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

How are Federal and State Taxes Used

Federal and state taxes are used to maintain and pursue the priority objectives of those governments. The U.S. Federal Government has one budget and the States have budgets of varying amounts and allocation based on the interests, goals and decision making within those states. Generally, federal and state taxes are used to preserve an economic, legislative and social system. This is done through tax budget allocations into parts of our society that benefit the system as a whole.

To illustrate the aforementioned, the Federal Government spends a great deal of tax dollars on national defense and social security; this serves to achieve two primary objectives 1) helps keep the nation safe, and 2) assists in sustaining contributors to society in accordance with their recorded historical taxes. When reviewing federal and state tax spending, it is important to note the possible inaccuracies, potential misinformation be it intentional or unintentional, and data discrepancies can paint a somewhat misleading or skewed interpretation of the financial reality.

Government budgets vs actual spending

It is important to note that state budgets do not necessarily reflect actual spending. Moreover, even though a state votes on and allocates funds through a budget, events during the year and/or underestimation or overestimation of costs may lead to government expenditures other than that budgeted for. This is also the case with the federal government. An example being the 2008 federal budget; at the beginning of 2008 it was not foreseen that federal aid would be spent to purchase the Mortgage Backed Securities (MBS Certificates) of large companies such as Freddie Mac and Fannie Mae.

In the 2008 U.S. Federal Government tax year, the budget was $2.902 trillion according to gpoaccess.gov summary tables. However, in 2008 U.S. federal deficit spending was $454.8 billion (cash basis) more than expected as per the U.S. Department of the Treasury. Another example is California in the 2008-2009 tax year; the State of California budgeted for a 51.9% allocation of tax revenue for education whereas usgovernmentspending.com estimates the same to be around 17%. These discrepancies between state and federal budgets and actual spending should be considered as potentially affecting the reality of government tax revenue spending. These discrepancies may be explained by reasons illustrated in sections II and IV below.

Total spending vs tax revenue

Another area of federal and state finances to be aware of is total spending versus tax revenue spent. A state may receive federal funding or spend on credit to finance systemic goals within a given year. This means that the percentage proportion of total tax dollars spent on specific areas of government operations such as education or health may not be the same or even similar to that of the total spending. For this reason it is important to have the correct data when arriving at conclusions regarding total government disbursements. Several websites contain useful information pertaining to federal and state spending and are listed at the end of this article.

Additional information may be obtained through each U.S. State’s department or executive branch that gathers, collects and distributes tax revenue. Examples of such include California’s Franchise Tax Board, New York’s Department of Taxation, Finance, Texas Comptroller of Public Accounts, and Maine’s Division of Revenue and Financial Services. In terms of the Federal Government, the above linked to U.S. Office of Management and Budget, also in the executive division of Government, compiles and publishes annual federal tax receipt information.

Where federal and state tax dollars go

There are several distinctions between federal and state tax uses. The U.S. Federal Government tends to focus on macro-economic and large scale societal agendas and goals whereas U.S. State tax budgets allocate funds for issues unique to a specific state that may not be as important in another state. For example, according to www.usgovernmentspending.com the State of New York spent 39% of its total 2007 expenditures on Health whereas the State of Montana spent 21% on the same. A general breakdown of government tax revenue spending is provided below.

Federal tax allocations

• Social Security
• Medicare
• National defense
• Interest on financing
• Infrastructure
• Administration
• Public services
• Research and development

State tax allocations¹

• Education
• Health and human services
• Penal system
• Government administration
• Law enforcement
• Transportation
• State services ¹ Varies by State

Cost classification and accounting methodology

Government tax allocations and classifications may be disputed by definition leading to further confusion about actual tax dollars spent. For example, a state may claim to have spent 35% of its annual outflow on welfare when 12% of that spending was on the salaries of government workers and overhead. Many scenarios in which government spending is spread over a range of items such as services, administration, products, and costs can be debated and identified. The reasons for erroneous, misleading or inaccurate conveyance of data can also vary and several possible explanations exist. For example, a part of the reason for this is presentation of data. If a government is aiming for financial transparency, but has too much information to make transparency easy for the public to interpret, simplification of financial data may be used. In such cases, expense categories may be grouped together under a larger category.

Lastly, accounting methods used by the government to present financial data also has an impact on what is spent where. Critics assertions of the U.S. Federal Government’s financial reporting claim official financial reports regarding budget deficits use cash accounting rather than accrual accounting which understates actual amount owed and emphasizes dollars spent. This difference can lead to a difference of trillions of dollars in Government spending, only part of which was from tax revenue in 2008 and 2009. In other words, even if tax revenue is used in a specific way, Government spending decision throughout a fiscal year may deficit spend based on future tax earnings and federal capacity to pay debt.

Sources:

1. http://www.govspot.com/
2. http://www.usgovernmentspending.com/
3. http://www.cbpp.org/
4. http://www.whitehouse.gov/
5. http://www.gao.gov/financial/citizensguide2008.pdf