Trusts can be effective tools to help manage and protect your assets and may reduce or even eliminate costs related to wealth transfer, such as probate fees and gift and estate taxes. But there are trade-offs to consider when establishing and transferring assets to a trust. In addition to selecting a trustee, crafting distribution provisions, and estate tax planning, families should also consider how income taxes will impact the trust’s ability to maximize their wealth-transfer goals.
This article focuses on federal trust income taxation, also known as fiduciary income, and the Uniform Principal and Income Act (UPIA). It is important to keep in mind that several states also tax fiduciary income, which should be a factor to consider when creating certain trusts. In fact, in some situations, state income tax liability can play an important role in determining the type of trust and what state the trust is incorporated in for income tax purposes. In all cases, it is best to consult with your tax professional to determine whether a trust strategy may be suitable for you.
How trusts are taxed
From a tax perspective trust assets are generally classified as either “principal” or “income.” Generally, the assets the trust owns represent its principal (e.g., stocks, bonds, or real estate) and what those assets earn or produce represent its income (e.g., dividends, interest, or rent). There are complex trust accounting rules that govern the treatment of a trust’s income, expenses, taxes, and distributions.
For income tax purposes, a trust is treated either as a grantor or a non-grantor trust.
In the case of a grantor trust, the grantor (i.e., the person who created the trust) is responsible for paying the tax on income generated by trust assets. Two common forms of grantor trusts are revocable living trusts and intentionally defective grantor trusts (IDGTs):
A revocable living trust allows the grantor to transfer assets into the trust while still maintaining complete control over and access to the assets. Assets transferred to a revocable living trust are not considered completed gifts and are included in the grantor’s taxable estate at death.
An IDGT gives the grantor some control over the assets so that they are responsible for paying the tax on income, but not so much control that the transfer of assets would be deemed incomplete for transfer-tax purposes. Generally, assets transferred to an IDGT are excluded from the grantor’s taxable estate at death.
For non-grantor trusts, who is responsible for paying the income tax depends on whether the trust is considered simple or complex:
A simple trust is one that meets 3 tests: it requires mandatory distributions of all income during the taxable year, it prohibits distributions of principal, and it prohibits distributions to charity.1
A complex trust is one that is not a simple trust; in other words, a trustee has more discretion relating to the distributions of income and principal (although the trust may provide for mandatory distributions of some or all of its income and principal).
In the case of a simple non-grantor trust, the beneficiaries are responsible for paying the income taxes on the income generated by trust assets, while the trust will pay the taxes on capital gains. For complex non-grantor trusts, the tax may be paid by the beneficiaries, the trust itself, or a combination, depending on the circ*mstances in any given year.
While the maximum rates are the same for a trust and an individual, trusts are taxed more aggressively than individuals. Consider that in the 2023 tax year, the top marginal tax rate for a single filer, 37%, begins after $578,125 of ordinary income. A trust is subject to that rate after reaching only $14,450 of income. In addition, trusts, like individuals, may be subject to the net investment income tax (NIIT) for any undistributed investment income. This is a 3.8% tax on either the trust’s undistributed net investment income, or the excess of adjusted gross income over $14,450, whichever is less. In comparison, a single individual is subject to the NIIT on the lesser of net investment income, or excess modified adjusted gross income over $200,000.2
As you can see, the amount of tax paid on the same amount of income can be much greater when the trust is responsible than when an individual taxpayer is.3
Lowering the trust's taxable liability
A distribution to a trust's beneficiary could result in a lower overall tax. That may be the case because the trust will take a deduction for the distribution, and given the higher thresholds for individual filers, depending on the beneficiary’s overall income level, the beneficiary may be in a lower tax bracket. However, there are some limits on how much income, for tax purposes, may be allocated to distributions made to beneficiaries from a trust. This is an important concept since a distribution to a beneficiary can be from income and/or principal depending on the income and capital gains generated by the trust in any given year.
For example, consider the situation where a beneficiary receives $10,000 as a distribution from a trust:
If the trust had no income, this distribution would be considered a distribution from principal.
If the trust had only $5,000 of dividends, this distribution would be considered a combination of income and principal.
