Whenever money is involved, odds are high the Internal Revenue Service (IRS) is also involved. One example involving estate planning is the use of trusts. Trusts are essentially legal tools that govern the distribution of certain funds. This piece will discuss how the IRS taxes two main types of trusts: revocable and irrevocable.
IRS and the revocable trust
The creator generally has control over a revocable trust. As a result, in most cases the IRS treats a revocable trust as a grantor trust. For tax purposes, the IRS considers the creator the grantor and holds the grantor responsible for tax obligations. This basically means the creator is expected to include any income from the trust within their tax returns.
IRS and irrevocable trust
In contrast, a creator generally does not have control over an irrevocable trust. This distinction results in the IRS treating an irrevocable trust as a separate entity. The creator does not include the trust income on their tax returns, instead the trust itself is responsible for any potential tax liabilities.
However, beneficiaries who receive distributions from the irrevocable trust are often responsible for any resulting tax.
Draft the trust to meet your need
It is important to note the reality of the tax obligations will vary for each trust. There is not one definitive rule that applies to all trusts. The actual impact of taxes on the trust depends on the wording used to create the trust. A well drafted document can provide the benefits of the trust while also minimizing and simplifying tax obligations.