A revocable living trust (RLT) provides a number of benefits to the grantor (the person who created and funds the trust):
In addition to the benefits listed above, one of the primary benefits of a revocable living trust is that because the grantor is still technically the owner of the assets in the trust, he or she is still entitled to the trust income and principle. This also means that the RLT pays no income tax because any income generated by the trust, passes back to the grantor.
RLTs pay no income taxes. This is because while the grantor is alive the RLT is disregarded by the IRS. In fact, RLTs don't even have a tax ID number because they don't need to file tax returns.
This means that when you transfer assets into or out of a revocable trust, no taxes are triggered and any income earned by the assets in the trust simply flows through to you. So, for example, if the trust owns stock and a dividend is paid, that dividend income needs to be reported on your tax returns.
The income taxation of an RLT is a simple matter because it pays no income tax while the grantor is alive. On the other hand, once the grantor passes away, a revocable living trust becomes an irrevocable trust and, at that point, there can be tax consequences.
Once the grantor of an RLT dies, the trust can no longer be changed or modified. By definition, this means the trust becomes irrevocable. Irrevocable trusts are not disregarded entities by the IRS. That means they pay taxes and the taxes they do pay can, in fact, be quite large.
Irrevocable trusts require a brand new tax ID number, just like a corporation does when it is established, and they require that the trustee of the trust report the trust income on a separate income tax return. What’s more, the way income is reported for an irrevocable trust can be somewhat complicated and may require the assistance of an accountant.
Having said that, irrevocable trusts often have no taxable income to report. Even if an irrevocable living trust does have taxable income, since trust tax rates are so high, trustees often opt to distribute such income to the beneficiaries of the trust.
In this way, the trust itself will pay no income taxes, but the recipient of the income received from the trust must report it on their individual income tax return, where it will be taxed at their own income tax rate.
RLTs do not pay income taxes and such concerns are therefore not an issue. However, once an RLT becomes an irrevocable trust, it might have to pay income taxes. Furthermore, given the complexity of reporting taxes for an irrevocable trust, you will probably need to work with a good accountant to help you with these income tax issues.
To learn more about how trusts are taxed and other important estate planning issues, please schedule a free appointment with an experienced estate planning attorney.