If you settle or otherwise resolve a trust or will litigation case, the amount you receive may be drastically reduced by taxes. There are a number of taxes that apply to trust and will assets, such as:
- Federal estate tax
- Income tax
- Real property tax
- Business personal property tax
- A host of other taxes.
All of these taxes can have a substantial effect on your recovery.
The most common types of taxes that affect a trust or will case are estate taxes and income taxes. Estate tax applies to any gross estate valued at more than $13.61 million. That applies to the overall estate value–not just your share of the estate (this amount is adjusted for inflation annually). In other words, even though you may only receive $2 million, if the total estate is valued at $20 million there could be estate taxes imposed and you could be liable for your pro-rata share of the estate tax due.
Income taxes apply to any income received by the trust or estate during the administration period. For example, if a house was worth $1 million on the date of the decedent’s death but then went up in value to $2 million by the time the house is sold and the proceeds are distributed two years later, then there would be a gain of $1 million that would be potentially subject to capital gains tax. The capital gains tax would then have to be paid either by the trust or estate (thereby reducing your share) or by you in certain circumstances. It is important to note that your receipt of an inheritance is NOT subject to income tax–it is only the income generated by the trust or estate assets that is subject to income tax.
Real property taxes can also cause unexpected surprises on inheritance recoveries. For example, under current law, particularly Proposition 19 passed by voters in 2020 and becoming effective in 2021, children can keep a parent’s low property tax valuation for a principal residence; provided that, the child makes the home their principal residence within a year of receiving that asset. Prior to Prop. 19, children could allocate real property tax basis to other types of real estate, including rentals and commercial properties. That has now been eliminated. As a result, if you inherit an apartment building from your parents, or a rental home, then that property will be reassessed at its current value for real property tax purposes. And the amount of real property tax will go up based on the reassessed value.
The State of California imposes a business personal property tax on all property owned or leased by a business except real property. For example, if the business owns an airplane, then that plane will be subject to an annual business personal property tax. The rate of the tax is 1 percent per year. This tax can have an impact on your trust or will recovery if part of your recovery is an operating business.
Each of the taxes described above can reduce what you receive when you settle or resolve your trust or will litigation case. Considering and analyzing each type of tax can help avoid ugly surprises. Below is a more in-depth discussion of these different types of taxes.
Federal Estate Taxes
Under current estate tax laws, every estate is subject to estate tax if it exceeds a gross amount of $13.61 million (as of tax year 2024). You can imagine that there are not a lot of estates that exceed this lofty amount. Most trusts and estates will be valued under $13.61 million and so the estate tax simply will not apply.
For those trusts and estates that do exceed $13.61 million there could be taxes to pay. Keep in mind that there is an unlimited deduction for assets passing to a spouse and for assets passing to charity. That can either reduce or eliminate estate taxes if a spouse and/or charity (or charities) are the only beneficiaries. If not, then the current tax rates for estate taxes start at 18 percent and tops out at 40 percent.
For example, let’s say that you have a trust with a total gross value of $25 million. The first $13.61 million is free of estate tax because of the estate tax exclusion. That leaves $11,390,000 potentially subject to estate tax. If this amount were to pass to the surviving spouse, or if it were funded into a special type of trust for the benefit of the surviving spouse (referred to as a Qualified Terminable Interest Property Trust (QTIP)), then the estate would receive a spousal deduction equal to the remaining $11,390,000 and there would be no estate tax due.
If, however, the remaining $11,390,000 were to pass to the children of the settlor, then estate tax would be imposed. The total estate tax on $11,390,000 would equal $4,501,800. The remaining amount left for the children would be reduced to $6,888,200. That is a large chunk taken out for estate taxes.
When estate tax is incurred, it is paid from the trust or estate before any distributions are made to the trust beneficiaries. In other words, the tax is imposed on the estate, not directly on the beneficiaries (although the result is the same–the beneficiaries lose a lot of money).
There is a bit of good news though. When a beneficiary receives an inheritance, it is not subject to income tax. There are a few exceptions that we will discuss in the next section below, but generally the total inheritance received is free of income tax by the beneficiary. This is important for estates at or below the $13.61 million estate tax exclusion amount because you will incur no tax in those estates–no estate tax and generally no income tax. Even better, the IRS does not impose an inheritance tax either–just the estate tax.
There are some states that have inheritance taxes, but not California. Thus, you can receive an inheritance and pay no income or inheritance taxes on it in California.
The bottom line for your litigated case: If you are litigating and/or settling an estate that has a gross estate value above $13.61 million you must address the estate tax issues. Even when a surviving spouse or charities are involved, it is still a good idea to analyze the estate tax angle and ensure there are no surprises. Remember, estate tax is on the value of the overall estate–not the value of what you receive. Just because your settlement gives you something less than $13.61 million, you could still be subject to a pro-rata share of the estate tax imposed if the overall estate is valued in excess of $13.61 million.
