A trust can be a valuable tool for estate planning and a variety of other purposes. However, when it comes to taxes for a trust, throwing a trust into the mix can sometimes create a bit of confusion. Whether you’re setting up a trust or you’re a beneficiary, it’s important to understand your potential tax liability.
This quick guide provides an overview of the basics you need to know about dealing with taxes for a trust.
1. The Type of Trust Matters
When determining who owes taxes for a trust, it’s important to know what type of trust you’re working with. The two primary types are revocable and irrevocable, and each is treated differently.
Revocable Trusts
A revocable trust remains under the control of the person who created and funded it (the “grantor”) throughout their lifetime. This type of trust can be amended or revoked by the grantor at any time without anyone’s permission.
While the grantor is alive, all income generated by the trust is taxable to the grantor. The grantor’s social security number is typically also the revocable trust’s tax identification number. The trust itself does not file a tax return and any income, deductions, or credits related to the trust are reported on the grantor’s individual tax return.
Irrevocable Trusts
Irrevocable trusts are also created and funded by a grantor, but once they are established, the grantor cannot spend the funds or amend or revoke the trust without permission from the beneficiary (unless the trust terms specifically authorize this).
These types of trusts typically have their own tax identification number. If the irrevocable trust is considered a grantor trust, then all income, deductions, and credits are reported on the grantor’s individual tax return. However, if the irrevocable trust is a non-grantor trust, the trust itself and the trust’s beneficiaries may have some tax liability.
The trustee reports all distributions to beneficiaries using IRS Form 1041. This lowers the trust’s tax liability and shifts it to the beneficiary instead. When a beneficiary receives a distribution, they will also receive a form known as a K-1 at the end of the year. This form shows the total amount the trust has distributed for the year and also shows how much is categorized as interest income and how much is attributed to principal distribution. The beneficiary uses the information on this form to determine their tax liability.
2. Distribution of Principal Isn’t Taxable
When a grantor places funds into a trust, the IRS assumes those funds have already been taxed, so they are not taxed a second time when they are distributed. However, any income and distributions earned by the trust after it has been established are taxable income in the year they are earned.
When a beneficiary receives a distribution from an irrevocable trust, it’s considered to be interest income first and then distribution of principle. For example, if an irrevocable trust earned $2,000 in interest and the beneficiary received a $3,000 distribution, then $2,000 would be considered taxable income and the remaining $1,000 would be a non-taxable distribution of principle. The beneficiary reports the taxable income on their personal income tax return and is taxed at their personal rate.
3. Irrevocable Trusts Pay Taxes on Retained Income
All interest and dividend income earned by a trust are taxable in the year it is earned. If a trust retains the earnings, rather than distributing them to beneficiaries, then the income is taxable at the trust level. For example, if the trust earned $2,000 in interest and did not make any beneficiary distributions, the trust would be taxed on the full $2,000.
If the trust distributed $1,500 to the beneficiary, the beneficiary would be taxed on $1,500 and the trust would be taxed on the remaining $500.
Consult with a Tax Professional
Understanding taxes for a trust can be a bit complex, so it’s a good idea to consult with a tax professional. Whether you’re a trust grantor, a trustee, or a beneficiary, the team at Gurian CPA can help you make sure your taxes are paid correctly. Contact us today to schedule a consultation.
