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Christie A. Donoghue:

In our previous videos, we learned about trusts, what they are, what beneficiaries should know, and what trustees do. Today, we'll talk about how trusts are taxed.

Marianela Melexenis:

The first thing to know is that trusts can be categorized into two main types, revocable and irrevocable. As their names suggest, you can revoke or undo a revocable trust you've created. Irrevocable trusts may not be undone. This has important tax implications.

Let's explore them with Susan. Susan creates a revocable trust. She's what's known as the grantor or settlor of the trust. She can revoke it.

The assets she contributes to it remain in her control. She still owns them. So her contributions to the trust are not a gift. She won't pay any gift taxes or use any of her annual gift tax exclusion or lifetime exemption.

But she will have to report all of the trust income on her individual tax return. You can think of a revocable trust as a glorified checking account where the grantor, Susan in this case, is responsible for all the receipts and disbursements that occur during the year.

Christie A. Donoghue:

Finally, the trust assets will eventually be included in Susan's estate when she dies. This will allow the assets to receive a step up in tax cost basis. That means the cost basis for tax purposes is no longer the price Susan paid when she purchased the assets. The fair market value of these assets on the date of her death, or an alternate date six months after her death, will now be classified as a long-term capital gain or loss.

This can reduce the taxes on those gains in a big way if the assets are ever sold. How does this work? In Susan's case, one of the trust's assets is a stock she purchased many years ago for $10. Since then, it has gone up in value, eventually reaching $100 when she dies.

That's a total gain of $90. However, because the stock receives a step up in basis from $10 to $100, the value of the stock at her death, the cost basis, has changed to $100. A sale at that price results in a taxable gain of $0. But what if Susan chooses to create an irrevocable trust and names her daughter Emma as beneficiary?

Since irrevocable trusts may not be revoked, the assets are removed from Susan's control. They are considered a gift from her to the trust. And she will need to file a gift tax return. The assets are now owned by the trustee.

And they aren't included in Susan's estate. And they will not receive a step up in tax basis upon her death. When the trust terminates, the assets will be passed on to Emma as the remainder beneficiary tax free. Now let's break this down a little further.

Irrevocable trusts can be divided into grantor and non-grantor trusts. Let's say Susan chooses an irrevocable grantor trust. The tax treatment is the same as it is for revocable trusts. Susan is responsible for paying the tax on all of the trust's income.

These trusts are a win-win for everybody involved. First, the income is taxed to Susan as grantor. And the tax she pays does not constitute a gift to the trust. Second, the trust grows income tax free.

Third, any distributions to Emma will be tax free because Susan is reporting all of the income on her individual tax return.

Marianela Melexenis:

The tax treatment for irrevocable non-grantor trusts is a bit different. Non-grantor trusts are basically a hybrid of different tax-paying entities. They share some characteristics of an individual tax return regarding income and expense components. But they have one special feature that separates them, an income distribution deduction.

As an added bonus, with proper planning, there may also be an opportunity to eliminate state income taxes. During the year, the non-grantor trust will receive interest and dividends and will hopefully realize capital gains. If Emma, the beneficiary, receives any distributions, she'll pay taxes on them. The trust will be allowed an income distribution deduction so the income will not get double taxed.

Realized capital gains are typically taxed to the trust along with any income such as interest and dividends that were not distributed.

Christie A. Donoghue:

So to sum it up, for revocable trusts, the grantor pays all income taxes. There are no gift tax implications. And trust assets receive a step up in cost basis upon the grantor's death. For irrevocable trusts, grantor contributions are subject to gift tax.

But they are removed from the grantor's estate. The assets do not receive a step up in basis upon the grantor's death. For irrevocable grantor trusts, the grantor pays all income taxes. And there are no gift tax implications on the taxes paid by the grantor.

For irrevocable non-grantor trusts, the trust pays tax on undistributed income and realized capital gains. Beneficiaries pay tax on any income distributions they receive. The trust is allowed an income distribution deduction. As you can see, the taxation of trusts is a complex subject.

And we've barely scratched the surface here. The bottom line is this. People create trusts for many reasons. To avoid probate, to shield assets from predators and creditors, and in the event of divorce, to protect those with abilities and disabilities, and more.

They can also be used to maximize the efficiency of estate, gift, and income tax planning.

Marianela Melexenis:

If you're interested in trusts and the taxes that might apply, please reach out to an experienced tax or estate professional to discuss your situation.

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