While you're alive, the Internal Revenue Service treats all the assets in a revocable trust as yours. If the assets earn the trust some income, you pay the tax on it. When you die, your trust becomes a separate taxpayer with its own tax ID number and its own tax return. The exception is if your trustee and the executor of your estate combine the returns.
Estate Tax Returns
The year you die, your estate files its own tax return, using Form 1041. Your executor has to file one for you, too. Everything you earned up to the day you died is your income. Income received later, such as investment interest, salary payments, or proceeds from a lawsuit, is your estate's income. Your estate's income tax bill is separate from whatever federal estate tax it pays. Even if your estate isn't big enough for estate tax, it may still owe income tax.
After you die, your trustee files for a taxpayer identification number for the trust and then files a tax return for any trust income. Federal law offers an alternative, though: electing to treat the trust income as part of the estate's income. In that case, your estate's 1041 includes the combined income from both "taxpayers." This only applies for the first two years after your death. If the trust is a long-term one, controlling assets for your family, it will have to file its own returns after that.
If your trustee and executor take the election, it's a lot less work for the trustee, who won't have to file a tax return or apply for a taxpayer ID until two years have passed. If the trust is just going to distribute the assets after your death, it may shut down before that point. Even if all your income-generating assets are in the trust and none in the rest of the estate, the IRS still allows the combined return.
Taking the Plunge
Living trusts have to meet the IRS qualifications to file a joint return, but that's usually not a problem. The biggest requirement is that you're the owner of both the estate and trust assets. To take the election, your trustee and executor must sign Form 8855 and submit it with the estate's tax return. If you have multiple trustees or executors, only one of each will need to sign. With multiple trusts, you need a trustee representing each trust to sign the form. Once they submit the form, the election is irrevocable.
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