Trusts are an important, yet commonly overlooked, part of Michigan estate planning. Many other people who are considering creating a trust for their estate planning needs do not understand the various tax implications associated with the different kinds of trusts. Choosing the correct trust for a person's needs requires understanding the relevant tax consequences, however, in addition to understanding the different ways each kind of trust functions and the different benefits.
Revocable trusts are a common type of trust because they allow the creator of the trust to retain control of the trust and the trust's assets during his or her lifetime (as long as he or she remains competent). They allow the creator to revoke or amend the trust whenever he or she may wish. Because the trust creator retains this control, all of the income that results from the trust is taxed to the trust creator. This means that, from a tax standpoint, the trust is entirely tied to the trust creator and does not stand alone. All income, deductions and credits are reported on the trust creator's tax return and the trust itself is not recognized as a separate entity for tax filing purposes.
In contrast, irrevocable trusts are treated very differently by tax laws. An irrevocable trust is distinguished from a revocable trust primarily by the fact that once an irrevocable trust is created, the provisions cannot be amended and all funds contained in the trust must be used only for the benefit of the beneficiary unless the specific trust document contains different authorizations. For this reason, an irrevocable trust is not invisible to the IRS in the same way that a revocable trust is. An irrevocable trust generally has its own tax identification number, which requires that a tax return be filed specifically to report the income and deductions of the trust.
Irrevocable trusts are generally divided into two different types where tax matters are concerned: grantor trusts and non-grantor trusts. The income, deductions and credits related to grantor trusts are reported on the tax return of the grantor, which is the person who gave the funds to the trust, but not necessarily the person who signs as the trust creator. In non-grantor trusts, the rules are more complicated. In general, a trustee's expenditures are deducted from the trust itself, while the beneficiary of the trust is taxed for the trust's income. Nonetheless, if income generated by a trust is not used for the beneficiary's benefit during a certain year, the trust as a separate tax entity is taxed for that income.
Source: SpecialNeedsAlliance.com, "A Short Primer on Trusts and Trust Taxation," accessed on Feb. 8, 2015