The Complex World of Trusts and Taxes

When establishing the terms of your estate plan, you might consider using a trust to pass assets along to your beneficiaries or transfer wealth to your loved ones. Establishing a trust is often a wise strategic decision, but at the same time, grantors should fully understand that income received via a trust is considered taxable income by the IRS.

The specifics of how that income is taxed might make a difference in your estate plans. The taxation of trusts will depend on various factors — from the type of trust that you establish to the type of income you leave behind and who the beneficiaries are.

The Complex World of Trusts and Taxes

Details like these can influence how the income is taxed. Either way, it’s vital to recognize that the distributions made to your beneficiaries will stem from the current-year income first, followed by the principal.

Please note that while this article contains a brief overview of the federal taxation process pertaining to domestic trusts, the laws in your state can also influence the outcome of your trusts. While the rules regarding trusts are extremely complicated, you can find peace of mind when you hire a tax professional who thoroughly understands the laws governing trusts in your state.

Who pays the tax on income from a trust? 

As a general rule of thumb, the grantor of a revocable trust must report taxes pertaining to income from the trust assets on their personal income tax return, otherwise known as IRS Form 1040. Unlike irrevocable trusts, which are set in stone upon creation, revocable trusts can be altered during the grantor’s lifetime. The grantor of a revocable trust must report the income because the grantor retains ownership of the trust and its assets until he or she passes.

The rules surrounding taxation on income from irrevocable trusts are different. As mentioned, irrevocable trusts cannot be altered after they are created, meaning the grantor gives up ownership and control of their assets upon forming the trust.

Also, any taxable income stemming from the assets of an irrevocable trust is reported by the trust, not the grantor as an individual, which is done using IRS Form 1041. This form has to be filed annually to report the trust’s income up until the grantor’s death. However, any income that is distributed to the beneficiaries by the trust is typically reported by each beneficiary via Form 1040.

Generally speaking, a trust that earns income during a given tax year should file Form 1041 to report where that income came from during said tax year. Also, when the grantor passes away, trusts and estates must file Form 1041 and Schedule(s) K-1, respectively, during that same year. They must file either on or before April 15 of the following year as well.

On the other hand, it’s important to understand that fiscal year estates and trusts need to file Form 1041 by the 15th day of the fourth month after the respective tax year comes to a close. If an extension is needed, you can take advantage of the automatic five-month extension, though you must file for said extension using IRS Form 7004.

Five things to keep in mind regarding the taxation of trusts

Let’s take a closer look at five key facts you should consider when dealing with the taxes imposed on trust income.

  1. Tax rates are lower for individuals than for trusts.
  2. The income tax treatment will vary based on the type of trust that you establish as well as the beneficiaries whom you name within your trust account.
  3. You can lower income tax responsibilities for your beneficiaries by structuring trusts to distribute income to them favorably.
  4. Unless otherwise stated, capital gains and losses are considered part of the trust corpus. As a result, they are generally not distributed to the beneficiaries.
  5. Foreign trusts are taxed and reported differently than domestic trusts.

Schedule K-1

The Schedule K-1 form is where you report income from trust-related distributions. Schedule K-1 asks whether the income you received was ordinary income or whether it stemmed from interest, dividends, capital gains or rental income. It also provides you with information regarding available deductions as well as the eligibility requirements for each one.

In addition to filling out a Schedule K-1, beneficiaries are also required to include on their personal income tax returns the amount of trust-related income they received. As a bonus, Schedule K-1 clearly reports each type of income separately.

For example, Box 2a denotes how much income you received from ordinary dividends. Meanwhile, Box 2b indicates what percentage of that amount is regarded as qualified dividends.

Also, Schedule K-1 reports information other than your share of income. This may include any tax credits that are applicable to your situation, and this is the information beneficiaries must keep in mind when preparing Form 1040.

The role of trustees when calculating trust income

When it comes to calculating trust income, trustees play an undeniably crucial role in the process. Trustees are the ones who are responsible for maintaining accurate and updated records of the income, expenses, gains and losses stemming from the trust.

From there, trustees must also report this information via Schedule K-1. Keep in mind that trust-related accounting rules are rather complicated, so this is no small feat. The rules are particularly complex in the context of large trusts that contain a plethora of assets, so appointing someone who’s experienced and knowledgeable about trusts as the trustee is vital.