How Do Taxes Work with a Living Trust? – Estate Planning

A Florida living trust does not affect your income tax liability during your lifetime. Income generated by the assets in the trust is typically taxed on the grantor’s tax return, just like income from any other source. Creating a living trust in Florida does not change how income taxes are paid on the trust’s assets.

Here’s how it works:

A Living Trust is A Grantor Trust

A revocable trust is typically considered a “grantor trust” under the Internal Revenue Code for income tax purposes. This means that the living trust is transparent for tax purposes. All trust income, deductions, and credits are reported directly on your income tax return (Form 1040) as if the trust did not exist. The trust itself does not pay separate income taxes during your lifetime.

Does a Living Trust Need A Tax Identification Number?

Your living trust does not need its own tax identification number and can report income and loss under your Social Security number. It does not need a separate Employer Identification Number (EIN) until your death or when you decide to make the trust irrevocable for some planning reason.

Tax ID is Required After Your Death

Your living trust generally becomes irrevocable at your death. At this point, the trust becomes a separate tax entity and must obtain its own tax ID number. The trust will also start filing its own tax return, Form 1041 (U.S. Income Tax Return for Estates and Trusts). Income retained by the trust will be taxed at trust income tax rates, which tend to be higher and reach the top tax bracket at much lower income levels than individual tax rates. Income distributed to beneficiaries is typically reported on their tax returns.

Estate Tax Considerations of Living Trusts

Your taxable estate at your death includes your living trust assets because you maintained control over these assets during your lifetime. The estate tax effect depends on your total estate size and the estate tax laws at the time of death.

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Income Tax Issues in Marital Trust Design

A bequest to an irrevocable credit trust may create income tax issues for the surviving spouse, who will lose a step-up tax basis for trust assets.  

In cases where a living trust leaves assets to a surviving spouse under the marital deduction and then to the children, the Internal Revenue Code provides that the children apply a new tax basis, or stepped-up basis, if the children subsequently sell the inherited assets.

Consider an example where two parents bought stock for $10 per share, and when the first parent dies, the stock is valued at $50 per share. The first parent leaves the stock in a marital deduction trust to the surviving spouse. Then, at the second parent’s death, the same stock is worth $60. The parents’ estate plan leaves the stock to their child. The parents’ child inherits the stock with a new income tax basis equal to its $60 date-of-death value. If the child sells the same stock for $70, the child’s taxable capital gain would be the difference between the $70 sale price and the $60 date-of-death value rather than the parent’s original $10 cost basis (a $10 capital gain).

In the above example, the child has received an income tax benefit from a $40 tax basis increase at the first parent’s death and another $10 basis increase at the second death—this is referred to as a “double step-up” of tax basis. When assets are left to a spouse in an asset-protected credit shelter trust, there’s a “step-up in basis” at the death of the first spouse, but there’s no step-up in basis for the child after the surviving spouse’s death. In the above example, if the first parent left the stock in a credit shelter trust, the child would pay upon sale a capital gain on the difference between the sale price and the single basis step-up at the death of the first parent. (tax imposed on a $20 capital gain).

Therefore, a living trust that leaves assets to a surviving spouse in a credit shelter trust for the spouse’s asset protection may impose additional income tax on children who inherit property from the surviving spouse.

How To Plan For Income Tax Effect of Living Trust Design

A Florida living trust design can include flexibility to permit the surviving spouse to decide whether the deceased spouse’s assets are left in a unified credit trust or a marital trust. This way, the surviving spouse may consult with legal and tax professionals, examine the value of assets at the time of transfer, evaluate asset protection issues, and fund the marital and credit trusts to best serve the family’s legal and tax goals.

About the Author

I’m an attorney who specializes in asset protection planning. I graduated with honors from Emory University Law School and have been practicing law for almost 15 years.

I have helped thousands of clients protect their assets from creditors. Before private practice, I represented the federal government while working for the IRS Office of Chief Counsel.