The creator of a revocable trust, legally called the "grantor," has the right to change, amend or revoke -- do away with -- the trust at any time. If the grantor is also named as the trustee or co-trustee of the trust, the trust does not have to file a separate federal income tax return. Also, the beneficiary has no tax responsibility until receiving income distributions at the death of the grantor.
Controlling Revocable Trusts
A revocable trust is a legal container that holds the grantor's assets while he's still living and passes them to beneficiaries at his death. The grantor has complete control over the revocable trust while living and can change it at any time. Once he dies, the property or assets transfer to the beneficiary. So the Internal Revenue Service considers the ownership of the assets in the trust to be the grantor's as long as he is alive. This means the grantor files taxes on his Form 1040 for any gains.
Filing Requirements for Beneficiaries
Revocable trusts become irrevocable, or unchangeable, when the grantor dies. If you're the beneficiary, the tax responsibility now falls on you and the trust. However, the trust pays taxes only on income it does not distribute. If all the income is distributed to the beneficiaries, the trust claims a deduction and the beneficiaries report and pay income tax on their individual tax returns. All the beneficiaries will receive a K-1 form from the trust reporting the amount of income distributed to them. The trust also includes any K-1s when it files its tax return.
Filing Form 1041
If any income stays within the trust, it will file Form 1041, U.S. Income Tax Return for Estates and Trusts. You can find this form with instructions on the irs.gov site, but you should seek professional help if you have to fill it out. Typically, this task falls to the successor trustee, who is named to take over the trust once the grantor dies. The trustee distributes the assets in the trust according to the guidelines of the trust. Once this is done, the trust ceases to be. However, this can take years based on how the trustee is instructed to distribute income or assets to the beneficiaries. The trust may also appoint a custodian to manage income distributed to beneficiaries who are minors.
Filing Personal Tax Returns
The beneficiary uses the K-1 to report income distributions on her 1040 and will attach a Schedule E, Supplemental Income and Loss form. The beneficiary pays taxes at her tax rate. If the income from the trust is significant, it can bump the beneficiary into a higher tax bracket. Most tax advisers recommend using a professional tax preparer, especially if the beneficiary has never completed this type of tax return.
- Thinkstock/Stockbyte/Getty Images