Parents or other family members may have assets they'd like to set aside for children or other beneficiaries who haven't yet reached adulthood or don't necessarily have the capacity to handle money. Putting the assets into an irrevocable trust allows the family member, or grantor, to minimize any estate taxes, protect the money or other assets from creditors, and allow the assets to earn income for the benefit of the beneficiary.
Irrevocable Trust Defined
Irrevocable means that it can't be taken back; in this case, once the grantor sets up the trust and contributes assets to it, he no longer has any ownership or control over those assets. If the trust needs to be modified or terminated, the beneficiary must give permission. This differs from a revocable trust, which allows the grantor to make modifications or take back the assets.
Tax on Beneficiary Distributions
When a beneficiary receives income from the trust, she'll typically pay taxes on it at the regular rate. However, when the original money or assets were contributed to the trust, the grantor had likely already paid taxes on them. The beneficiary pays taxes only on the portion of money representing interest that has accumulated on the principal, or original assets. The trust itself must file a tax return each year, and it pays tax on the interest income, but only if the income stays in the trust and isn't distributed to the beneficiary.
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Once the trust distributes income to the beneficiary, it shows this as a deduction from its own taxable income on its Form 1041 tax return. The beneficiary then receives IRS Form 1065, also called Schedule K-1. This tax form breaks down the details of the beneficiary's distribution. It shows how much of the income received from the trust is taxable and how much income represents the original principal and requires no tax payment. The beneficiary reports only the taxable amount on his tax return.
Estate Taxes and Probate
Once a grantor places assets inside of an irrevocable trust, she no longer has ownership of the assets. Upon the grantor's death, since these assets belong to the trust, they don't need to go through probate. This means that any beneficiary has access to the trust assets without delays, which could amount to several months in the case of probate. Additionally, because the trust owns the assets, the grantor's estate doesn't have any claim, so beneficiaries don't need to pay any estate taxes on the income.