How are Irrevocable and Revocable Trusts Taxed? (2023)

Last Updated: December 10, 2022 9 min read
Author: Zach L.

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Depending on the powers listed in the trust, an irrevocable trust can either be seen as a simple, complex, or grantor trust by the IRS for tax purposes.

How are Irrevocable and Revocable Trusts Taxed?

A revocable trust is one that can be revoked or changed. It is reversible, and the person who sets up the trust can change its provisions after it has been created.

So, it is a type of trust that can be revoked or changed by the creator at any time. The creator retains complete control over the trust and can make any changes. This flexibility makes revocable trusts a popular choice for estate planning. However, it is essential to note that revocable trusts become irrevocable upon the creator’s death, so there are no more changes that can be made at that point.

A trust is irrevocable if the terms of the trust agreement cannot be changed and the trustee cannot be removed without the beneficiaries’ consent. An irrevocable trust gives the beneficiaries certain rights and protections. For example, the beneficiaries may have the right to require the trustee to provide them with information about the trust property and the trustee’s actions.

The creator of an irrevocable trust cannot change the terms of the trust or revoke it. Once the trust is created, the creator gives up all control over the trust property and the trustee’s actions. Depending on the circumstances, this can be a good or bad thing.

If you are considering creating an irrevocable trust, you should consider these points before going ahead.

Income Taxation of a Revocable Trust

Income Taxation of a Revocable Trust

A revocable trust is an arrangement used by owners to manage their assets. The person who sets up the trust can revoke it at any time. A revocable trust can be created in a way that the trustee pays taxes on behalf of the beneficiary.

The income tax liability for a revocable trust depends on how it was set up. If the trustee pays taxes on behalf of the beneficiary, this is not taxable to them, and they do not need to include it in their taxable income. However, if they are not paying taxes on behalf of the beneficiary, they would need to report this as taxable income because they are responsible for paying their own taxes and cannot shift that responsibility onto someone else.

Revocable trusts are not taxed at the trust level. They are taxed as if they were owned by the grantor or settlor of the trust. This is a living trust that can be modified or revoked by the person who created it. It means that income earned by the trust is taxed to the grantor of the revocable trust rather than being taxed to a separate entity at a different rate. This is the same for capital gains or any other trust income, while the trust is revocable it is really just forwarded to the creator of the trust.

Estate taxes can cause problems for your family members, so if you're considering a revocable trust, consider the pros and cons carefully.

However, revocable trusts are an effective part of your estate plan for people with diverse business interests as they offer flexibility in management and distribution.

Income Taxation of Irrevocable Trust

Irrevocable trusts are not taxed on their income. They are also not taxed on any income distributed to the beneficiaries.

The trust is liable for income taxes if it makes a distribution of property to a beneficiary who is not a trust. If the beneficiaries are both trusts and individuals, then the trust will be liable for tax only to the extent of distributions made to individuals who are not trusts.

Income from an irrevocable trust is taxed differently than income from a revocable trust. Revocable trusts are taxed as part of the grantor's estate, while irrevocable trusts are taxed separately. This means that revocable trusts are subject to estate taxes, while irrevocable trusts are not.

The income of an irrevocable trust is not taxed until it is distributed to the beneficiaries. The beneficiaries are then responsible for paying the taxes on the distribution.

An excellent way to keep your wealth out of the hands of the IRS is by using an irrevocable trust. The income of this type of trust is not taxed until it is distributed to the beneficiaries. The beneficiaries then have to pay taxes on the distribution as income which would be reported on their individual tax return.

What Type of Trust is Right For You?

What Type of Trust is Right For You?

There are many different types of trusts out there, and so far we have only covered revocable and irrevocable trusts. For you to make an informed decision here is a quick breakdown of a few other popular types of trusts.

Simple Trust

A simple trust is the first of two types of trust for tax purposes. A simple trust has to do the following to qualify as a simple trust in the eyes of the IRS.

  • The trust assets cannot be distributed
  • The trust must distribute all of the income it earns to the trust beneficiaries on an annual basis, but not the assets of the trust
  • The trust must not make distributions to charitable organizations

The items of income from the trust are taxable income for the beneficiaries of the trust, even if they do not withdraw trust funds. If there are capital gains taxes they are applied to the trust, and not to the beneficiaries.

Complex Trust

A complex trust is more of a catch-all of any type of trust that does not qualify as a simple trust and is the second type of trust for estate tax purposes. For example, complex trusts can accrue income, and a trust’s income doesn't have to be the only thing that it distributes. It can even make deductible charitable payments according to the internal revenue code 642(c).

Charitable Trust

There are two main kinds of charitable trusts, a charitable remainder trust, and a charitable lead trust. The grantor of the trust should research these two types to determine what makes sense for them, the charity in question, and their other beneficiaries. Let's break it down a little bit.

  • Charitable remainder trust. This trust is slightly complicated. You can continue to receive an income from the distribution of the assets in the trust that does not produce income. You also receive a charitable donation tax deduction that is equal to the amount of the assets marked for distribution to charity. When the term ends or your death (whichever happens first), the charity that was selected receives the rest of the assets.
  • Charitable lead trust. This trust is named as such because the first distribution of the proceeds of the trust are distributed to a charity or charities of your choice and you will receive a charitable donation tax deduction equal to the amount of the distribution. After this distribution happens, the remainder of the assets in the trust are distributed to the beneficiary of the trust.

Testamentary Trust

Testamentary trusts contain some or all of a grantor's assets and it is outlined in the person's last will and testament. You cannot establish a testamentary trust until the death of the grantor, and then the executor of the will settles the estate as predetermined in the will.

Non-Grantor Trust

A non-grantor trust is similar to a complex trust, which is a catch-all trust definition. Any trust that is not a grantor trust is a non-grantor trust. A non-grantor trust is a separate legal entity from the grantor so it has its own tax identification number (TIN). Non-grantor trusts usually have a tax rate much higher than an individual, so make sure to do your homework if you are thinking of creating a non-grantor trust.

Annuity Trust

Annuity trusts are to provide a steady source of income for you or a different beneficiary of the trust. They are beneficial to set someone up for retirement, or if someone is unable to work due to disability or special needs.

When deciding whether or not to create a revocable living trust or irrevocable grantor trust, there are a few factors to consider. First, you must determine if you want the ability to change your mind and revoke the trust at any time. If you do, a revocable trust is the right option. However, if you want to ensure the trust cannot be revoked or changed once it is created, then an irrevocable trust is a better choice.

Additionally, it would be best if you considered your family's needs and goals. If you want the trust to be used for asset protection or estate planning purposes, an irrevocable trust may be a better option. However, if you wish to set up a way to quickly and easily transfer assets to your loved ones after you die, then a revocable trust may be more appropriate. Ultimately, the best decision depends on your specific needs and goals.

Final Thoughts

Final Thoughts

When it comes to estate planning, trusts are a key tool that you can use to protect your assets and ensure that your loved ones are taken care of after you're gone. However, there are two main types of trusts: revocable and irrevocable. Which one is right for you?

A significant distinction between revocable and irrevocable trusts is that the former can be changed or canceled at any time, while the latter cannot. This makes them a safer option for those who want to ensure that their assets will be protected after they die but don't want to lose control over them.

Irrevocable trusts also offer tax benefits, making them a more attractive option for those looking to reduce their tax liability. For example, an irrevocable trust's income is taxed at a lower rate than income generated by a regular bank account or investment portfolio.

So which type of trust is right for you? Make sure to contact multiple estate planners and shop around. This is your legacy, so take the time to do it right.

This post is not legal advice or tax advice.