Join Attorney Thomas B. Burton in the latest video in our Estate Planning 101 series, where we discuss the following topic: "How Are Revocable Living Trusts Taxed?"
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Welcome back to estate planning 101, I'm Attorney Thomas Burton. I'll be your guide through this wonderful world of estate planning and today's topic is "How are revocable living trust taxed?"
So this is a question that comes up very often in my practice. I'm an estate planning and asset protection attorney here in Wisconsin and we use revocable living trust extensively, to help people avoid the time expense and delay of probate court and pass their assets to their heirs without excess delay and expense and one of the primary tools we use to do that is a revocable living trust.
Today in estate planning 101, we're going to go over how revocable living trusts are taxed and you'll forgive my art skills today but you'll see here we've got a house and money, there's lots of different assets we can put in a trust and you can watch, I have a video called "How to fund your trust". That's a great video to watch about how to get assets into your trust after you formed it and that's also in the estate planning 101 series but today, this question often comes up when I'm meeting with folks, to put a trust plan in place for their estate and they're wondering how are the taxes going to work if I put this trust in place because for many people, they've gone through most of their life owning their individual assets in their own individual names. So as the title on real estate says, 'John Smith' or 'John Smith' and 'Sue Smith' married couple with rights of survivorship here in Wisconsin or something like that and it's possible they own a business as well and they may have property in the business name but once we form a trust, what happens is it's like we're setting up our own entity to manage our personal affairs and sometimes I tell people, it's useful to think about setting up a corporation like Walmart. Sam Walton set up Walmart and Walmart outlived Sam Walton right? In theory, a corporation has a perpetual life, it can go forever, longer than any one person. The same with your trust, you can set it up during life and it can outlive, you outlive your death and that's the key to avoiding the expensive probate process after your death because if you don't have a trust, everything in essence shuts down upon your death and that's where we have to get the court involved, to get assets transferred from you to your heirs. Whereas, if you set up the trust, it can begin during life and continue after your death.
Watch some of my other videos on trust for more about how that works but let's start off with the taxation in today's class.
So let me, just a second here, let me get this and we're going to look at the top half first and that is a revocable living trust is generally what the IRS calls a grantor trust during your life. In most cases, we're going to want to set it up as a grantor trust and the reason it's a grantor trust, there's several powers the IRS say, can make a trust a grantor trust but for today's presentation, I'm not going to get into all of them but the primary one with the revocable living trust is the power to change beneficiaries. So the name revocable means the trust is revocable meaning you can completely revoke it. Say, I don't want it anymore or change it during your life and many folks want this because similar to a will they want the flexibility to be able to change their mind later if they want to ultimately change beneficiaries. For instance, let's say you want to leave more or less to one beneficiary such as a child or a beneficiary has a learning disability, a physical-mental disability and you need to change, let's say, set up a special needs trust for that child and maybe put more into that trust for that child. That's the flexibility in the revocable living trust and so usually this power to change the beneficiaries is what will give us grantor trust status, from the IRS, during your life and the grantor trust means for your revocable living trust, that the income and expenses flow through from the trust to your individual tax return. So Form 1040, for an individual and then that's the form you send to the IRS, just like you've always done your individual taxes. So in essence, when we put assets into the trust, let's say, we put in your house and your brokerage account and that the house, a lot of times, the house doesn't generate income, right? So that doesn't generally matter on your tax return anyway but your brokerage account, in a good year, let's say, it does generate income and you get that statement from Charles Schwab, let's say and it shows the income and any dividends you may have received. Well that money would flow through right to your individual Form 1040 and you would report it there like you always have. So the great thing about forming a trust is during your life for tax reasons, we don't have to have anything really change from that day forward. It's all reported on your individual tax return and you don't have to go home and do something special in terms of filing a new tax return. Now today we're talking about revocable living trust, there are other types of trusts such as irrevocable trust where we may, on purpose, do the taxation differently but this is for revocable living trust. Generally during your lifetime, you have to file no separate tax return and the outside of that, is it also keeps it simpler for you and you aren't paying, if you work with the tax preparer, to have an extra tax return prepared during life and it is all very simple and that's why we call revocable living trust a great 'Will Substitute', meaning we're substituting that trust plan instead of a will, we're having everything flow through the trust to make it simpler.
