How is Income in Irrevocable Grantor Trusts Taxed?

Q. My mother set up an irrevocable grantor trust with your firm as part of her estate planning. Can you explain more to me about what that means? She also asked me to inquire about how the trust’s income is taxed and what forms she should use to file. Thanks for your help!

A. Thanks for your question! The Internal Revenue Service (IRS) defines a grantor trust as one in which typically the person who created the trust (the “grantor”) retains some control or use over the assets of the trust. Any trust in which the grantor is a trustee is a grantor trust. Though a trust may be irrevocable in that it cannot be revoked unilaterally by the creator of the trust, if the grantor retains any control over the disposition of the assets, even indirectly, such as the ability to change the beneficiaries and change trustees (powers typically contained in our Living Trust Plus® asset protection trust), it will be treated as an irrevocable grantor trust by the IRS.

How Irrevocable Grantor Trusts Work

When you set up a trust through a Virginia estate planning attorney, DC estate planning attorney, or Maryland Estate Planning Attorney, you’re creating a legal entity that will take ownership of your assets and then distribute them to your heirs when you die. An irrevocable trust is one that the creator may not unilaterally revoke after its creation. Contrary to popular belief, the term irrevocable does not mean that the creator cannot make changes to the trust. This is a common misconception among the general public and among Virginia Estate Planning Lawyers, Maryland Estate Planning Lawyers, and DC Estate Planning Lawyers. On the contrary, our typical Living Trust Plus® asset protection trust allows the creator to change the beneficiaries and change the trustees of the trust at any time, either during life, or upon death via their last will and testament. The grantor of the trust places the trust assets in the hands of a trustee (often the grantor also serves as the trustee) who is responsible for managing the assets for the benefit of beneficiaries named in the trust. Because the trust is irrevocable, the Internal Revenue Service considers the trust to be a separate entity for tax purposes, and although a separate tax ID number may not always be required, we typically recommend it.

Taxation of Irrevocable Grantor Trusts

If an irrevocable trust has its own tax ID number, then the IRS requires the trust to file its own income tax return, which is IRS form 1041. During the lifetime of the grantor, any interest, dividends, or realized gains on the assets of the trust are taxable on the grantor’s 1040 individual income tax return.

After the grantor’s death, the trust assets are considered part of the decedent’s estate and therefore receive a full step-up in basis for capital gains tax purposes. Also, if the primary residence owned by the trust is sold by the trust during the grantor’s lifetime, the grantor is entitled to take $250,000 capital gains exclusion in connection with the sale, assuming all other requirements for that exclusion are met.

These are a few important things that you should know:

Trusts that have their own tax ID number must generally file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year where the trust has $600 in income or the trust has a non-resident alien as a beneficiary. However, if the trust is classified as a grantor trust, the Form 1041 is purely informational (here is a sample on our website), as an irrevocable grantor trust does not pay its own taxes; rather, the creator of the trust, as the grantor, reports all items of income and allowable expenses and deductions and credits on his or her own Form 1040 Individual Income Tax Return. Thus, the grantor/individual would pay the total tax liability upon the filing of his return for that taxable year.
Along with Form 1041 for the trust, you file a Grantor Trust Statement (sometimes called a grantor trust letter) – and a copy of the Grantor Trust Statement also gets attached to the personal 1040 filed by the grantor. If the trust owns rental real estate, Schedule E also gets attached to the Grantor Trust Statement and attached to the 1040.

• You will most likely need to manually file your 1040 and 1041 and attachments, as the electronic filing systems typically don’t have a Grantor Trust Statement and typically don’t allow you to upload documents not already in their system.

Tax Rules are Always Changing. Be Sure to Plan Ahead!

The changing tax landscape is one of many reasons why the need for estate planning remains as important as ever. If you have not done your estate planning or had your planning documents reviewed in the past several years, please don’t hesitate to call us foran initial consultation:

Estate Planning Fairfax: 703-691-1888
Estate Planning Fredericksburg: 540-479-1435
Estate Planning Rockville: 301-519-8041
Estate Planning DC: 202-587-2797

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About Evan H Farr, CELA, CAP

Evan H. Farr is a 4-time Best-Selling author in the field of Elder Law and Estate Planning. In addition to being one of approximately 500 Certified Elder Law Attorneys in the Country, Evan is one of approximately 100 members of the Council of Advanced Practitioners of the National Academy of Elder Law Attorneys and is a Charter Member of the Academy of Special Needs Planners.

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