The death of a loved one can create a lot of financial complexity. For families that have set up irrevocable trusts to facilitate the transfer of assets from one generation to another, the tax implications can be even more complicated. However, there are some basic rules that any heir should know if they get an inheritance from an irrevocable trust.

Estate taxes
In general, whether an irrevocable trust will be subject to estate tax at the death of the person who set up the trust will depend on the trust's terms and what the person did in setting up the trust. Typically, because the irrevocable trust is a separate legal entity, it isn't included in the estate of the person who created it. The creation of the trust is often a taxable gift that requires a gift tax return, and that can have implications for eventual estate tax liability, but even there, heirs get the benefit of having avoided estate tax on the appreciation in the trust property's value.

One exception, though, involves life insurance trusts. If the person creating the trust retained incidents of ownership in the insurance policy, such as retaining the power to change beneficiaries, cancel or transfer the policy, use the policy as collateral for a loan, or borrow money against the policy's value, then it will be included in the person's estate regardless of the irrevocable trust's ownership. If the trust is included in the estate, then estate taxes may be due, and the net amount of your inheritance could shrink.

Income taxes
What happens with 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 you and other heirs, then the key thing to remember is that your tax basis in those assets will be whatever the trust's tax basis was. You'll need to make sure you have detailed information from the trustee before making plans to sell those inherited assets.

On the other hand, if the trust continues beyond the death of the person who created it, then complex trust tax rules apply. Often, some or all of the regular distributions that the trust makes to you will be treated as taxable income to you, and you'll get a year-end informational return that indicates how much income is taxable and whether it's characterized as ordinary income, capital gains, or other specialized types of income.

Every trust is different, so generalizing beyond these simple rules is difficult. Using irrevocable trusts as an estate planning tool typically involves substantial amounts of money, and so going to the expense of consulting an experienced attorney or accountant to guide you through the tax ramifications is a smart move for most people in this situation.

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