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: