Who Pays Income Taxes on a Revocable Living Trust?

Revocable Living Trusts are used to avoid probate (court supervised estate administration) at death, and to reduce the time delay and costs involved in transferring assets to the trust beneficiaries. But if you set up a revocable living trust, does that require a change to your income taxes? Will you need to file a separate income tax return for your revocable living trust? And who pays the tax on income earned by the trust assets?

Here is a brief summary of how the income taxes work for a revocable living trust.

While you are living

When you create a revocable living trust, you will sign a document as the “grantor” (that’s the person who creates a revocable living trust).  Under the terms of the trust, you can amend or even revoke the trust (that’s why it’s called a revocable trust). In addition, when you’ve transferred your personal assets into the trust, you’ll still be entitled to receive the trust income and principal. As a result, the IRS rules require that you’re still taxed on all of the income earned by the trust assets. That mean your own Social Security number will be used for the trust’s bank accounts and investments. It also means that as long as you live, all of that income is reported to your own tax return, so you won’t need to file a separate trust tax return.

Isn’t that relief? Your revocable living trust will not complicate or change your taxes. However, even though the IRS considers these trust assets to be taxed to you personally, those assets that are in the trust will avoid probate estate administration at your death.

After your death

When you die, the trust will continue. The trust becomes its own separate taxable entity and as a result it will need its own taxpayer identification number. Your final tax return will be filed by your executor or trustee, for income earned through your death. The income earned by trust assets after your passing will be listed on the trust’s own, separate income tax return. The trust will need to file an annual fiduciary income tax return (on Form 1041). When the now irrevocable trust makes distributions to beneficiaries, then generally the trust will deduct from income the distributions made. The beneficiaries will recognize a portion of the distribution received as income on their own income tax return. It is important to note that not all of the distribution is taxable to the beneficiary: the distribution is taxable only to the extent that it represents income that the trust assets earned. The rest of the distribution is a nontaxable return of premium.

The beneficiaries will need to wait each year until they receive a report for the trust about the income to be reported on the beneficiary’s own individual income tax return. If the beneficiary files his or her tax return too early and fails to include his or her share of trust income, the beneficiary will need to file an amended trust tax return (Form 1040X).

If the trust does not make distributions to beneficiaries, then the trust will pay taxes on its own income. In that case, the beneficiaries will not need to recognize income since they did not receive a distribution.