How Dissolving a Trust Affects Taxes

Trusts can be somewhat complicated legal entities. They’re designed to hold and maintain property on someone’s behalf for eventual or ongoing release to the beneficiaries named in its formation documents, called the trust instrument. And a trust instrument might be designed to make transfers to beneficiaries in dribs and drabs, maybe because those beneficiaries aren’t particularly good with money.

These types of trusts might live on indefinitely. Other trusts disperse all their assets then close when the individual who created them, called the grantor, dies. In either case, many of the tax rules are the same.

An irrevocable trust requires that the grantor release all further rights to his property after he places it into the trust’s name. As the name suggests, he can’t change his mind, take his property back and dissolve the trust. There are some loopholes, of course, but as a general rule, irrevocable trusts are forever. They offer some benefits that revocable trusts don’t, such as asset protection and avoidance of estate taxes.

The grantor cannot also act as trustee, managing the assets held within the trust. He must step aside. An irrevocable trust is established with its own tax ID number. It’s typically a long-term arrangement, designed to live on regardless of whether the grantor dies.

Revocable trusts are considered to be something of an extension of the grantor. He often acts as trustee, managing the assets he’s placed in the trust’s name, and the trust uses his Social Security number for tax purposes. He typically names someone as successor trustee to take over management of the trust at the time of his death or if he should become incapacitated. These trusts are mostly used to avoid probate.

These trusts are often dissolved after the grantor dies and their assets are turned over to the beneficiaries. Some revocable trusts might live on for a period of years, however. They might remain open until such time as any minor children who are named as beneficiaries reach legal adulthood so they can manage their own inheritances.

It often happens that assets placed in any type of trust increase in value over time or earn interest income. An irrevocable trust must file an annual income tax return whenever its assets earn more than $600 in a year. In the case of a revocable trust, any gains or losses are reported on the grantor’s personal tax return.

When the grantor of a revocable trust dies, the trust then typically establishes its own separate tax ID number. Its income tax return is due on the 15th day of the fourth month after the end of its tax year. The successor trustee can choose December 31 as the end of its tax year – and often does – or any other date that falls within 12 months from the date of death.

As with an irrevocable trust, an income tax return is only required if a revocable trust earned $600 or more during the year. And if it immediately dissolves, transferring all assets to its beneficiaries, an estate income tax return might not be required regardless of how much it earned.

When a trust dissolves, all income and assets moving to its beneficiaries, it becomes an empty vessel. That’s why no income tax return is required – it no longer has any income. That income is charged to the beneficiaries instead, and they must report it on their own personal tax returns.

Here’s where it gets tricky when the trust dissolves. Beneficiaries don’t have to report and pay taxes on gifts they receive that were funded into the trust by the grantor when he created it. These are the trust’s principal. Beneficiaries only have to report and pay taxes on trust income they receive.

So, if you inherit a home from a trust and you move in and live there, that house is not taxable to you. But if you rent it out, that’s taxable income. If you sell it, you might be liable for capital gains taxes.

Now, let’s say you inherit an investment account from a trust instead. If the account was worth $100,000 at the time it was placed in the trust, that represents trust principal, and it’s not taxable. But if the account earned $50,000 in income over the years and it’s now worth $150,000, this represents taxable income to you of $50,000. This is the case whether the trust dissolves or simply pays you those earnings, keeping the investment account itself and remaining open.

If the trust is filing a tax return, it can claim a deduction for all income passed on to its beneficiaries. Schedule K-1 is issued to all beneficiaries, showing them how much they received and how much they must report on their own tax returns. Even if the trust doesn’t file its own tax return because it’s distributed all assets and income to its beneficiaries and shut down, Schedules K-1 must still be issued.