Orange County Estate Planning Lawyer Blog
Living Trust Taxation – The IRS ignores revocable living trusts
LIVING TRUST DEFINED
The term “living trust” is commonly used by estate lawyers and financial planners to describe a trust which is established during a person’s lifetime and which is revocable and changeable.
Living trusts – are also known as “revocable trusts”. A living trust could have components which are permanent and not revocable so the actual documentation establishing the trust has to be read before you can say for sure if the trust is revocable.
TRUST DOCUMENTATION IS NOT REGISTERED WITH THE GOVERNMENT
Documentation prepared to establish a trust is not registered with any government agency or taxing authority. The only way to find out what a trust says is to actually have the documentation prepared and signed when the trust was formed. Typically the estate lawyer will retain a copy of any trust prepared and then the people establishing the trust will have their own copies. However, in the context of probate and estates, we have seen instances where the trust documentation is lost or destroyed so nobody can figure out what the trust requires. That is the subject of another blog.
THE IRS DOES NOT RECOGNIZE REVOCABLE TRUSTS FOR TAX PURPOSES
The Internal Revenue Code, which is the place where all of the federal tax laws are located in the federal legal system, has a special term for revocable trusts. That term is “grantor trust”. Under the grantor trust rules the person who transfers property to a trust and retains certain powers or interests is treated as the owner of what is transferred to the trust for income tax purposes. This means for example if you transfer a savings account to a revocable trust, the interest income on that savings account is reported on your personal tax return. The IRS does not recognize revocable trusts (grantor trusts) as a tax paying entity. The IRS does not require revocable trusts (grantor trusts) to have a separate tax ID number. In fact, if it is a revocable trust, your Social Security number would be the number on the account in this situation.
TAX REPORTING OF REVOCABLE TRUST INCOME
A normal part of establishing a revocable/living trust/grantor trust is to transfer assets into the trust. Depending upon the type of asset being transferred, different documentation is required which the estate planning lawyer would advise you about. Here is how the transfer works for bank accounts. For example, Joe Smith establishes a living trust and requests the bank to transfer his account into the trust. The title on the account will read “Joe Smith, trustee of the Joe Smith living trust dated 10-1-14”.
That account title will appear on checks and bank statements. The bank will ask for a tax ID number and since the living trust is a revocable/grantor trust the tax ID number will be Joe Smith’s Social Security number. At the year-end, the bank will issue form 1099s for the interest income on the account which will have Joe Smith Social Security number on them. Joe Smith will then report the income as shown on that form 1099 on his personal income tax return.
RETAINED THE POWERS AS DEFINING GRANTOR TRUSTS
Actually the definition of a grantor trust includes not only being revocable but also other powers as well. If there is a power to control the beneficial enjoyment, retention of certain administrative powers or of powers are held by the spouse of the person establishing the trust, the trust would be considered as a grantor trust for tax purposes.
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DEATH OF A SPOUSE IN LIVING TRUST SITUATION
A typical living trust established by a married couple will have provisions to divide up the trust estate at the death of the first spouse. This is commonly known as an A–B trust. When this happens, the assets belonging to the spouse to die, are put into typically the B trust and that is a permanent and non-revocable trust. At that point, a federal tax ID number has to be obtained for the B trust because permanent and nonrevocable trusts are recognized by the IRS and do have to file income tax returns. The returns to be filed are form 1041 fiduciary income tax return and California fiduciary income tax return form 541. These tax returns are due on April 15.
