How Are Revocable Trusts Taxed

Taxation of Revocable Trusts in Washington D.C.

Trusts are established for legal protection and safeguarding of assets. Most people set up a revocable trust to reduce the time and cost of transferring assets to beneficiaries and avoid probate after one’s passing. However, while the focus is usually on asset management and obtaining government benefits, it is essential that all parties involved in a revocable trust understand tax requirements. 

The grantor owns the revocable trust’s assets for income tax purposes. Assets maintained in a revocable trust will be included in the grantor’s gross estate, and as a result, assets will receive a new basis when the grantor dies. Since the grantor has revocation rights, the grantor is considered to own the trust’s assets. Thus, income generated during the trust is reported under the grantor’s Social Security Number. All assets, dividends, and income earned by those assets are reported to the Internal Revenue Service (IRS) and appear on the grantor’s personal income tax return.

For most purposes, the grantor has absolute control of assets in a revocable trust. As a grantor, you can take back assets into your ownership as you please. You can also sell or give them away. The choice is all yours.


What Are Revocable Trusts?

A revocable trust, also known as a living trust or inter vivos trust, is a legal arrangement in which an individual (the grantor or settlor) places their assets, such as real estate, bank accounts, investments, and other property, into a trust.

The creator (grantor) may revoke or modify a revocable trust without anyone’s approval or consent. The trust’s creator has unrestricted control of the assets in the trust as long as they remain alive and competent. The trust usually continues for conventional estate planning purposes should the creator pass away.

A revocable trust creator can revoke the trust at any time and may even provide an automatic shift to irrevocable status under specific circumstances. For instance, a revocable trust creator may provide for an automatic shift to irrevocable status in the case of funding by someone other than the grantor themselves.

Whether a trust is revocable or irrevocable is determined by state laws and trust instruments (deed of trust).

Advantages of a Revocable Trust

A revocable trust offers several advantages in estate planning. Here are the top benefits of a revocable trust:

  • It allows individuals to maintain control over their assets while they are alive.

  • It avoids probate, thereby ensuring privacy.

  • It ensures a smooth transition of asset management in case of incapacity.

  • The trust provides flexibility to change beneficiaries and terms, making it a dynamic tool for evolving needs.

Overall, a revocable trust streamlines the distribution of assets, potentially reducing costs and delays and provides an efficient way to manage one’s estate. It also allows for tax planning strategies to mitigate tax liabilities.

What Is a Grantor Trust?

In the context of a revocable trust, a grantor trust is a legal term that refers to the grantor of the trust being treated as the owner for income and estate tax purposes. The grantor has full power and control over the assets in the trust, making them responsible for reporting any income generated by those assets on their personal tax returns.

For income tax purposes, the grantor contributes the funds to the trust. The IRS considers all revocable trusts to be grantor trusts if the grantor retains the power to revoke and reenact the trust assets in themselves.

From a tax perspective, whether an irrevocable trust is classified as a simple, complex, or grantor trust depends on the powers outlined in the trust document. An irrevocable trust can also be treated as a grantor trust if it follows any of the definitions contained in IRS Codes §§ 671,673,674, 675, 676, or 677.  

Generally, all income is taxed to the grantor in a grantor trust, irrespective of whether the grantor receives distribution from the trust. For income tax purposes, grantor trusts are treated as alter egos of the grantor.

Are Trusts Required to File Income Tax Returns?

Trusts are required to file Form 1041: The U.S. Income Tax Return for Estates and Trusts for each taxable year where the trust has an income of more than $600 or if the beneficiary is a non-resident alien.

However, if a trust is classified as a grantor trust, no Form 1041 is required. In this case, the grantor should report all income and allowable expenses on his Form 1040 or 1040-SR, U.S. Individual Income Tax Return. Consequently, the grantor would pay the total tax liability upon filing their return for that taxable year.

Grantors of a revocable trust are responsible for listing the trust income on their personal income tax return. They are also responsible for paying applicable taxes, whereas the beneficiaries are not.

On What Form Is the Revocable Trust’s Income Reported?

The revocable trust’s income is reported using the Form 1041. Income distributed to beneficiaries is reported by the trust using Form K-1.

Trusts are required to issue a tax document called a Schedule K-1 to beneficiaries, summarizing any funds distributed to them by the trust. Beneficiaries have to then include these receipts from the trust on their individual tax returns.

How Is the Tax Calculated for a Revocable Trust?

Trust income is taxed based on what type of income it is. Capital gains from selling a stock may be taxed differently from income gained from a business. Additionally, trust income is often taxed differently than personal income.

Grantor trusts generally require the grantors to report all income from a trust on their tax returns. The taxation of a trust can, however, be quite complex. Consider consulting an estate planning attorney for help determining how the tax for your trust may be calculated.

An Estate Planning Attorney Can Help You

The grantor pays income taxes on behalf of the revocable trusts during their lifetime. However, upon their death, the trust becomes irrevocable. Once this happens, it will have to file a tax return and may be required to pay income taxes. Given the complexities involved in income tax reporting, consider enlisting the help of an estate planning attorney.

Whether you are a grantor or trustee, Kevin C. Martin, Attorney at Law, PLLC, is an estate planning attorney in Washington, D.C., who can help you understand how trusts are taxed and other important estate planning topics. Schedule a free consultation with us today!