With the tax season fast approaching, clients may have questions about how their trust is taxed, who is responsible for tax filings or how trust income taxes get paid. Here are some answers to the most common questions you may have to field about trust taxation.
Do all trusts pay income taxes?
It depends. A trust is a separate legal and taxable entity. Whether the trust pays its own taxes depends on whether the trust is a simple trust, a complex trust or a grantor trust. Simple trusts and complex trusts pay their own income taxes. Grantor trusts do NOT pay their own taxes—the grantor of the trust pays the taxes on a grantor trust’s income.
How do I know if a trust is a simple trust?
A simple trust is a trust that: a) requires all trust income to be distributed at least annually; b) has no charitable beneficiaries; and c) makes no distributions of trust principal.
If the trust does not meet the above definition of simple trust, it is usually either a complex trust or a grantor trust.
What is a grantor trust?
A grantor trust is a trust where the grantor is treated as the owner for income tax purposes only, by retaining certain powers over the trust assets as described in the trust agreement. Grantor trusts can either be revocable or irrevocable. Because of these grantor-retained powers, the grantor trust is ignored for income tax purposes. Some of these powers include:
- Grantor or the grantor’s spouse retains the power to revoke or amend the trust (revocable trusts);
- Grantor retains the power to substitute trust assets with assets of equal value;
- Grantor retains power to borrow trust assets without adequate security;
- Grantor or grantor’s spouse may receive distributions from the trust (spousal lifetime access trusts); or
- Trust income may be used to pay premiums on life insurance policies on life of grantor or grantor’s spouse (irrevocable life insurance trusts).
Though there are other grantor-retained powers that make a trust a grantor trust, the above are the most common.
For income tax purposes, the grantor trust is treated as the same taxpayer as the grantor, even though the trust is a separate legal entity and separate legal owner of the trust’s assets. So, the trust’s income items are reported on the grantor’s personal income tax return and the grantor pays the taxes.
If the grantor does not retain any grantor trust powers, such as those listed above, and the trust is not a simple trust, it is a complex trust.
Does a trust file its own income tax return?
Yes, if the trust is a simple trust or complex trust, the trustee must file a tax return for the trust (IRS Form 1041) if the trust has any taxable income (gross income less deductions is greater than $0), or gross income of $600 or more.
For grantor trusts, it depends. A grantor trust may use the grantor’s Social Security number as its taxpayer identification number, or it may obtain its own taxpayer identification number from the IRS. If a grantor trust uses the grantor’s Social Security number as its taxpayer identification number, it does not need to file its own income tax return as all tax documents such as 1099s will be issued to the grantor directly to report on the grantor’s individual income tax return. However, if a grantor trust has its own taxpayer identification number, it may have to file its own tax return for informational purposes only. The pro forma tax return identifies the trust as a grantor trust and includes a grantor trust letter that lists all income items that should be reported on the grantor’s individual income tax return, so that the grantor can pay the taxes.
If the trust is its own taxpayer, does the trust also have to file a state income tax return and pay state income taxes as well?
Yes, if a state has tax jurisdiction over the trust, the trust will have to file a state income tax return and pay state income taxes in that state. Each state has its own rules regarding whether it has tax jurisdiction over a trust. Some states such as New York may tax a trust if the grantor resided in New York when the trust was funded, unless there are no New York trustees, no New York situs trust assets and no New York source income. Other states like California may tax a trust if one of the trustees or beneficiaries is a California resident. Because each state has different rules for imposing income taxes on trusts, it is possible for a trust’s income to be taxable in multiple states. However, if you know these rules, you can reveal opportunities to reduce or eliminate a trust’s state tax liability. For example, if the grantor resided in New York when the simple or complex trust was funded, New York state tax liability may be eliminated by replacing a New York trustee with a trustee who is not a New York resident, as long as the trust has no New York situs assets or New York source income.
For a trust that pays its own income taxes, what deductions can the trust claim?
The usual deductions a simple or complex trust can claim on its tax return are for state tax paid, trustee fees, tax return preparer fees and the income distribution deduction. Because a grantor trust is not considered a separate taxpayer, it cannot claim its own deductions.
Trustee Fees and Tax Return Preparer Fees
For trust expenses such as trustee fees and tax return preparer fees, only the portion attributable to taxable income is deductible. For example, if the trust’s income consists of $10,000 in dividends and $5,000 in tax-exempt interest, only two-thirds of the trustee fees and tax return preparer fees are deductible.
Income Distribution Deduction
To determine the trust’s income distribution deduction, you must first calculate the trust’s distributable net income (DNI). DNI is defined by the Internal Revenue Code—generally, it is equal to total trust income (including tax-exempt interest but excluding capital gains or losses), less deductions such as state tax paid, trustee fees and tax return preparer fees.
If the trust’s total distributions to beneficiaries is greater than DNI, the income distribution deduction = DNI – tax-exempt interest.
If the trust’s total distributions to beneficiaries is less than DNI, the income distribution deduction = total distributions – (Total distributions × tax-exempt interest/DNI).
If the trust claims an income distribution deduction on its tax return, the amount deducted gets passed to the trust beneficiary on a Schedule K-1, and the trust beneficiary must report the Schedule K-1 income items on his or her own personal income tax return.
How do a trust’s income tax rates compare with an individual’s income tax rates?
For the 2020 tax year, a simple or complex trust’s income is taxed at bracket rates of 10%, 24%, 35% and 37%, with income exceeding $12,950 taxed at that 37% rate. By comparison, a single person’s income is taxed at bracket rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%, with income exceeding $518,401 taxed at that 37% rate. Because the trust’s tax brackets are much more compressed, trusts pay more taxes than individual taxpayers. Below are the 2020 tax brackets for trusts that pay their own taxes:
- $0 to $2,600 in income: 10% of taxable income
- $2,601 to $9,450 in income: $260 plus 24% of the amount over $2,600
- $9,451 to $12,950 in income: $1,904 plus 35% of the amount over $9,450
- Over $12,950 in income: $3,129 plus 37% of the amount over $12,950
What is the 65-day rule?
Under the 65-day rule, a trustee can make distributions to trust beneficiaries within 65 days after year-end and treat those distributions as if they were made in the previous tax year. The deadline for the distribution is March 6 (March 5 in a leap year). An irrevocable election must be made on the trust’s income tax return to treat the distributions made within the 65-day window as made in the prior tax year. For tax year 2020, if trustees make distributions to trust beneficiaries before March 6, 2021, they can elect to treat those distributions as 2020 tax year distributions. The trustee would claim an income distribution deduction for these “65-day rule” distributions on the trust’s 2020 tax return and shift some of the trust’s 2020 income tax burden to the trust beneficiaries, who would be taxed at lower rates than the trust. Trustees may take advantage of the “65-day rule” when the trust’s distributions to beneficiaries during the calendar year are less than the trust’s DNI for that year. If that is the case, the trustee may make “65-day rule” distributions up to the trust’s DNI to maximize the trust’s income distribution deduction and shift the tax liability on those distributions to the beneficiaries.
Richard Yam is senior vice president, trusts & estates, at Wealthspire Advisors.
