By The Wyoming LLC Attorney TeamJun 14, 2022
A Revocable Living Trust (RLT) offers various benefits, including asset control, easy changes, and probate avoidance. During the grantor's lifetime, it pays no income tax, as it's disregarded by the IRS. Instead, any income generated flows through to the grantor. After the grantor's passing, the RLT becomes irrevocable, requiring a tax ID number and potentially incurring taxes. However, distributions to beneficiaries often minimize the Trust's taxable income.
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’s income and principle. This also means that the Trust pays no income tax of its own because any income generated by the Trust, passes back to the grantor. This distinction applies to all Colorado Trusts.
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. An RLT will use the social security number of the grantor.
This means that when you transfer assets into or out of a Revocable Trust, no capital gains or other 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 will 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 will be required to obtain a tax ID number. From that point forward, the Trust will be required to file a tax return and 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 are obligated to settle taxes, and the taxes can indeed be substantial.
Irrevocable Trusts require a brand new tax ID number 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, not at the Trust's higher income tax rate.
Revocable Living Trusts do not pay income taxes and such concerns are therefore not an issue during your lifetime. However, on your death, your Revocable Living Trust becomes an Irrevocable Trust and it will have to file a tax return and 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.
Although Trusts may not be essential for the majority of individuals, if you feel that you might need one, we suggest speaking with an experienced estate planning attorney. They will be able to provide guidance and assistance as needed.