Federal Income Taxation of Trusts
The Internal Revenue Service (IRS) considers the settlor of a revocable living trust to be the owner of the trust’s assets. For federal income tax purposes, all income of a revocable living trust essentially passes through and is taxed to the settlor. This is because the settlor retains full control over the terms of the trust and access to its assets–including the right to terminate the trust by revoking it.
Upon the settlor’s death, the trustee or executor of the settlor’s estate files his or her final income tax return (on IRS Form 1040), which declares all income the settlor earned prior to death. For example, if a settlor were to pass away on October 1, 2024, then the final income tax return for the settlor would cover the period from January 1 to October 1, 2024. Any income derived after the date of death will be reported on an income tax return (on IRS Form 1041) filed by the trust and/or estate depending on where the income was received.
Irrevocable trusts are treated a little differently for income tax purposes. Most irrevocable trusts will not be taxed to the settlor the way revocable trusts are treated. Instead, the irrevocable trust will either pay the tax at the trust level, or the tax consequence will be distributed out to the irrevocable trust beneficiaries. There are rare exceptions where an irrevocable trust is intentionally created to allow all income to be taxed to the settlor, but this is by design and typically only used in advance estate planning techniques.
Income taxation of irrevocable trusts will depend on whether the trust is determined to be “simple” or “complex” under the IRS regulations. If the trust mandates that all income must be distributed to the trust beneficiaries at least annually, then by definition the irrevocable trust will be a “simple” trust for tax purposes. This means all income taxes will pass through the trust and be reported to the beneficiaries on a Form K-1.
The trust beneficiaries will then report the income on their individual returns and pay the resulting tax, if any. This is true even where a beneficiary receives no distributions from the trust. As you can imagine, this could create a hardship if the trust receives income that is taxable to the beneficiaries, but then the trustee fails to distribute the income to the beneficiaries. But remember, this pass-through taxation only applies to trusts that mandate the distribution of income to the beneficiaries. So, unless you have a trustee who is ignoring the trust terms, the trust income should be distributed to the trust beneficiaries before the tax is due to be paid.
Irrevocable trusts that do NOT mandate the distribution of income, even those that allow income distributions but leave them to the discretion of the trustee, are deemed “complex” trusts under the IRS rules. With complex trusts, the trust will pay the tax unless the income is distributed to the trust beneficiaries in which case the beneficiaries will pick up the tax (again through a K-1 being issued by the trust at the end of the tax year).
The big issue with income taxation of inheritance is with the receipt of retirement funds. Things like 401(k)s, IRAs, and any other type of income tax deferred funds. These assets have a built-in income tax liability because the money was allowed to be set aside pre-tax. Once the money is distributed from these types of accounts, they will be subject to income tax by the beneficiary(ies). There are ways to delay the withdrawal of funds from these types of accounts and the rules vary as between a spouse versus children or other non-related beneficiaries. Retirement accounts take special planning to avoid disaster. Be sure to check with a tax professional before making any moves, or taking any distributions, from retirement accounts.
As you can see, the income taxation of irrevocable trusts can be complicated. There is no reason for you to guess at what your tax liabilities may be. Instead, take some time to sit down with a tax professional and map out the potential tax consequences. You will be happy you did so before agreeing to any settlement of your trust share or trust distribution. You may not be able to escape the tax altogether, but at least you will know what to expect.
California State Taxation of Trusts
The State of California’s Franchise Tax Board states that a trust’s trustee may be required to file a return if any of these are true:
- The trustee or beneficiary (non-contingent) is a California resident
- The trust has income from a California source
- Income is distributed to a beneficiary who is a California resident
And the trust has:
- Gross income exceeding $10,000
- Net income exceeding $100
If you have to file taxes on a trust in California, you will use the California Fiduciary Income Tax Return form (FTB 541).
A trust in California may be required to make quarterly estimated tax payments. Generally, a fiduciary of a trust must make estimated tax payments if the trust expects to owe at least $500 in tax for the tax year (after subtracting withholding and credits). Form 541-ES provides instructions for coming up with the estimated tax for fiduciaries.
As with federal income taxes for trusts, the State of California takes some advance planning to deal with effectively.
Contact Our Experienced Trust Litigation Attorneys in Los Angeles, CA
If you the beneficiary of a trust and have concerns about how the trust and/or distributions from the trust are being administered, an attorney with Albertson & Davidson LLP can help you. Our experienced California trust litigation attorneys can advise you of your options for challenging the trust or its trustee and zealously represent you in court if necessary.
We are tough negotiators and hard-nosed litigators. We stand, we fight — and we win. For a free and confidential consultation, contact us online or at (800) 601-0170 today.
