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Taxation of Irrevocable Trusts

As we approach another tax season, an area of taxation that can be complicated for taxpayers involves the tax treatment of irrevocable trusts. Taxpayers should consult with a tax attorney or CPA.  It is often time beneficial for taxpayer to pay tax on trust income at their individual rate. If the trust is considered a Grantor Trust under the IRS Code, then its income should be taxed a the individual taxpayer’s tax rate.

Why do people create irrevocable trusts? Most irrevocable trusts are formed to protect assets from the cost of long-term care (nursing homes, medical costs, etc.). An older individual might create an irrevocable income-only trust (creator of trust retains only the right to income from the assets and the right to live in the residence) and transfer a house and $120,000 of assets (stocks, cash, etc.). The trust should, if properly structured, protect the assets for Medicaid eligibility. In the typical scenario, upon the grantor’s death his property transfers to his heirs. In the meantime, the grantor continues to live in his home and collect income from his property.

Who pays tax on the income generated by the assets in the trust? If the trust is structured as a grantor trust, the income is taxed to the creator of the trust as this individual rate. The trust must meet the Grantor Trust Rules for its income to be taxed to the grantor at his tax rate. The Grantor Trust Rules allow the trust to be disregarded for income tax or estate tax purposes. As a result, the grantor trust income is taxed to the grantor on this individual tax return.

Some professionals believe that an irrevocable trust is a separate entity that must file its own tax returns. However, if the irrevocable trust is a grantor trust then the income is reported on the grantor’s individual tax return. Also, bear in mind that if the grantor trust owns the grantor’s residence, upon sale of such residence, he will report it on his individual return and potentially qualify for the capital gain exemption.

If an irrevocable trust is properly drafted, it should satisfy the Medicaid eligibility rules, while allowing the grantor to pay income tax on trust income at his individual rate. Furthermore, the assets in the trust should receive a step-up on basis upon the grantor’s death. Consequently, the grantor’s heirs may avoid paying capital gains tax on inherited property that appreciated in value during the grantor’s life.