Making Taxation of Trusts As Easy as Pie
Most people enjoy options—whether it’s related to something as simple as dessert or as complex as trusts. Trusts lend protection, control, flexibility, and often efficiency to an estate plan, but that doesn’t make them simple to manage. One of the most confusing aspects of trust management is the subject of taxation.
What Is a Trust?
Trusts are legal agreements that allow for the ownership of certain assets to be transferred from the grantor (one who creates the trust and funds it with assets) and controlled by a trustee for the benefit of a beneficiary. Trusts don’t necessarily take personal ownership of an asset away from the trust beneficiary—especially when the beneficiary retains control by also being the trustee. However, some trusts are established with third-party trustees acting as fiduciaries.
When properly structured, trusts can protect trust property from:
• Reallocation in a divorce settlement
• Certain tax obligations
Trusts can also give individuals and couples a level of control over their legacy after they’ve passed because the trust document can specifically detail how and when assets are to be distributed to beneficiaries.
A trustee is charged with the responsibility of managing assets, making sure the trust’s owed taxes are paid, and distributing assets according to the document’s directives. This duty is commonly known in the law as “fiduciary responsibility .”
Trust Taxation Basics
A trust’s treatment for tax purposes is determined by the trust document, which highlights the importance of involving your CPA from the beginning of the trust creation process. Then, the Internal Revenue Service (IRS) applies roughly the same rules to the taxation of trusts as it does to the taxation of individuals, although trusts are considered a separate legal entity. Therefore, the following five statements outline the taxation of trusts.
1. If the trust is a revocable trust, and the grantor is also the beneficiary, then the trust is basically ignored for tax purposes. All income generated by the trust assets is reported on the Form 1040 of the grantor/beneficiary.
2. With some modifications, the taxable income of the trust is calculated in the same manner as an individual.
3. The trust gets to take a tax deduction for the amount of taxable income that is distributed to the trust beneficiaries.
4. The trust pays income tax on the taxable income that is left after the distribution deduction.
5. The beneficiaries report income and pay tax on the distributions of taxable income they received.
Simple Trust or Complex Trust?
Whether taxes are paid through the trust or through the beneficiary’s personal return could be affected by whether the trust document specifies that is a simple or complex trust.
• A simple trust is one that doesn’t make charitable contributions or
allow for any distributions other than those that come from income earned, which must be distributed to beneficiaries in the tax year that it is earned. A personal exemption of $300 applies when calculating the trust’s taxable income.
• A complex trust can make charitable contributions and is not required to pay out all income in the year that it is earned by the trust. In a complex trust, the principal value of an asset may also be paid out. A personal exemption of $100 applies when calculating the trust’s taxable income.
With a simple trust, beneficiaries may expect a higher personal tax consequence since all income must be paid out during the tax year that it is earned and is reported in the beneficiaries’ income tax returns; meanwhile, the trust gets a deduction for that paid-out income. In the case of a complex trust, there is no requirement for all income to be distributed to the beneficiaries – so the trust pays income taxes on the net taxable income that is retained in the trust.
Trusts can experience capital gains and losses just as other taxpayers can. In a trust, capital gains are treated differently from ordinary income. If a trust has capital gains during the year (whether a simple or complex trust), then they're typically taxable to the trust rather than the beneficiary, except for the year of a trust termination. Long-term capital gains tax rates apply if the asset that was sold was held by the trust for a year and a day. And the rules of capital losses incurred by trusts are modeled after individual tax law; losses are offset against capital gains and deductions for any excess losses are limited.
Forms to be Filed
Form 1041 is a separate tax form that is required to be completed by the trustee of either a simple or complex trust and due 3.5 months after its year-end. (So for a calendar year trust, the Form1041 due date is April 15.) If a trust has any taxable income or gross income of $600 or more, then the trust must file with the IRS. However, if the trust beneficiary is a non-resident alien, then the trust must file—even if its income is less than $600.
The deduction to the trust for income distributed to beneficiaries is figured by completing Schedule B of Form 1041 and reported to the beneficiary on a Schedule K-1. The beneficiary then pays the income tax on the taxable amount of the distributions that is shown on his or her K-1.
CRI’s professionals understand the challenges associated with trust accounting and tax reporting. Ask us how we can help you plan and manage your trust effectively to ensure that it is properly reporting income, gains, and expenses. Our CPAs might just make setting up a trust seem as easy as pie.