For most income tax purposes, there is no significant impact when assets are transferred to a revocable living trust. The client must report trust income, losses, deductions, and credits as though they were personally incurred. No fiduciary income tax return need be filed if the client who establishes the trust is also the trustee. (This suggests that the grantor of a revocable trust should be the trustee or co-trustee). This tax theory that the revocable trust is the income tax alter ego of the grantor is known collectively as the grantor trust rules. But if the grantor is not the sole or co-trustee, the trust must obtain a separate ID number and file information Form 1041.
Usually, the holding period of the client is tacked on to the holding period of the trust for purposes of determining capital gain and loss when an asset transferred to a revocable trust is sold. But, if for any reason (such as the death or permanent incapacity of the grantor), the trust becomes irrevocable, a new holding period begins. That period starts on the day the trust becomes irrevocable. Planners should also note that if the trust becomes irrevocable during the grantor’s lifetime, and then the grantor dies, the basis of the assets in the trust may not receive a step up.
The ability to treat the grantor and the trust synonymously for most income tax purposes means that it is generally safe to transfer installment obligations, a principal residence, a partnership interest, or a U.S. savings bond to a revocable living trust.
There are, however, some important exceptions to the rule that generally transfers of assets to or from a revocable trust have no adverse income tax implications. There are several assets that, if transferred to a revocable trust, will not have the expected tax neutral effect and instead result in adverse consequences. These assets include:
- S corporation stock problem – The problem here is particularly dangerous since it occurs, not during the client’s lifetime, but rather, after his death. If the revocable trust does not meet S corporation requirements under Code section 1361 (essentially requiring all income to be distributed currently to one beneficiary or that the trust be taxed at the highest income tax rate), the S election may be inadvertently terminated. S corporation stock can be owned by a revocable trust until the trust becomes (for whatever reason) irrevocable. So if the trust becomes irrevocable (for instance at the grantor’s death), S corporation stock must generally be transferred out of the trust within two years.
- Professional corporation stock problem – Most states allow only professionals to hold the stock of a professional corporation. This may not include a revocable trust.
- Section 1244 stock problem – Ordinary, rather than capital loss, is allowed when stock in a small business corporation (defined in Code section 1244) is sold at less than its basis. But this favorable treatment does not apply if the seller is either an estate or trust. For favorable tax treatment, the seller must be an individual. So the loss on a sale by a revocable living trust of closely held stock would be a capital rather than an ordinary loss.
- Incentive stock option problem – An Incentive Stock Option (ISO) is a right to purchase stock issued to corporate employees and contain certain statutory tax advantages.19 The ISO must be granted to a specific employee and must be expressly nontransferable as long as the employee lives. But if the options are held by a revocable trust, the tax advantages will be denied. The transfer to a revocable trust may be considered a taxable disposition.
- IRAs, retirement plans, and annuities – Although revocable trusts are often the beneficiary or contingent beneficiaries of IRAs and qualified retirement plans, some authorities caution that it may not be possible to roll benefits over tax free (as would be the case if the client’s spouse were the recipient).
There may also be problems when trust assets are distributed to beneficiaries. One such potential problem concerns the loss disallowance rules. Losses may be disallowed when assets are distributed to beneficiaries after the grantor’s death to fund a pecuniary (specific dollar amount) bequest.15 Furthermore, the rental loss deduction allowed for losses incurred of up to $25,000 a year can be used to offset other income of an estate (provided the decedent actively participated in the property’s management), but no such deduction is permitted to a trust.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM