If you’re a beneficiary, grantor, or trustee of an irrevocable trust, it’s important to understand the specifics of how trust disbursements work and who is liable for the taxes. Following, you’ll find a quick overview of the important details and a few examples for clarification.
Taxation of Irrevocable Trust Disbursements
When an irrevocable trust disburses funds, the trust takes a taxable deduction for the amount distributed and issues a tax form to the beneficiary. This form, known as a K-1, shows the total disbursement received and includes a breakdown of the amount that is attributed to interest income versus principal balance. The beneficiary can then use this information to determine their tax liability.
Irrevocable trust disbursements can range from completely tax-free to being taxed at the highest marginal tax rate, or possibly even higher. The difference depends on whether the disbursement came from the original principal or dividends and interest that accumulated after the trust was established.
Sound a bit confusing? Let’s take a closer look.
Principal Distributions vs. Growth & Interest
When a grantor establishes an irrevocable trust and deposits money into it, the IRS assumes that the funds were already taxed before they were placed into the trust. Therefore, it is not taxed again when it is disbursed. However, once the money is in the trust, it will likely earn dividends and interest. These earnings are considered taxable income and are taxed to either the beneficiary or the trust.
If the trust holds the income and does not disburse it to the beneficiary by year-end, then the trust is liable for the taxes. However, if funds are distributed to one or more beneficiaries, the income is taxable to the person who receives it.
The taxable amount depends on the interest vs. principal allocation. Irrevocable trust disbursements are assumed to first come from interest and then from principle. For example, if an irrevocable trust generated $3,000 in interest and the trustee distributed $5,000 to the beneficiary, $3,000 would be taxable to the beneficiary and the remaining $2,000 would be a non-taxable distribution of principle.
Consider a different scenario, where the trust earned $3,000 in interest but the beneficiary only received a $1,000 disbursement. In this case, the full $1,000 is taxable to the beneficiary and the trust is also responsible for paying taxes on the remaining $2,000.
Important Tax Documents
When dealing with irrevocable trust disbursements, there are two important tax documents you need to be aware of. The first is an IRS Form 1041. This form is used to show the interest deductions the trust takes when it distributes interest to beneficiaries. By reporting the distribution on this form, the trust lowers its taxable income and passes the liability to the beneficiary who received the distribution.
The second form is the K-1. This form is generated by the trust and submitted to the IRS. The IRS then delivers the form to the beneficiary, who is responsible for paying any taxes owed on the disbursement they received.
Consult with an Expert Regarding Your Trust Disbursements
Irrevocable trust disbursements can be a bit complex. If you’re a beneficiary or a trustee of an irrevocable trust, it’s a good idea to work with a tax professional to ensure all of the necessary paperwork is filed and the taxes are paid correctly. The experts at Gurian CPA are here to help. Contact us today to schedule a consultation.
