Basics of Trust Income Taxation 

June 10, 2018

The federal income taxation of trusts is one of the more obscure topics in the realm of tax and finance. There aren’t many trust tax returns each year.  So the lack of attention to this area of taxation is actually not too surprising. Nonetheless, trust income taxation is still a very important issue.  That’s because trusts serve many useful functions in our society. For instance, a common trust use is to assist someone with special needs.  Or they can help support someone not yet of adult age. Trusts may also effectively assist in utilizing income for a specialized purpose.  Another common use is to help a specific person fulfill a particular goal.  

In this article, we’ll identify the different types of trusts.  We’ll then highlight some of the key points which distinguish one type of trust from another. We’ll then turn to some of the more basic rules of trust income taxation. We note at the outset that this article is only a very general introduction to the topic.  That’s necessarily true because, as will become clear, the details of trust income taxation can become quite complex. In the future, however, we’ll dive into this complexity by examining more specific aspects of trust income taxation. 

Overview of Trusts 

trust is a legal entity.  A primary use of a trust is to hold and disburse funds for the benefit of another party. The person who establishes the trust is the “grantor” (or the “settlor” or “trustor”).  The manager of the trust is the trustee or the fiduciary.  The person that benefits from the trust is the beneficiary. The same individual may fill each of these different roles, depending on circumstances.  This, though, is typically not the case. 

Grantor Trusts

There are a variety of types of trusts.  They further particular functions. The two main types of trusts are grantor trusts and non-grantor trusts. Grantor trusts are trusts over which the grantor retains control over the disbursement of the trust’s assets.  That means that the grantor himself or herself functions as the trustee. The grantor is also typically the beneficiary in this type of trust. Grantors retain the ability to dissolve the trust at any given time.  The grantor also possesses the ability to transform the trust into a non-grantor trust. The grantor’s retention of control over the disbursement of trust assets is very important.  In such a scenario, the grantor is ultimately responsible for paying taxes on the income generated by the trust. Grantor trusts do not have separate  legal status independent of the grantor.  Rather, the grantor continues as the true owner of the assets held by the trust. 

Non-Grantor Trusts

Non-grantor trusts stand in contrast to grantor trusts.  They are trusts over which the grantor passes legal control of the trust assets to a third party trustee. The identity of the players involved is a defining feature of non-grantor trusts.  That is to say, they have separate and distinct persons as grantor, trustee and beneficiary. Non-grantor trusts are independent legal entities, distinct from the grantor.  As such, they must file their own tax returns.  The only exception to this filing rule is the amount of income they generate and whether it exceeds a certain threshold. The assets held in a non-grantor trust are no longer legally the property of the grantor.  Non-grantor trusts may not be altered or dissolved unilaterally by the grantor. 

Basic Rules of Trust Income Taxation 

The taxation rules which apply to trusts differ depending on the type of trust. In a grantor trust, the funds that are initially donated to the trust, that is, the principal or “corpus,” are not taxed when distributed back to the grantor. Instead, the grantor receives a “basis” equal to the principal.  Subsequent distributions decrease this basis. This makes intuitive sense.  That’s because taxing the principal would equate to taxing the initial donation into the trust. When a grantor trust generates income, however, typically from investments, this income retains its character (i.e. ordinary income, capital gains, etc.).  It’s reported on the grantor’s individual tax return (Form 1040). Grantor trusts are a perfect example of a true pass-through entity.  That’s because income in the the trust flows through to the grantor. 

Separate Tax Returns May Be Required

Non-grantor trusts, in contrast to grantor trusts, file their own tax returns.  They must pay taxes on income to the trust not sent to beneficiaries.  The tax filing and payment obligations of non-grantor trusts arises because they are considered legal entities separate and distinct from the grantor for tax purposes, Non-grantor trusts file Form 1041.  That’s the same tax form applicable to estates. If a non-grantor trust generates income which isn’t distributed to beneficiaries by the close of the calendar year, it’s taxable to the trust.  It’s tax rate differs from the individual beneficiaries.  The tax is, instead, calculated at rates which apply specifically to trusts.

When a non-grantor trust distributes income to beneficiaries, the beneficiaries must pay tax on the income.  The amount is based on the extent to which the income received is taxable (i.e. the income is not tax-exempt). Beneficiaries will receive a Schedule K-1 from the trust.  It shows items of income and deductions attributable to the trust.  It’s the same type of Schedule they’d receive if they had a distribution from a partnership or other pass-through entity. When the trust distributes taxable income to beneficiaries, the trust gets a “distribution deduction”.  That allows the trust to avoid double taxation. 

Trust Income Taxation Assistance

Again, these are only the basics of trust income taxation. In the future, we will come back to this topic.  We’ll discuss some of the more advanced tax and accounting principles which apply to trusts. Here at Mackay, Caswell & Callahan, P.C., we take great pride in perfecting our craft.  We try to deliver top notch service to our clients.  Trust income taxation is just one part of this task. If you have a question regarding trusts, or any other tax issue, please reach out.  One of our NYC tax attorney will be on your case in double quick time. 

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