The following article originally appeared in an issue of Planning Partners Press, a free newsletter provided courtesy of Carolina Family Estate Planning to Triangle-area financial professionals.
That is one of the most common questions about the administration of trusts and estates The answer is, “it depends.” The beneficiaries, and perhaps the trusts themselves, are subject to the income tax. Distributions of principal are not subject to income tax. Distributions of income are subject to income tax. The trust has to pay income tax on any income that is not distributed.
Some trustmakers have so much control over the trusts they have created that the IRS ignores the trusts completely. These are called Grantor Trusts and any income earned by the trust is simply part of the trustmaker’s personal income tax return.
If a trust or estate has over $600 of income during the year, the trustee (or executor) must file an income tax form called a Form 1041. The biggest difference between a 1041 and a 1040 is that a trust gets a deduction for distributions of income to beneficiaries. This results in ensuring that either the trust or the beneficiary, but not both, pays income tax on every dollar of income. The trustee files an informational return, a K-1, if there were any distributions. This lets the beneficiaries know how much of the distributions they received are taxable to them. If there is any tax due by the trust, the trustee is responsible for making sure the income tax is paid.
A rule that is sometimes hard to grasp is that trust income and the taxable income of trusts are not the same thing! For example, most states’ laws regard capital gains distributions as principal, not income, for trust accounting. For income tax, these are income. It is important to keep this in mind while working with trust income.
The income tax on the amount of trust income that is distributed to beneficiaries is paid by the beneficiaries, as part of the beneficiaries’ tax returns. The income keeps the same character as it had for the trust; for example, if the trust had long-term capital gains and distributes them, the beneficiary has long-term capital gains. This amount is a deduction on the trust’s income tax return. So, somebody’s going to pay income taxes on any income earned by the trust. It could be the trustmaker (in a Grantor Trust), the beneficiary (if there were distributions), or the trust itself. The trustee does not decide which distributions are income and which are principal; we calculate the Distributable Net Income and apply the DNI rules to determine who pays what. The results are sometimes surprising, especially when the trust receives tax-free income.
Keep in mind that the tax rates for trusts are the same as for individuals, but the brackets are smaller so the trust marginal tax rates are usually higher. Trusts reach the 35% income tax bracket at only $11,200 of taxable income.
It is important that trustees review their income and distributions with their tax advisors at the end of the year. Fortunately, the IRS grants trustees (and executors) the option to treat distributions during the first 65 days of a tax year as made in the prior year; so, the trustee and his tax advisors do have a couple of months to get this done. During that review, they can figure out what the best results would be and structure the distributions to achieve them.