When people think about estate planning, they think about wills, trusts, beneficiaries, distributions, creditors, maybe disputes between heirs, etc.
These are the most visible parts of an estate plan, including trusts.
But the one underlying truth behind pretty much all legal transactions, including estate planning and trusts, is the one that hounds every one of us throughout our life. And as we shall see, it follows us, to a certain extent, even beyond death.
Taxes.
The one thing certain, other than death, as the saying goes…
For a living trust, a trust cannot be truly closed until tax obligations are settled.
In this article, we take a look at some of the tax implications involved in the administration and closing of a living trust.
The Trust as a Separate Entity During Administration
Typically, a revocable living trust is treated as grantor trusts. That is, the IRS disregards the trust as a separate entity from the grantor since the grantor/trustee retains control over the trust assets. A grantor trust would typically be reflected on the grantor’s personal tax returns.
If the trust was originally set up as an irrevocable trust, then it may be considered a separate entity from the outset.
In any case, a revocable living trust becomes irrevocable upon the death of the grantor, which means that at this point, it becomes a separate taxable entity.
The successor trustee takes over administration of the trust upon the death of the grantor. This is sometimes called a “temporary custodian” phase where the trustee administers the estate prior to closing. And among the various obligations of the trustee is the filing of tax returns and paying of all outstanding taxes.
When a trust becomes a separate taxable entity, it must have its own taxpayer identification number and file its own returns.
Some of the forms to file include IRS Form 1041 and FTB Form 541.
The IRC §645 Election
Under IRC §645, the trustee, together with the fiduciary of the decedent’s estate, may jointly make an election for the trust to be treated and taxed as part of the related estate for income tax purposes.
Making this election allows the fiduciaries to streamline tax filing for the estate as a whole. But more importantly, using this election allows the trust to avail of a few advantages including:
- a potentially lower tax bracket
- using a fiscal tax year rather than a calendar year to allow for the deferral of the tax obligations of the beneficiaries
- if qualified charitable payments are made, then under IRC §642(c), the trust may claim a charitable deduction to reduce the trust’s taxable income
In addition, the trust may qualify for relief including an exemption from paying estimated taxes for the first two years after the settlor’s death, or until all estate and trust assets are distributed.
We highly recommend consulting with an estate planning attorney before making this election, however. The benefits and disadvantages of doing so depend entirely on the unique circumstances of each case.
The Final Trust Income Tax Return
Before the trust can close, and before the trust assets are distributed, the trustee is required to file the final income tax return for the trust.
This return must clearly indicate that it is the final income tax filing, and must include the following information:
- all income received by the trust in its final taxable year
- administrative expenses
- any deductions being availed of by the trust
It is important that the information and the details provided in this final return be checked thoroughly and accurately. Mistakes or errors may end up delaying the closing of the estate, and potentially open up the trustee to unnecessary liability.
Pass Through Benefits of Losses and Deductions
One significant benefit of closing an estate is that any losses or deductions by the trust may be passed through to the trust beneficiaries, who can claim these losses or deductions on their individual income tax returns, subject to applicable tax rules and limitations.
In order to maximize this benefit, there must be careful coordination between the trustee, the beneficiary, and the estate planning attorney. Rushing to close a trust without evaluating the tax benefits may effectively deny the beneficiaries of this not-insignificant tax benefit and the overall value that may be derived from the trust itself.
The Trust Accounting
The trustee is obligated to provide all records and information relevant to the trust to the beneficiaries. This includes a formal accounting of the trust administration including the assets, its value, any gains or losses, receipts, disbursements, distributions, debts and liabilities paid, taxes, and the assets that remain for final distribution.
This promotes transparency and is one of the fiduciary responsibilities of the trustee.
More importantly, a complete and accurate accounting may work to prevent any misunderstandings or conflict that can potentially delay the closing of the trust. Full transparency and meticulous record-keeping goes a long way to clarify any questions or challenges that may be raised, thereby minimizing potential disputes.
Conclusion
A successful closing of a trust requires tax finality. As a separate taxable entity, the trustee must file the trust’s tax returns and compile a complete and accurate accounting, including its tax liabilities and payments.
For full compliance with prevailing tax laws, and to ensure that the trust has availed of all the legal and statutory benefits available to it as a taxable entity, we highly recommend consulting with an estate planning attorney.