An irrevocable trust is a legal entity that cannot be altered, amended or revoked after its creation. Irrevocable trusts are typically established to protect assets from creditors, benefit the beneficiaries and minimize estate taxes. But there are circumstances that warrant the termination of an irrevocable trust like when its purpose is fulfilled or its assets have been exhausted. The decision to terminate an irrevocable trust can stir notable financial implications, particularly when it comes to taxes. A financial advisor can help guide you through the estate planning process and potentially assist in setting up an irrevocable trust.
What Happens When an Irrevocable Trust Is Dissolved?
Dissolving an irrevocable trust can be a complex process, usually requiring consent from all beneficiaries, filing the necessary paperwork and potentially getting court approval. For instance, in states such as California, a petition to terminate the trust needs to be filed with the probate court.
Beneficiaries and trust assets can face notable repercussions when a trust is dissolved. For example, if the trust was designed to offer a steady income, this income stream could get disrupted when the trust is terminated. Additionally, if the trust held assets that have seen substantial appreciation in value, these could carry significant tax implications when they’re distributed.
Potential Tax Consequences of Terminating an Irrevocable Trust
When assets held within the trust are liquidated and distributed to beneficiaries, those transactions may trigger a combination of income and capital gains taxes.
The tax liability associated with these distributions will depend on whether the entity is a grantor trust or a non-grantor trust. With the former, the person who created the trust is considered the owner of the assets, and is responsible for the taxes. A non-grantor trust, on the other hand, gets taxed as a separate entity. As a result, the trust itself and its beneficiaries are the ones who will pay the tax bill on the distributions.
Income Taxes
An irrevocable trust may hold assets that generate income, including bank accounts, bonds and dividend-paying stocks whose earnings are taxed as ordinary income. Keep in mind that the full value of distributions from a trust’s principal aren’t subject to income taxes – only the gains.
In the event that an irrevocable non-grantor trust is terminated, the income that the assets have generated will presumably be distributed to the beneficiaries. It will be their responsibility to pay the taxes on the money. However, if the trust that’s dissolved is a grantor trust, the income tax liability will remain with the person who created the trust.
Capital Gains Taxes
Assets that appreciate in value within an irrevocable trust are subject to capital gains taxes. When these profits are realized and distributed upon the termination of a trust, it’s the beneficiaries who will pay the tax rate that corresponds with their income level.
Estate Taxes
When assets are transferred to an irrevocable trust, they are removed from the grantor’s taxable estate, lowering the person’s potential estate tax liability when they die.
Keep in mind that only large estates – those worth more than $13.61 million – are subject to the federal estate tax in 2024, so it’s not something most people have to worry about. This has made irrevocable trusts a valuable estate planning tool for the wealthy, helping them minimize their estate tax liability.
But in March 2023, the IRS announced that the step-up in basis does not apply to assets held in irrevocable grantor trusts. For those assets to receive the step-up, the IRS clarified, they must be included in the grantor’s gross estate and be subjected to the federal estate tax. The termination of an irrevocable grantor trust could trigger the estate tax if assets return to their taxable estate.
What to Consider Before Terminating the Trust
Before pulling the plug on an irrevocable trust, it’s important to consider several factors like the potential tax consequences and possible alternative solutions. For individuals in the high-income bracket, the potential tax consequences could be a major deterrent. Conversely, for those from middle-income backgrounds, the immediate financial impact, like the potential loss of income from the trust, may weigh heavier.
For instance, if the trust holds significantly appreciated assets like real estate or vintage cars, the beneficiaries could face a hefty tax bill upon dissolution and may benefit from an alternative strategy.
Rather than dissolving the trust, for example, it might be worth exploring ways to modify it to better fit the beneficiaries’ current needs and situations. This may include decanting, which involves moving assets from one trust to another with more favorable terms. Doing so can move the trust to a state with more favorable laws while retaining protection from creditors and giving the trustee more flexibility to make distributions.
Finally, it may be wise to consult a financial advisor or attorney before deciding to terminate an irrevocable trust.
Bottom Line
Terminating an irrevocable trust can have significant tax consequences, triggering a combination of income, capital gains and estate taxes. Hence, understandingthese implications along with exploring alternative solutions is critical before deciding to dissolve a trust.
Estate Planning Tips
- A financial advisor can help you make a plan for your assets for when you’re no longer around. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Estate planning is about more than simply making a plan for your money. Advance directives are legal documents that enable individuals to retain control over their health care decision if they become incapacitated. If they’re something you want to consider, be sure to read SmartAsset’s comprehensive guide on advance directives for health care.
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