Tax Implications of a Revocable Living Trust

Learn about how taxes are handled when establishing a revocable living trust including how taxes are handled during transition periods after death.

Tax Implications of a Revocable Living Trust

A revocable living trust (RLT) is an entity excluded from taxation. This is because, as long as the grantor is alive, the Internal Revenue Service (IRS) will not consider the RLT. In fact, RLTs don't even have a tax identification number because they don't need to file tax returns. The person who creates and finances the Living Trust is known as the grantor.

When the living trust is established as a revocable trust, which is the most common agreement, the grantor can transfer assets into and out of the trust or even terminate it if they so choose. Therefore, the grantor is still entitled to receive the income and capital of the Trust. As a result, the IRS continues to tax the grantor on the trust's income. Since the Trust can use the grantor's social security number to establish investments and bank accounts, all income related to the Trust can be reported on the grantor's tax return. No separate tax return will be necessary for a revocable living trust.

However, although the grantor pays taxes on the Trust's income, the assets are legally in the hands of the Trust, which will survive the grantor's death. That's why the Trust's assets don't need to go through the probate process. In a conventional revocable trust structure, the grantor retains the power to revoke the trust and modify its terms. This power to revoke or modify raises several tax considerations. First, the trust will be considered a grantor trust (for example, Regs.

Sec. 671-679). Second, any transfer to the trust will be considered an incomplete gift and will not be subject to gift tax (Regs. 2511).

Third, the trust assets will be included in the grantor's estate for estate tax purposes (Sec. 2036).Operational aspects during the revocation period A revocable trust will remain a grantor trust unless or until the grantor relinquishes the power to revoke, initiates appropriate modifications to the trust during its lifetime, defers it to a non-grantor trust, or dies. Therefore, all income, profits, losses, deductions, and credits are reported on the grantor's annual income tax return. Upon the death of the grantor, the trust continues uninterrupted, meaning that assets held in the name of the trust are unaffected (although they are still subject to the terms of the trust) and will not require probate.

However, for income tax purposes, the trust will now be considered an independent taxpayer and will have to obtain a TIN, even in cases where the trust obtained a different TIN during the life of the grantor (Regs. 6109).Care must be taken during the trust transition year when declaring the amount of income, profits, losses, deductions, and credits attributable to the grantor and the trust in the periods before and after death. For example, if the trust provided the grantor's SSN under one of the options listed above, it will be necessary to provide a TIN to third-party payers, since the grantor's SSN expires with the grantor. Upon receiving a TIN, banks and brokers may require the trust to open new accounts, which could present logistical and time challenges for the trustee.

A similar question may arise when the trust obtained a TIN during the life of the grantor.

The trustee must determine

, based on the number of accounts and the overall complexity of the trust transactions, whether to use the grantor's SSN (if allowed) or a TIN over the life of< b >the grantor. Either way, thorough analysis and reconciliation should be carried out to ensure that an appropriate allocation is made to each of < b >the grantor's and non-grantor's trust periods.< b >In addition ,< b >the tax preparer may need to start some tax reporting exercises (for example,. Upon< b >the death of < b >the grantor ,< b >the grantor's trust status ends and any fiduciary activity prior to death must be reported on< b >the grantor's final income tax return. < b >As mentioned earlier ,< b >the grantor's trust , which was once revocable , will now be considered an independent taxpayer , with its own responsibility to declare income tax. Depending on< b >the language and guidelines included in < b >the trust document ,< b >the trust can be considered < b >a simple trust (one that must distribute all of its income annually and that does not also distribute< b >the corpus or capital ) or< b >a complex trust.

At< b >the same time ,< b >the deceased grantor's estate will emerge and it will also be considered an independent taxpayer for income tax purposes. The estate will have its own responsibility to file taxes and must obtain a TIN. < b >An often overlooked , but important , distinguishing factor applicable to an estate is its ability < b >to choose a tax year other than a calendar year. < p >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< B >< P An often overlooked but important distinguishing factor applicable to an estate is its ability to choose a tax year other than a calendar year.

Choosing an end-of-year date can provide beneficiaries with an opportunity to defer taxes and give executors more time to organize estate issues. This can be especially advantageous when someone passes away late in a calendar year. During this election period, income and deductions are reported together but net distributable income must be calculated separately for both estate and trusts. At election end date, electoral trusts are considered distributed into new trusts which must report using calendar year basis which may result in beneficiaries receiving two requests for Schedule K-1 - beneficiary’s share of income deductions credits etc.

Professionals should be aware of potential tax implications upon death of Grantors in order to provide their clients with prior advice as well as value added advice. Revocable trusts provide creators with significant flexibility when addressing changes in people’s lives while providing them with non-tax advantages such as avoiding probate process in certain jurisdictions where it is expensive and lengthy.

Phillip Alleva
Phillip Alleva

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