There are many different types of trusts and different ways they are subject to taxation. If you are establishing or administering a trust, it’s important to be aware of the tax rules. In many cases it is also appropriate for the beneficiaries to be familiar with these rules.
Here are some ways the more widely used trusts are taxed. Note that there are always exceptions, but the general rules are covered below.
Living trusts. A living or revocable trust is a trust established by a grantor who is also the trustee and beneficiary and who retained the power to make changes or revoke it. These trusts are legal entities but have no tax effect. They are not taxed. Instead, the grantor picks up all income on his or her individual tax return. These trusts also have no effect on estate taxes with all assets includible in the estate of the beneficiary. Further, a living trust is not required to obtain its own taxpayer identification number (TIN) and can use the TIN or Social Security number of the grantor. A living trust does not need to file any tax returns.
Irrevocable trusts. These are trusts that are established by a grantor that cannot be altered and that have a separate trustee managing the trust, either someone you know or a professional trustee. Transfers to an irrevocable trust are subject to gift tax rules and can be taxed. The trust will pay income tax on all income earned by the trust that is retained in the trust, if the trust does not contain grantor trust provisions discussed below. If the trustee distributes the income to the beneficiaries, then the beneficiaries, not the trust, will pay tax on that income. There are many strategies involved in determining whether the trust or beneficiary pays the tax, and these depend on various circumstances of the grantor, beneficiaries and purposes of the trust. A trust’s tax rate is determined by a special trust tax table, and trust tax rates reach top brackets at very low income ceilings.
Grantor trusts. These are irrevocable trusts that have special income tax attributes defined in Internal Revenue Code Sections 671-679, where they are referred to as grantor trusts. These trusts are treated for gift- and estate-tax purposes as irrevocable trusts, but they are treated for income tax purposes in ways similar to living trusts—for example, grantor trusts are not required to obtain TINs or to file tax returns. The grantor will pick up all the income on his/her individual tax return.
Trusts established by estates. Many wills call for the creation of a trust, and these will always be irrevocable and can never be grantor trusts; therefore, they are subject to taxation the same as irrevocable trusts. However, during the estate administration period, an estate will file a fiduciary tax return to report any taxable transactions, and this will be reported on the same form that a trust files (Form 1041, U.S. Income Tax Return for Estates and Trusts). These rules are unusual even by trust standards and should be reviewed by a tax professional if you are in this situation.
Fiscal year. The fiscal year of a trust must be a calendar year unless the trust was established under the terms of a will (or if it is a living trust and an election is made using IRS Form 8855, Election To Treat a Qualified Revocable Trust as Part of an Estate, in which case it can use a fiscal year that ends no later than the end of the 11th month following the date of death).
Reporting mechanism. When beneficiaries are subject to the taxation on distributions received, it is reported on the Form 1041 Schedule K-1.
Filing requirements. Trusts that are subject to taxation must file a Form 1041 if there is any taxable income for the tax year, gross income of $600 or more, or if a beneficiary is a non-resident alien.
State taxation. Trusts may be subject to taxation by the states they are organized in, where the grantor resided, where the trustee resides or where certain assets are located depending on many circumstances. The amounts taxed are similar to those taxed under federal rules, but how they are taxed is much more complicated than under federal rules. This is another situation where a knowledgeable tax professional should be consulted, and this should be done before a trust is established if possible.
Other trusts. There are many other types of trusts that are subject to taxation including those with characteristics that are not covered here.
Conclusion: Anything with taxes is complicated, but trust taxation is particularly complicated, and for that reason it is strongly recommended that if you are considering establishing a trust, it is best to consult with a knowledgeable estate-planning attorney or CPA.