assets within the trust. Since the primary trustee can amend revocable living trusts at any time, assets potentially subject to higher taxation can be added at later times to avoid potential higher taxation if a form 1041 is filed.

Revocable living trust tax tips

The use of a revocable living trust may be a good legal strategy but in terms of taxation, these types of "legal entities" may be best left to later years since the assets within a revocable living trust may be taxable at a higher rate than if they were in another financial instrument. A few tips one might consider before and after establishing a revocable living trust are the following:

• Consider alternative trusts: Trusts such as Life Insurance trusts can allow income to grow tax deferred and in the case of estate beneficiaries tax free.

• State Probate Law: Since revocable living trusts are used primarily to avoid probate and to increase privacy of beneficiaries, being familiar with the applicable state law may reveal certain advantages or legal mechanisms that exist within the probate process.

• Trust Assets: Certain assets within a revocable living trust may not incur income on an annual basis and/or provide negligible tax deductions to normal income. Such assets may be placed in a revocable living trust without disproportionate tax losses. Example of such assets may include jewelry, and art.

• Form 1041 Instructions: Become familiar with the tax consequences and preparation time associated with having a revocable living trust. If a revocable living trust must be used, consider optional filing methods.

• Estate Planning Professionals: Consulting with an estate planning professional, whether it be a financial planner, accountant or lawyer may be prudent especially in cases of large estates.

Summary

Revocable living trusts are subject to similar if not higher taxation than regular income unless income within the trust is re-distributed to not taxable trusts. To file taxes on revocable living trust income, an IRS form 1041 can be used, however the tax rates on income using this reporting method are higher. In light of this using an optional tax reporting method illustrated by the IRS may incur lower taxation.

Assets held within a revocable living trust become taxable as an estate after the death of the death and distribution of the trust owner(s) and may still incur regular income taxes if the trust earns income before assets have been distributed by the trustee(s). Becoming familiar with the purpose, techniques, benefits and disadvantages of revocable living trusts may assist one in appropriately reporting taxes as well as in the decision to list assets within such a trust.

Sources:

http://www.irs.gov/pub/irs-pdf/f1041.pdf
http://www.irs.gov/pub/irs-pdf/i1041.pdf
http://www.nysscpa.org/cpajournal/old/08770612.htm
http://www.irs.gov/instructions/i1041/ch01.html#d0e474
http://www.irs.gov/businesses/small/article/0,id=106538,00.html