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An irrevocable trust can come with many benefits. Its primary characteristic is the fact that the creator of the trust cannot amend the terms of the trust nor can the creator spend trust funds for anyone other than trust beneficiaries unless the terms of the trust permit it. In certain instances, the trust terms allow the trustee a limited ability to amend certain trust beneficiaries. Irrevocable trusts are often used in special needs planning as an irrevocable trust can provide financial support for an individual with special needs without jeopardizing the continued receipt of government benefits.

While there are many potential benefits of an irrevocable trust and many uses for this legal tool, it is still important to consider the benefits and consequences of certain trust arrangements. For instance, taxation is important to understand. Irrevocable trusts can have unique tax consequences that should be taken into account.

How Are Irrevocable Trusts Taxed?

The majority of irrevocable trusts are considered separate entities for tax purposes. They have their own tax identification numbers and income generated by an irrevocable trust is reported with that identification number with a Form 1099. The trust will report its income and deductions for federal income taxes each year on Form 1041.

How an irrevocable trust will be taxed will vary depending on whether it is considered to be a grantor trust or a non-grantor trust. A grantor is a person who contributed funds to the trust. This can be different from the person who signs the trust as the trust creator, for income tax purposes. Usually, all trusts funded with assets owned by the trust beneficiary, first party trusts, are categorized as grantor trusts for income tax reasons. Trust income, deductions, and credits are, therefore, reportable on the personal income tax return of the beneficiary. When an irrevocable trust is a grantor trust established as a third-party trust, meaning someone other than the beneficiary funded the trust, the trust creator may want to remain responsible for paying income taxes on trust income during his or her lifetime and this can be accomplished by the trust grantor retaining particular rights to the trust.

When an irrevocable trust is categorized as a non-grantor trust for income tax purposes, things look different for tax purposes. When the trust pays expenditures for a trust beneficiary, the trust will receive a deduction. At the same time, all or part of the trust’s income will become the tax burden of the beneficiary. This is because of the Internal Revenue Code provisions that assert that trust distributions made for the benefit of a beneficiary of a non-grantor trust result in income being carried out to that beneficiary. In other words, the beneficiary will pay income tax on trust distributions. This, however, can be a best case scenario as the beneficiary, especially in the event that it is a special needs trust, may not be earning any or may only be earning a little income and, therefore, will be in a low-income tax bracket. Without other sources of taxable income, the beneficiary will only incur tax consequences for trust distributions that exceed the standard deduction for the beneficiary. Income retained by the trust and not distributed, however, will be taxed to the trust.

Estate Planning Attorney

Estate planning is truly important but can be incredibly complicated. Tax consequences are a particularly complex element. The knowledgeable estate planning team at Verras Law is here to help and here to answer your questions. Contact Verras Law today.