Tax Treatment of Living Trust Distributions
A living trust (also known as a revocable trust) is an estate planning tool that enables an individual to transfer ownership of assets to a trust during his lifetime. Creating a living trust eliminates the need for probate court after death. It also gives the transferor (commonly called a grantor) control over the assets and the distributions. The trustee pays taxes on these distributions; the trustee is either the grantor or an independent third party.
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Beneficiaries of Distributions
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The grantor can designate distributions to anyone he wishes; however, people usually set up living trusts to provide the grantor himself with income. After the grantor's death, the distributions usually go to the spouse or children.
Tax Liability Ownership
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During the grantor's life, he is liable for the taxes incurred because he retains control of the assets in the trust. After death, the trustee becomes responsible for paying the taxes. A trustee is an individual or organization appointed in the trust document who holds legal title and responsibility for the trust assets and for managing those assets.
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Tax Benefits of Living Trusts
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A living trust can reduce estate tax liability by fully using the Unified Credit. The Unified Credit is a set amount that the government says an individual can eliminate from his estate tax liability. Normally, a married couple would only be able to use one Unified Credit, but with the correct structure a living trust gives both spouses access to the Unified Credit, doubling the amount sheltered from estate taxes. This structure is commonly in the form of an "A-B Trust." For example, if the living trust has "A-B" provisions and the husband dies first, the gross estate of the husband separates into two trusts. "Trust A" will be the amount equal to the federal exemption under the unified credit (which changes every year); "Trust B" will hold the remainder of the assets for the wife's benefit (called a marital trust). "Trust A" uses the husband's exemption amount. When the wife dies, her exemption amount will also apply, but the trustee will pay estate taxes after the wife's death on the amounts beyond the exemption amount for the wife.
Distributions During Lifetime
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The grantor must claim the distributions he takes each year as ordinary income, and they will be taxed according to his tax bracket. Usually, he will not need a separate tax return. He only includes income earned in the current tax year on the yearly tax forms. The income does not accrue for tax purposes.
Distributions After Death
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After the grantor dies, the living trust becomes its own legal entity. Distributions go to the beneficiaries named in the trust document. The trust's funds will pay out taxes, and the trustee is responsible for making those tax payments.
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References
- Photo Credit tax forms image by Chad McDermott from Fotolia.com
