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Inheritances Inevitably Lead to Tax Consequences: Irrevocable Trusts Basics

Taxes and inheritance issues go together like Halloween and trick or treating. Tax planning is a critical part of estate planning, and families who wish to transfer assets from one generation to the next need to prepare for both aspects, as settling an estate can easily become quite complicated. Many estate plans include the use of irrevocable trusts. There are some basics that heirs need to know if they are beneficiaries of these trusts.

How an irrevocable trust is set up has a significant impact on the tax liability, according to an article in The Motley Fool, "Tax Consequences of an Inheritance From an Irrevocable Trust." There are some instances where irrevocable trusts are subject to estate taxes. It is important to understand how irrevocable trusts work and the different types of irrevocable trusts.

Because an irrevocable trust is typically a separate legal entity, it's not part of the estate of the person who created it. Its creation is usually a taxable gift that requires a gift tax return, which can have implications for eventual estate tax liability. Nonetheless, heirs receive the benefit of avoiding estate tax on the trust asset's appreciation in value.

One caveat is life insurance trusts. If the person creating the trust retained incidents of ownership in the policy (retaining power to change beneficiaries, canceling or transferring the policy, putting the policy up as collateral for a loan, or borrowing money against the policy's value), it will be included in the person's estate-regardless of the irrevocable trust's ownership. If this is the case, estate taxes may be due, and your inheritance could decrease.

The impact of income taxes also depends on the terms of the irrevocable trust. If the trust terminates at the person's death and the trust distributes assets to the heirs, your tax basis in those assets will be that of the trust. Make sure you have detailed information from the trustee before making plans to sell those inherited assets.

But if the trust continues beyond the death of the person who created it, then some complex trust tax rules apply. There may be regular distributions that the trust makes to you which will be treated as taxable income. You'll receive a year-end informational return that shows how much income is taxable and if it's ordinary income, capital gains, or other specialized types of income.

Every trust is different, so get sound advice from a qualified estate planning attorney. He or she will guide you through the tax issues and make sure you're in good shape.

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