Do You Have to Pay Taxes on a Revocable Trust?

A revocable living trust is a flexible legal arrangement allowing an individual to transfer assets into a trust while retaining control during their lifetime. This type of trust can be changed or revoked at any time by the person who created it, known as the grantor. While offering significant estate planning benefits, such as avoiding probate, its tax implications are important to understand. Generally, a revocable trust does not pay its own income taxes during the grantor’s lifetime, as the Internal Revenue Service (IRS) views the trust and the grantor as the same entity for income tax purposes.

Taxation During the Grantor’s Lifetime

During the grantor’s lifetime, a revocable trust is typically considered a “grantor trust” for federal income tax purposes. All income, deductions, and credits generated by the assets held within the trust flow through directly to the grantor’s personal income tax return, Form 1040.

The trust often uses the grantor’s Social Security Number (SSN) for tax identification during this period. This eliminates the need for a separate Employer Identification Number (EIN) for the trust in most cases. The income is simply reported as if the grantor still personally owned the assets.

Taxation Upon the Grantor’s Death

Upon the grantor’s death, a revocable trust typically becomes irrevocable. Once irrevocable, the trust usually transforms into a separate tax-paying entity distinct from the grantor’s estate. This change necessitates the trust obtaining its own Employer Identification Number (EIN) for tax purposes.

Assets held within the now-irrevocable trust are generally included in the deceased grantor’s taxable estate for federal estate tax purposes. This inclusion is because the grantor retained control over the assets during their lifetime. However, assets held in a revocable trust typically receive a “step-up in basis” to their fair market value as of the grantor’s date of death. This adjustment can significantly reduce potential capital gains taxes for beneficiaries if they later sell the inherited assets.

Tax Reporting Requirements

During the grantor’s lifetime, tax reporting for a revocable trust involves all income, deductions, and credits being directly reported on the grantor’s individual income tax return, Form 1040. This reflects the “grantor trust” status, where the trust is disregarded for income tax purposes.

Upon the grantor’s death, the now-irrevocable trust becomes responsible for filing its own income tax returns annually using Form 1041, U.S. Income Tax Return for Estates and Trusts. This form reports the trust’s income, deductions, and any distributions made to beneficiaries. If the trust has gross income of $600 or more, or if it has any taxable income, a Form 1041 filing is generally required. Beneficiaries who receive distributions from the trust may also be required to report this income on their personal tax returns, typically via a Schedule K-1 received from the trust.