A trust can be a powerful estate-planning tool, but contrary to popular belief, trusts do not make all taxes disappear. The families who set them up still need to consider tax consequences.

To start with, trust beneficiaries typically need to pay tax on the interest income they get from a trust, but not on any distribution from the principal. The logic is that whoever placed the principal in the trust already paid taxes on it. However, trustees cannot decide on their own which part of the trust monies is principal, thus skipping the tax for the beneficiaries. Any funds distributed in a given year are assumed to be that year’s taxable interest income. Only then are distributions considered to be principal. (However, the principal may still be subject to capital gains taxes.)

Each year, the trust must send the beneficiaries an annual IRS Form K-1, which breaks down principal from interest income. The trust itself has to file Form 1041, which is similar to the Form 1040 most individuals have submit, except it’s for estates and trusts. If the trust doesn’t distribute all the interest income, then the trust itself has to pay taxes.

Getting into the details

Those are the basics, but trust taxation can get as complex as individual taxes — in fact, there are some similarities. For example, trusts can:

  • Take advantage of preferential capital gains rates.
  • Earn tax-exempt income.
  • Be subject to the alternative minimum tax.
  • Deduct certain expenses to reduce taxable income.

However, the organization of each trust makes a difference in how the taxes are handled. For example, with revocable grantor trusts, the grantors pay any taxable income on their returns. It’s the same with an irrevocable grantor trust: The IRS considers trust income as earned by the grantor, even if it is distributed to a beneficiary. Such trusts may give a break on estate and gift taxes, however, which is a boon for the very wealthy. An irrevocable trust that is not a grantor trust, however, is considered a separate entity. In this situation, the beneficiary must pay the taxes.

Charitable remainder trusts are tax-exempt — for the most part. There’s no tax on any income the trust retains. However, any noncharitable beneficiary is still subject to tax.

This is just the beginning; other factors can affect the tax situation. For example, a trust can be the beneficiary of an IRA, but this technique can restrict the management of the IRA and requires special trust language. The bottom line? Families setting up trusts should work with professionals who understand the tax implications of each trust decision — when they’re first set up, and as they start paying out to beneficiaries.

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