If the trust had $5,000 of dividends and a $5,000 capital gain, even though this totals the $10,000 distribution, this distribution would also be considered a combination of income and principal.
Important considerations
Although trusts are often the cornerstone of a family’s wealth-transfer strategy, failing to carefully consider a trust’s potential tax liability can impact the strategy’s effectiveness. Because of the complexity of the fiduciary income tax environment, families and their attorneys should carefully consider the trustee they select and their experience serving as a fiduciary.
Choice of trustee. Ultimately, the trustee is responsible for maintaining accurate records of income, expenses, gains, and losses to enable the trust to properly report its income and calculate any applicable tax liability. As a result, a trustee must possess the expertise and skill to properly document and record trust transactions and then apply the complicated rules of trust accounting. For trusts with larger principal balances, this can be a time-consuming and complicated exercise, which is one reason why many families chose professional trustees with experience managing complex trusts.
Investment management.Taxes are one of several factors that a trustee must balance when considering how to invest trust assets. Because trust tax brackets are compressed, it is important that a trust’s investment strategy is aligned with the trust’s overall goals, risk tolerance, and beneficiary needs. For example, a trust that is required to make regular distributions of income will need an investment strategy that generates sufficient income to meet the trust’s needs without generating excess income (or capital gains) that could increase either the trust’s or the beneficiaries’ income tax liability. The trustee, or the investment manager the trustee hires, will need to consider the impact taxes will have on the trust’s overall investment strategy.
Conclusion
The taxation of trusts can vary significantly depending on whether the trust is a grantor or a non-grantor trust and whether and how much income and principal is distributed to a beneficiary. For non-grantor trusts, income distributions may greatly reduce the overall amount of income tax liability owed, depending on the tax situation of the beneficiary. It is critical to work with your attorney and tax advisor to consider the specifics when it comes to drafting and using trusts, including trust taxation, to avoid results that may differ from the original intent of your estate plan.
I'm a seasoned expert in the field of trusts and estate planning, with a comprehensive understanding of the intricacies involved in managing and protecting assets through trust structures. My expertise extends to federal trust income taxation and the Uniform Principal and Income Act (UPIA). Allow me to delve into the concepts addressed in the provided article.
Trust Taxation Overview:
Trusts serve as effective tools for managing and safeguarding assets, potentially reducing or eliminating costs related to wealth transfer, such as probate fees and estate taxes. However, establishing and transferring assets to a trust involves trade-offs, including considerations for federal trust income taxation.
Federal Trust Income Taxation:
For tax purposes, trust assets are categorized as either "principal" or "income." The trust's principal comprises assets like stocks, bonds, or real estate, while income represents what those assets earn, such as dividends, interest, or rent.
Grantor Trusts:
Grantor trusts, like revocable living trusts and intentionally defective grantor trusts (IDGTs), treat the grantor (the trust creator) as responsible for paying taxes on trust-generated income. Revocable living trusts allow the grantor to maintain control over assets, while IDGTs provide some control without including the assets in the grantor's taxable estate at death.
Non-Grantor Trusts:
Non-grantor trusts are either simple or complex. A simple trust mandates income distributions, prohibits principal distributions, and bars distributions to charity. Beneficiaries of simple trusts are responsible for income taxes on trust-generated income. Complex trusts afford trustees more discretion in income and principal distributions, and taxes may be paid by beneficiaries, the trust, or a combination thereof.
Tax Rates and Considerations:
Trusts face more aggressive taxation than individuals. In 2023, the top marginal tax rate for trusts starts at $14,450 of income, in contrast to $578,125 for individual filers. Additionally, trusts may be subject to the net investment income tax (NIIT), further increasing their tax liability.
Lowering Taxable Liability:
Distributions to trust beneficiaries can result in lower overall taxes, as trusts may deduct distributions. The allocation of income and capital gains to beneficiaries from a distribution depends on the trust's earnings in a given year.
Important Considerations:
The choice of a trustee is crucial, as they are responsible for accurate record-keeping and navigating complex trust accounting rules. Trust investment management must align with overall goals, risk tolerance, and beneficiary needs, considering the impact of taxes on the trust's strategy.
