Income Taxes & Irrevocable Trusts

When you set up a trust, you're creating a legal entity that will take ownership of your assets and then distribute them to your heirs when you die. Since a trust is separate from the individual who creates it, it is not subject to the legal process known as probate, in which a court must approve a will and the transfer of money, investments, real estate and other assets according to the will's instructions. Irrevocable trusts also offer important tax advantages.

An irrevocable trust is one that the creator may not change after its creation. The "grantor" of the trust places the trust assets in the hands of a trustee, who is responsible for managing the assets for the benefit of beneficiaries named by the trust. Since the assets are no longer under the grantor's control, the Internal Revenue Service considers the trust to be a separate entity for tax purposes.

If you don't have an irrevocable trust, the assets that pass to your heirs are included in your estate, though the IRS allows a few asset types to be excluded from the estate. As of the time of publication, the IRS excludes $5.43 million of your covered assets from estate taxes, but once that tax kicks in, it claims 40 percent. Individuals with large estates and no trust can expect the IRS -- as well as state tax authorities in states with an estate tax -- to claim a significant portion of their goods and property.

Irrevocable does not necessarily mean "tax free." The IRS requires trusts to file their own income tax returns, known as fiduciary returns, using Form 1041. If an irrevocable trust earns income that is ordinarily taxable, it is then subject to income tax; if and when the trust makes distributions to beneficiaries, those individuals and organizations receiving assets are also subject to tax on their distributions. In the case of revocable trusts, which the grantor can revoke or amend, all income that is not tax exempt is taxable to the grantor.

The $5.43 million exclusion from estate tax includes gifts, which the IRS also taxes under certain conditions. Whether or not you have an irrevocable trust, you are allowed to gift $14,000 to an individual or organization without incurring any gift tax. If you go over that threshold, you must file a gift tax return and let the IRS know the amount of the gifts. Over your lifetime, these excess amounts are added to your estate for tax purposes. Donating money through an irrevocable trust -- which can also pay beneficiaries during your lifetime -- is one way to escape this rule and avoid estate tax on money you intend to give to heirs.