Now the other major question is what happens after you're gone and that's death. So a lot of times, setting up a revocable living trust, people do it because they heard about probate and for many people, if they've gone through a probate for a friend or loved one, they come into my office and they tell me about the time, the expense and the endless paperwork they spent on the probate and they often say, "I don't want to do that again" and that's very understandable, in my opinion, from dealing with probate paperwork, I understand why lots of people don't ever want to do it again, if they've done it once for a friend or relative. So a great reason. Not the only reason to set up a trust, but a great reason is to avoid probate upon your death. One of the many great reasons. Check out my other video on 'Top 3 reasons to make a trust' and we cover other reasons as well but many people are aware that once you die, then it changes right and one of the changes we want is that after death, your revocable trust becomes irrevocable meaning not changeable. No one can change your beneficiaries because you don't want someone to be able to change your trust after you're gone, right? In general, the reason you're putting it down in writing is you want your wishes to be honored. So at death, we have this cutoff where the trust was fully revocable or changeable by you and you are what we call the grantor of the trust and you may see that language in your trust if you work with my office or another attorney and that's where we get that word 'Grantor', what the IRS uses, when they talk about a grantor trust but after you pass away, your trust is no longer changeable or revocable. We want it to be set in stone, the people you named as beneficiaries are the beneficiaries and your other wishes regarding your property must be followed. So the trust becomes irrevocable and then we go to this step after death, where the trust obtains its own tax ID number. This is a relatively simple process but you can have your trustee contact, the attorney, who set up the trust or another attorney, help them get that tax ID number for the trust, from the IRS and just do this in a, you know, you don't have to do it immediately, deal with the funeral things like that, let the attorney know. They'll need a death certificate and they'll get the tax ID number for you and then you open a new account in the name of the trust as of the date of death. If it's for a married couple, it's the date of the death of the second person. If you're single, it's your day to death and then we get a new tax ID for the trust and the income and expenses from your date of death forward, flow through the trust because you're gone. You're no longer filing a tax return. In general, your trustee will file one tax return for you, in the year of your death. Whatever year you die, whatever month you die, you still need to file a final year tax return for however many months you are alive in that year and then the trust will file after that point, after the date of the death. So in essence, the trust becomes irrevocable on your date of death, it springs into existence and that's when it would file its own tax return and the income and expenses flow through the trust under Form 1041 which is the tax return for trust in the states and your trustee would file that with the IRS and the filing period will depend on what month you die but in general, for a lot of trusts, I tell folks if it's a trust set up primarily to avoid probate and it's not the type of trust we have continuing for years and years and years, let's say, all your beneficiaries are adults and in your trust you said, if they're all over age 25, they can receive the money right away, for example. Well then it's often possible with the trust that we can wrap everything up after your death within one year and just file one tax return for the trust and that means, it really only needs to file one tax return and incur the cost of, if you use a CPA or account to file a tax return, one year of tax returns and after that all the assets are distributed and they go to the beneficiaries and there's no further tax filing requirement. Now one other great thing, I should note is remember the gifts you give your beneficiaries are tax free to them as long as you're below the 11.48 million tax exemption per person. That's a tax-free gift at death, that's why you often want to leave gifts to people at death because they get it tax free at death and if you're below that limit, your estate doesn't pay any gift tax either but we're talking here about the income tax on the assets. So if you pass away and the trust owns stocks and bonds and they throw, they generate some dividends, let's say, in the 9 months after your death, well those dividends would be reported on the tax return but let's say, after those 9 months, we get the stocks distributed to your beneficiaries. Well then they become owned by those heirs, let's say, your children and they report the dividends on their tax return the next year. So for a lot of my clients, I don't want you to worry too much about this because it's often possible because we can wrap up, if we do a trust properly, we can wrap up the administration in a year or less. Whereas a probate, the minimum time is 6 months to 2 years and for more complex estates, they do take longer. So you may end up filing a couple years of tax returns but for a trust, it's very doable to have the trustee wrap everything up within one year if all the beneficiaries are adults and we don't need the trust to continue on. Now if it's the type of trust that continues on for minor children, that's fine, the trust will just file a tax return as long as it needs to go and if it's a type of trust you set up to go forever, that's fine too, just be aware the trust will file its tax return each year and in those situations, we may do their special planning, how to structure the income that goes out to the beneficiaries to reduce any taxes the trust would pay. So talk with your lawyer about that in that situation and that's we won't get into that in today's video but in general, keep in mind, high level, that after death, the revocable trust becomes irrevocable meaning not changeable, so no one can change it. We obtain a tax ID for the trust and then those income and expenses flow through to the 1041 trust tax return which we send to the IRS and this is often the case that we can do this all in one year meaning your trustee has to file one final tax return for the year you died and one tax return for the trust and then it's all taken care of. So in my practice, like I said, I often see confusion about this and I totally understand it because there are many type of trusts out there but for the most common estate planning device, the revocable living trust, they're actually a really easy tool because we can have all the income and expenses flow through to you, during your life as a grantor trust, on your personal tax return and there's no extra tax filing requirement during.
I hope this video was helpful to you in today's estate planning 101. If these videos are helpful, I appreciate you giving it a like or a comment so it helps others find this information for free on YouTube. Thanks for watching and we'll see you next time.
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