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The KRASA LAW, Inc. Estate Planning Blog

Friday, June 14, 2013

Does Your Trust Need to Pay Taxes?

A trust is the most common estate planning document.  Many clients inquire as to whether their trusts are required to file their own tax returns.  As with all legal answers, “it depends.”  The nature and structure of a trust determines whether it is required to file a tax return.

 All trusts feature the same three roles: (1) a trust maker, who establishes the trust, dictates the terms of the trust, and transfers assets into the trust; (2) a trustee who manages the assets of the trust; and (3) a beneficiary who uses and enjoys the assets of the trust.

The most basic type of trust is often referred to as a “revocable living trust.”  At its inception, the same person (or the same married couple) occupies all three roles.  During the lifetime of the trust maker, the trust is completely revocable and amendable.  Because the trust maker has total control over all of the assets of the trust and may manage them however he or she sees fit, the IRS and the Franchise Tax Board do not recognize a difference between the trust maker and the trust.  As a result, the trust does not file a separate return.  The IRS and the Franchise Tax Board “look through” the trust and simply tax the trust maker on his or her 1040 and 540 under his or her Social Security Number.  

When the trust maker dies, the trust becomes irrevocable.  At this point, because the trust can no longer be changed and because the trust maker can no longer be taxed individually, the trust becomes a tax payer.  In general, the trustee obtains a Tax ID Number from the IRS which is essentially a Social Security Number for the trust.  If the trust has any income for the year, the trustee will likely be required to file a federal and state trust tax return, Form 1041 and Form 541 respectively.  

In obtaining the Tax ID Number, there is a question on the application that is often answered incorrectly: the “start date” of the trust.  Many people incorrectly understand this question to mean the original date the trust was executed.  However, because the IRS does not recognize the existence of a revocable living trust for tax purposes, the “start date” of the trust is not the date the trust was executed but instead the date of the trust maker’s death.  If the date the trust was executed is mistakenly entered on the Tax ID Number application, the trustee will receive a letter for the IRS asking why it hasn’t received years of trust tax returns that of course were not necessary.

Another factor to consider is whether a Tax ID Number is even required after the death of a trust maker.  If the trust does not contain any income producing assets, then a Tax ID Number might not even be necessary.  For example, a trust might only contain the decedent’s residence or small non-interest bearing checking account.  The trustee would be able to distribute the assets to the beneficiaries without having to file a trust tax return at all.

For more advanced estate planning purposes such as tax planning, asset protection, and Medi-Cal planning, a trust maker might choose to establish a trust that is irrevocable at its inception.  Based upon how many powers the trust maker retains, the irrevocable trust might or might not require its own Tax ID Number.  

As with most legal issues, the specific circumstances dictate whether a trust is required to file its own tax return.  A qualified attorney can help a trustee navigate these rules to ensure that his or her duties are carried out appropriately. 


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KRASA LAW assists clients with Estate Planning, Elder Law, Pet Trusts, Asset Protection, Special Needs Planning and Probate / Estate Administration in Pacific Grove, CA(93950), Monterey (93944, 93940, 93943, 93942), Salinas (93901, 93905, 93906, 93907), Hollister (95023,95023) Pebble Beach (93953), Carmel By The Sea (93921), Seaside (93955) and Carmel (93923, 93922) in Monterey County and San Benito California.

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