Harry Margolis
Irrevocable trusts must obtain their own taxpayer identification numbers and file an annual tax return each year using Form 1041. If they do pay income taxes, the schedule is much more accelerated than that for individuals, reaching the top rate of 37% after just $13,050 of income (for the 2021 tax year). However, few irrevocable trusts actually pay any income tax because they only have to do so to the extent they retain the income earned and don’t distribute it and only if they are not “grantor” trusts, which are irrevocable trusts in which the grantor has retained certain powers that make the trust income taxable to him.
To the extent the income of a non-grantor trust is distributed to beneficiaries it is taxed to the recipients and the trust acts as a pass-through for tax purposes. In that event, the trust issues the beneficiaries K-1s, which are similar to 1099s issued by financial institutions.
Other tax issues are also straightforward with respect to revocable trusts and can depend on the form of the trust with respect to irrevocable trusts. For instance, a house held by a revocable trust that is sold will qualify for the $250,000 exclusion for capital gains. Capital gain on the sale of a house held by an irrevocable trust may or may not qualify for the $250,000 exclusion depending on whether or not it is a grantor trust for tax purposes.
Upon the death of the grantor of a revocable trust, the trust property receives a step-up in basis, meaning that any capital gains disappear. Again, upon the death of the grantor of an irrevocable trust, the trust property may or may not receive a step-up in basis depending on whether the trust property is includable in the grantor’s taxable estate. The rules are somewhat different for income and estate taxation, so a trust may receive a step-up in basis upon the grantor’s trust but not be considered a grantor trust for income tax purposes.
Irrevocable trusts never receive a step-up upon the death of a beneficiary. So a trust that provides for a surviving spouse will receive a step-up in basis upon the grantor’s death but not a second step-up upon the surviving spouse’s death. Or a trust that was created for the benefit of a child will not receive a step-up when the child dies and the trust is distributed to the grandchildren.
As you can see, trust taxation can be very complicated (and we’re only scratching the surface here), but these principles apply throughout. Any questions should be directed to an accountant or tax attorney.
Interests of beneficiaries
All trusts have both current beneficiaries who have certain rights to trust income and principal distributions and future beneficiaries who will receive income or principal in the future after the occurrence of a triggering event, often the death of the current or “lifetime” beneficiary. While the interests of current beneficiaries of revocable and irrevocable trusts are identical, the interests of future beneficiaries can be very different.
Future beneficiaries of revocable trusts essentially have no rights because the grantor can always change the trust and thus eliminate them as beneficiaries. So, they have no right to a copy of the trust, to see trust accounts, or even to know that the trust exists.
The rights of beneficiaries of irrevocable trusts depend on whether their interest or role as beneficiary is “vested,” in other words on whether it can be changed. As we discussed in our prior article about trusts , they can contain a power of appointment permitting either the grantor or someone else, often an interim future beneficiary, to change who will receive property. If such a power of appointment exists, then the interest of the future beneficiary can be eliminated and has not vested.
A nonvested future beneficiary has no rights concerning the trust. However, a vested future beneficiary has significant rights. The trustee must take her interests into account in making trust distributions to current beneficiaries and the future beneficiary has the right to view the trust instrument, to know the identity of the trustees, and in some instances to view trust accounts.
An example can explain how this might work. Grandpa creates a trust for the benefit of Grandma, giving her a power of appointment. Assuming Grandma doesn’t exercise her power of appointment, the trust will continue after her death for the benefit of their children, Child A, Child B, and Child C. They each have a power of appointment over their share, but if they don’t use it, their shares will pass to their children (the grandchildren) after all the children have died.
After Grandpa’s death, Grandma becomes the lifetime beneficiary. The children’s interests have not vested because Grandma can still remove them as beneficiaries through her power of appointment. They have only a limited interest in the trust.
After Grandma dies, the three children become the primary beneficiaries and, again, the interests of their children are quite limited since the middle generation also has powers of appointment over their shares. Let’s assume that Child B dies leaving his own children and not exercising his power of appointment. At that point, even though they may have to wait until the deaths of Child A and Child C to receive anything, the interests of the children of Child B will have vested, giving them rights to the trust document, trust accounts and information about the trustees.
As you can see, while they are both “trusts,” the differences between revocable and irrevocable trusts and the interests of the beneficiaries can be quite significant.
Next time: What you need to know if you’ve been appointed trustee
Harry S. Margolis is a Massachusetts estate and elder law planning attorney. He answers consumer questions about estate planning at AskHarry.info and most recently published The Baby Boomers Guide to Trusts: Your All-Purpose Estate Planning Tools .
