Will Terminating an Irrevocable Trust Affect my Taxes?

A common question relating to trusts is whether terminating the trust will affect taxes.  The termination of irrevocable trusts can be a complex legal topic.

When does an irrevocable trust automatically terminate in California?

  • There are some circumstances where the trust terminates by law:
  • The term of the trust expires.
  • The purpose of the trust is fulfilled.
  • The purpose of the trust becomes unlawful or is impossible to fulfill. 

When can an irrevocable trust be dissolved?

  • When all beneficiaries consent to termination. 
  • If continuing the trust is necessary to carry out a material purpose of the trust, it can’t be terminated unless a court determines that the reason for doing so outweighs the interest in accomplishing the purpose of the trust. 
  • When the Fair market value of the principal of the trust has become so low in relation to cost of administration that continuation under the existing terms defeats accomplishment of its purposes.  
  • For other reasons beyond the scope of this article. 

What are the potential tax consequences of terminating an irrevocable trust?

  • When trust assets are liquidated and distributed those transactions may trigger taxes. 
  • If the trust is a grantor trust, then the person who created the trust is considered the owner of the assets and is responsible for taxes. 
  • If the trust is a non-grantor trust, it gets taxes as a separate entity, and the trust itself and beneficiaries are the ones who will pay the tax bill on distributions. 

What are some general principles for trusts and income taxes, capital gains and estate taxes?

  • An irrevocable trust may hold assets such as stocks or bank accounts that generate income and these gains are taxed as ordinary income. This tax applies to the profits, not the principal. 
  • Assets in the trust that increase in value are subject to capital gains taxes when the profits are distributed, and the beneficiaries will pay the tax rate that equates with their income level. 
  • When assets are transferred to an irrevocable trust, they lower the person’s estate tax liability when they die, but keep in mind that this is something most people do not need to consider since only large estates are subject to the federal estate tax in 2023. 

Contact an Experienced Estate Planning Attorney

This article contains general information about the tax consequences of terminating an irrevocable trust, but consulting a professional about the specific tax liabilities and strategies involved is highly recommended. At the Law Office of David Knecht, we can help you understand the tax consequences of the various tools available for estate planning, and we can customize a plan that is perfect for your goals and your family. Contact us today at 707-451-4502.