For most people, estate planning is a crucial strategy to protect their hard years of investments while also securing the future of loved ones. That said, people are generally more familiar with wills than trusts regarding estate planning.
Trusts tend to be more complex than wills, but come with more benefits and greater control than the latter. Trusts also carry the unique feature of being actionable during the life of the estate owner while also outliving them years after they have left the scene.
Put simply, a trust is a legal entity often used for estate planning purposes that “owns” the assets or property of an individual or an organization. A grantor who transfers the assets creates the articles of the trust. A Trustee administers the assets of the trust before finally being dispersed to the beneficiaries.
Some time back, trusts were largely marketed as an estate planning tool for the wealthy. Today, anyone can organize their assets (including bonds, rental property, CDs, vehicles, and savings accounts) into a trust.
A family trust is broadly categorized into two;
- Revocable trust: One that can be changed throughout the life of the grantor.
- Irrevocable trust: One that cannot be amended during the lifetime of the grantor. It carries several tax benefits.
What is an Irrevocable Trust?
As stated before, an irrevocable trust is similar to a contract signed in stone (literally, no pun meant). Once signed, it cannot be amended, modified, or revoked. Since a revocable trust has no associated tax benefits, we cannot compare it to an irrevocable trust.
Ideally, an irrevocable trust cannot be modified unless otherwise stipulated in the trust agreement. Some advocates or trustees may leave a limited provision to make changes should unforeseen circumstances arise. A good example that would trigger amendments in an irrevocable trust is if the beneficiary relocates to another state having different tax and trust laws. Contingencies should also be present for incidences such as the beneficiary's death.
Types of Irrevocable Trusts
- Gifting Trust: Created to receive and hold gifts for family members.
- Asset Protection: Has the prominent role of protecting the estate owner from future creditors, including long-term care expenses.
- Life Insurance Trust: Largely used for tax and investment planning by those with large estates potentially facing an estate tax liability
- Charitable Trust: Can provide significant capital gains tax savings and remove assets from the taxable estate.
The big question is, why would anyone formulate a contract assigning the control of their assets to another party without the hopes of ever rewriting that covenant? That brings us to the benefits of an irrevocable trust.
Benefits of an Irrevocable Trust
A. Tax Benefits of an Irrevocable Trust Tax Return
For individuals and organizations with a bountiful asset portfolio, an irrevocable trust can be a useful tool to lower the burden of estate taxes. With an irrevocable trust, estate owners qualify for estate tax exemptions and remove taxable assets from the estate. Any property assigned to a trustee in an irrevocable trust no longer belongs to the grantor. This can come in handy for massive estates.
All property owned by a trust is excluded from your taxable estate once you die. Thus, if you'd love to wisely give assets to your beneficiaries in timed distributions without making outright gifts, an irrevocable trust would be an excellent idea.
B. Non-Tax Benefits of an Irrevocable Trust
An irrevocable trust has other benefits aside from significant tax savings, such as acting as a haven from future creditors. Since there has been a transfer of ownership of property, the grantor's future creditors cannot lay claim to the assets. Similarly, the beneficiaries are secure from creditors until the trust property is transferred to them.
Moreover, an irrevocable trust protects the interests of family members who are minors or financially irresponsible since it may contain provisions regarding how and when the assets will be distributed.
Another group that may benefit from an irrevocable trust is disabled persons. The disabled face stringent income and asset limitations, especially concerning receiving gifts. They may lose government benefits such as Supplemental Security and Medicaid if they receive an excess of a specified amount. An irrevocable trust may be one way around this since they have been divested of substantial control over the trust. However, time constraints do apply.
Do You Need to File Taxes for an Irrevocable Trust?
Yes. An irrevocable trust is a separate legal entity mandated to file annual income tax returns.
All income disbursed to beneficiaries should be reported by the beneficiaries, while the trust should report income that is yet to be distributed. Therefore, if the trust earns more than $600 in income for any tax year, then such an irrevocable trust should file a federal income tax return.
Since an irrevocable trust is under the trustee's care, they will be responsible for filing Form 1041 and reporting the income stream. This differs from a revocable trust, where the grantor controls the trust and reports income on their personal Form 1040.
Filing Form 1041 as a grantor's trust has several perks, including:
- The amount the grantor gifts the trust remains intact. Thus, the irrevocable trust remains as fully loaded as possible.
- Makes it possible for the grantor to sell assets to the irrevocable trust without it being regarded as gain.
- The grantor can comfortably pay taxes at their tax bracket, which is more or less lowered in comparison to the highly compressed trust tax brackets.
How to File an Irrevocable Trust Tax Return
There are several processes involved when filling out an IRS form for an irrevocable trust. The process begins with securing a federal employer identification number (FEIN). It's listed in the format 12-345678X and can be applied through the mail, online, or by fax. At this juncture, the trustee will divulge their name, the name of the trust, plus the address.
The next step is to file the U.S. Income Tax Return for Estates and Trusts, otherwise referred to as Form 1041. This is the primary document when filing for an irrevocable trust tax return. Herein will contain the gains, losses, deductions, and accumulated income for the irrevocable trust. As stated earlier, the trustee will fill in Form 1041 if the trust earns over $600 in taxable income annually. The trustee may further need to file Schedule K-1 denoting the income distribution to the beneficiaries.
Generally, trusts and estates enjoy similar deductions and credits forwarded to individuals. That said, estates and irrevocable trusts have the added benefit of deducting income distributions to beneficiaries. Irrevocable trust tax returns should be filed and submitted on or before April 15. However, there are instances when trustees may need an extension to submit Form 1041. In such a case, the trustee will have to submit Form 7004 for an automatic 5-month extension.
You can refer to the IRS website for more information on Form 1041 and the stipulations involved.
Tax Planning with Magellan
Estate planning with trusts is priceless as a strategic means to protect one's years of hard work, savings, and investments. However, the process can get pretty complicated, especially when vast sums of money and assets are involved. One may have the modest services of financial planners, accountants, and sometimes advocates, but these services require coordination for a spotless estate plan.
Here at Magellan Planning Group, we combine all that plus our decades of experience in estate, financial, and tax planning. We meticulously go through your irrevocable trust to guide you in ensuring there are no gaps in your planning. Our expert CPAs at Magellan will not only help you in filing your tax returns but will also shed insight on instances of tax inefficiencies.
Do you feel your tax burden is becoming overwhelming? Do you believe the taxes on your social security benefits are unwarranted? Reach out to Magellan for a comprehensive review of your tax planning and the best financial strategies to manage your taxes.