Every year on Tax Day, millions of Americans prepare to send in their final tax returns, awaiting refunds or fearing debt. Yet not every individual income tax return pertains to a person. Trust agreements, too, must pay taxes – and many types of trusts must file their own tax returns.
Understanding how trust taxation works can not only help you minimize your trust’s taxes and maximize your family’s inheritance, but can also give you a greater understanding of a trust’s purpose in an estate plan.
Simple vs. Complex vs. Grantor Trusts
On the surface, a trust agreement is an agreement between three parties, upheld through the creation of an independent legal entity. These parties are the grantor, the trustee, and the beneficiary. The legal entity is the trust itself, which can hold onto assets, earn income, and pay taxes.
There are countless different kinds of trusts. Some trusts exist to help politicians or non-profit executives with a financial claim in a variety of different industries avoid facing lawsuits due to a conflict of interest, by leaving them in the dark about the nature of these investments and leaving the fiduciary duty to manage these investments solely in the hands of a trustee. Some trusts cut grantors off from their own property while they still live, in order to protect those assets from creditors and preserve it for their loved ones.
Some trusts are built to pay out a steady income to a special needs beneficiary over the course of years, if not decades. In some states, trusts created solely for the caretaking of a pet can last until the end of the pet’s lifetime. In the case of a macaw, for example, that can be as long as 70 years.
Yet despite the infinite complexity and flexibility of a trust, when it comes to income taxation, trusts are split into three distinct groups: simple trusts, complex trusts, and grantor trusts.
- Simple trusts are any type of trust that distributes every cent of earned income on an annual basis, with no additional provisions for accumulating income over time. Simple trusts are taxed at the beneficiary’s tax rate, rather than the trust’s tax rate. A simple trust’s income taxes are paid through the beneficiary’s tax return.
- Complex trusts have a greater degree of flexibility on how and when income is distributed. In the case of a complex trust, a trust can accumulate income for more than a year before paying it out or might only pay out a set amount of income each year, regardless of how well the trust is “earning”. Complex trusts are taxed on the trust’s tax rate, which depends on the amount of taxable income it earns. Unlike simple trusts, complex trusts must fill out their own tax returns – through a managing trustee.
- Grantor trusts are trusts that are still managed by the grantor. Most living trusts designed to distribute assets upon death allow a grantor to continue to manage and “own” the assets therein, before a trustee takes over. Because of this, the contents of a grantor trust are counted as the grantor’s own property, and any income earned in a grantor trust is taxed on the grantor’s income taxes. The grantor manages these taxes through their own tax return.
Any income earned by the trust’s principal – through investments, business operations, royalties, or rent – is taxable. Most of the time, only a trust’s income is taxed, not the principal amount.
The principal of a trust is the amount funded into it by a grantor. The reason the principal is not taxed is because it is assumed that this income has already been taxed. When a grantor funds assets and income into a trust, those assets and income become the trust’s principal.
Like any other person, however, a trust can also have deductions. A trust’s deductions may include trust fees and costs, state and local taxes, charitable contributions, investment expenses, interest on property, property taxes, and depreciation expenses.
Note that tax law is constantly changing. While the proposal didn’t go through, President Biden’s last tax law proposal included provisions that would make funding a trust a taxable event, while simultaneously reducing the estate tax exemption amount. Being up-to-speed on how tax laws have changed is one of the key reasons to consult a legal professional whenever you wish to create or amend your estate plan.
One of the key differences between a simple trust and a complex trust is who gets taxed. This is the big question when setting up a trust for your loved ones.
If a trust manages to distribute its income over the course of a year, then the taxable portion is taxed on the beneficiary’s expense. This results in a lower tax liability, because an individual’s tax rate will often be lower than the trust’s tax rate. To maintain a trust’s status as a simple trust for tax purposes, it must distribute its distributable net income (DNI) within the annual deadline.
There is a degree of flexibility with this annual deadline, called the 65-day rule. This basically means that the end-of-year deadline for distributing a trust’s DNI can be pushed to March 6 (March 5 on a leap year), and still count towards the previous year.
Meaning, any income distributed before March 6, 2023, can count towards the trust income distributed within the tax year 2022. In other words, if a trust did not manage to distribute its minimum income (defined as the DNI) within 2022, it has until March 6, 2023, to make additional distributions to avoid dealing with the higher tax rate.
Filing a Tax Return as a Trust
If a grantor chooses to structure a trust’s distributions to take advantage of the full flexibility of a trust’s distribution schedule, versus the tax benefit of complete annual distributions, the trust must file its own taxes.
This requires a trustee to acquire an Individual Taxpayer Identification Number for the trust, and file tax Form 1041 and Schedule K-1 to detail the trust’s income and applicable deductions, and the beneficiary’s share of income, deductions, and credit, respectively.
Trusts are Flexible (and Complicated)
It’s been said time and time again, but bears repeating: trusts are flexible and complicated legal arrangements, more so than a will or most other estate planning documents. This level of complexity has a distinct advantage – a trust allows wealth to be safely and competently managed as per your wishes, long after you are gone. But this arrangement has its fair share of costs.
If you want to use a trust to properly manage your wealth and ensure your family’s financial stability for years to come, then it is important to get it right. Protect your assets and minimize your taxes – and your trust’s taxes – through professional legal help. Don’t risk costly mistakes. Consult a legal professional today.