Conclusion:
The taxation of trusts varies based on grantor or non-grantor status and the distribution of income and principal. Careful consideration of a trust's tax implications is essential to ensure alignment with the original intent of the estate plan. Consulting with experienced professionals, including attorneys and tax advisors, is critical for effective trust planning.
Generally speaking, beneficiaries must pay taxes on any distributions they receive that the trust paid from income that it earned in the current tax year. A beneficiary does not have to pay taxes on any distributions that the trust makes from its principal balance. This is to avoid double taxation.
Instead of trusts paying any tax owed on the trust's income, the trust's beneficiaries usually pay this tax on any distributions they receive. That said, the beneficiaries do not pay taxes on any distributions received from a trust's principal, which is the initial amount of money transferred to the trust.
As the table below demonstrates, trusts are subject to higher tax rates than individuals. Federal income tax rates for trusts in 2023 are: For trust income between $0 to $2,900: 10% of income over $0. For trust income between $2,901 to $10,550: $290 + 24% of the amount over $2,901.
Beneficiaries of a trust typically pay taxes on the distributions they receive from a trust's income. The trust doesn't pay the tax. Beneficiaries aren't subject to taxes on distributions from the trust's principal, however. The principal is the original sum of money that was placed into the trust.
Selecting the wrong trustee is easily the biggest blunder parents can make when setting up a trust fund. As estate planning attorneys, we've seen first-hand how this critical error undermines so many parents' good intentions.
You can transfer assets to the trust while getting an annuity payment. If the assets in the trust appreciate enough, you can pass that excess value to your heirs with little or no tax. GRATs are a popular wealth transfer strategy with ultra-wealthy Americans.
One type of trust that helps protect assets is an intentionally defective grantor trust (IDGT). Any assets or funds put into an IDGT aren't taxable to the grantor (owner) for gift, estate, generation-skipping transfer tax, or trust purposes.
Alaska, Nevada, South Dakota, Tennessee and Wyoming don't tax trusts, period. Delaware doesn't levy its state income tax on income and capital gains generated by irrevocable trusts with nonresident beneficiaries. And while New Hampshire does have an interest and dividends tax, trusts are exempt.
Certain types of trusts can help avoid estate taxes. An irrevocable trust transfers asset ownership from the original owner to the trust beneficiaries. Because those assets don't legally belong to the person who set up the trust, they aren't subject to estate or inheritance taxes when that person passes away.
What Are the Tax Advantages of a Trust? Irrevocable trusts allow amounts to be contributed annually without being subject to gift taxes. The annual exclusion is $17,000 for 2023 and $18,000 for 2024. 7 Also, their assets are generally protected from estate taxes.
What Are the Disadvantages of a Trust in California? Trusts are costly to create. Creating a trust without an attorney may be less expensive, but doing so leaves the trust much more vulnerable to trust contests and other legal litigation. It is also more time-consuming to properly set up a trust than to create a will.
There is no federal inheritance tax. In fact, only six states tax inheritances. There is a federal estate tax, however, which is paid by the estate of the deceased. In 2024, the first $13,610,000 of an estate is exempt from the estate tax.
When you inherit money and assets through a trust, you receive distributions according to the terms of the trust, so you won't have total control over the inheritance as you would if you'd received the inheritance outright.
Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc. Use Schedule K-1 to report a beneficiary's share of the estate's or trust's income, credits, deductions, etc., on your Form 1040, U.S. Individual Income Tax Return.
For tax year 2023, the 20% maximum capital gain rate applies to estates and trusts with income above $14,650. The 0% and 15% rates continue to apply to certain threshold amounts. The 0% rate applies up to $3,000. The 15% rate applies to amounts over $3,000 and up to $14,650.
Form 1041 is a tax return filed by estates or trusts that generated income after the decedent passed away and before the designated assets were transferred to beneficiaries. The executor, trustee, or personal representative of the estate or trust is responsible for filing Form 1041.
With the new IRS rule, assets in an irrevocable trust are not part of the owner's taxable estate at their death and are not eligible for the fair market valuation when transferred to an heir. The 2023-2 rule doesn't give an heir the higher cost basis or fair market value of the inherited asset.
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