Are Trust Funds Taxed?
Whether or not trust funds are taxed is a question that many people ask. The answer to this question depends on a variety of factors, including the type of trust.
Generally, trusts must report all of their income on their own taxes, even if the money is distributed to beneficiaries. This includes taxable and tax-exempt income as well as capital gains and distributions.
Types of trusts
There are many different types of trusts, each with its own purpose and use. But one of the most common ways that a trust is used in estate planning is to reduce or eliminate the tax burden on a beneficiary.
A trust can help to minimize or even eliminate estate taxes while at the same time providing for a person’s long-term financial goals. The type of trust used will depend on the goals of the person establishing the trust and the individual’s personal circumstances.
Some of the more popular types of trusts include revocable living trusts, irrevocable trusts and asset protection trusts. All of these trusts are designed to transfer assets to a designated beneficiary while minimizing or eliminating estate taxes.
Typically, revocable trusts can be changed or revoked at any time by the person who established them. They can be set up as a part of a will, or they can be created during the lifetime of the trustor.
Another common type of trust is a trust fund. These are similar to revocable trusts, but they have more restrictions on how they distribute assets.
Revocable trusts allow you to move assets into and out of the trust at any time, as well as change the terms of the trust. They can also be used in conjunction with a will to pass certain assets quickly to beneficiaries.
Irrevocable trusts, on the other hand, are a bit more difficult to rescind. In addition to the potential tax benefits, revocable trusts offer the flexibility to pass appreciated assets quickly to beneficiaries without estate taxes.
A third type of trust is a charitable trust. These are often created in conjunction with an estate plan to avoid or minimize gift and estate taxes, as well as provide a way for the grantor to support his or her chosen charity.
In addition, a special needs trust may be used to provide financial support for someone with special needs while maintaining the person’s eligibility for public benefits. These types of trusts need to be administered correctly so that the individual is not negatively impacted by the distributions.
Taxes on trust income
Trusts are commonly used as wealth planning vehicles. However, they can be complicated to understand. In addition to taxation issues, beneficiaries often do not realize how their trust structures may impact their entire financial picture–from the decisions they make about spending and investments to meeting goals and making future plans.
The IRS treats income and distributions of a trust differently than taxable income and distributions from an individual’s assets. A beneficiary’s tax bill will include the income that is taxable to the trust, as well as any deductions the recipient may qualify for.
Generally, the trust reports this income to the beneficiaries on a Schedule K-1 that the trust sends them. This form lists how much of the income came from interest, dividends, capital gains, rental income, or ordinary income.
A trust’s distributions are taxable to the beneficiaries in part because they have already been subject to tax. They are also deductible by the trust if they are part of tax-free income or retained income from previous years that the trust has already paid taxes on.
To determine the amount of the distribution that is taxable to the beneficiary, the trust must calculate the total of all distributions, subtract any tax-exempt income, and then multiply by the Distribution Deduction (DNI). If the DNI is below $0, then no tax will be due on this portion of the distribution.
If the DNI is more than $0, then a percentage of the distribution is considered to be taxable to the beneficiary and must be reported on Schedule K-1, which the trust sends to the beneficiary. The amount of the taxable distribution will depend on whether it is from principal or from income.
Because trust income and distributions are taxable to the trust, as well as the beneficiaries, they are usually more complex than a person’s own personal income tax. This is why it is important to have a qualified tax professional assist with the taxes on a trust.
A grantor trust, on the other hand, is more streamlined from an income tax standpoint. This is because the trust creator, who is usually a grantor, reports all of the trust’s income, deduction and credit on his or her own personal tax return. If a grantor’s spouse has a joint trust, neither the grantor nor the beneficiary receives Schedule K-1 because both spouses report their income on their own personal tax returns.
Taxes on distributions
A distribution is money received from a trust or estate, which is often taxed differently than funds that are invested in an ordinary investment account. The IRS has tax rules for disbursements from trusts that are important to understand.
When a trust distributes income to beneficiaries, the beneficiaries are responsible for paying taxes on those amounts. This is an area that can be challenging for trustees because they have to determine the proper allocation of taxable income and the amount of tax-exempt income to distribute.
As a result, it is critical that trusts review their income and distributions with tax advisors. Trustees can use this review to develop strategies that will minimize taxable income and maximize tax-free distributions.
In addition to the statutory provisions that apply to trusts, many other factors can affect whether or not a distribution is taxable. Among them are the type of trust (a grantor trust or a non-grantor trust) and the nature of the distribution.
Grantor trusts are the most common form of trust, and they are typically created by individuals with a desire to give away assets while controlling the investment decisions. They are not only the owner of the assets in the trust, but they also have full authority to change the trustees and investments.
Generally speaking, a grantor trust must report the income from the trust on the grantor’s personal tax return, rather than on the trust’s. However, this is not true of all grantor trusts.
The IRS allows trustees to deduct the lesser of distributable net income or the sum of any amounts “properly paid or credited or required to be distributed” to the beneficiaries (IRC SS 661(a)). This deduction includes both taxable and tax-exempt income to the extent that the amount is derived from trust income. Unless the trust instrument or state law dictates otherwise, the distribution must be reduced by a proportionate share of DNI.
In addition, the IRS provides that depreciation and depletion deductions must be apportioned between the estate and the beneficiaries based on the proportion of net accounting income minus distributions to net accounting income. If the trust instrument or state law does not provide a formula for determining this allocation, it must be done based on the accounting method and period of the trust or estate.
Taxes on capital gains
The taxation of trust funds is often an important consideration for CPAs, estate planning attorneys, and trustees. This is because trusts have higher income tax brackets than individuals, making it essential to understand the different types of taxes that may be at play in a particular situation and how to manage them to minimize the amount of tax paid on the trust’s assets.
The first issue to consider is whether the trust will be taxed on any capital gains if it distributes them to a beneficiary. If a trust owns property and sells it for more money than its cost basis, the holder of that trust must pay capital gains tax on any profits he or she receives from the sale.
Fortunately, the IRS allows a trustee to deduct distributions made during the first 65 days of 2022 from his or her 2022 tax return as if they were made in 2018. This gives trustees and their advisors an extra couple of months to plan and make their distributions in the best way possible.
Another important aspect to remember is that capital gains and qualified dividends are not subject to the Net Investment Income Tax (NIIT). This 3.8% surtax is imposed on the lesser of undistributed net investment income or modified adjusted gross income above certain thresholds. Individuals do not have to pay this tax until their net investment income exceeds $250,000 for married couples or $200,000 for singles.
Because of the NIIT, trustees must be particularly careful to allocate income and distributions as much as possible to current beneficiaries, which is often the easiest way to avoid the higher trust income tax rates and NIIT. Trustees and their advisers should also look into the language of a trust to see what income can be distributed to current beneficiaries and to whom.
A common question is, “Can I give a trust the power to distribute its income and capital gains to my children or other heirs?” This is a difficult issue for most clients. They generally want to keep the income and capital gains inside the trust as much as possible for estate tax protection, divorce protection, creditor protection, and various other purposes.