By Emily Menjou, VP/Personal Trust Fiduciary Manager
As each tax season comes and goes, I’m reminded that many clients and beneficiaries are unclear on the income tax implications associated with income earned in their trusts, and more specifically, who pays the tax? The question is straightforward, but the answer depends on a variety of factors. For example, is the trust a grantor trust or a non-grantor trust? Is income required to be distributed, or is it discretionary? Is income currently being distributed?
Grantor Trusts
The IRS generally defines a grantor trust as any trust “over which the grantor or other owner retains the power to control or direct the trust’s income or assets.” The grantor is the person who created and funded the trust, and often serves as trustee during his or he own lifetime with the ability to control the trust’s income and assets. Revocable or living trusts are common forms of a grantor trust.
The powers retained by the grantor to control or direct the trust assets result in ownership for income tax purposes. Therefore, any income or deduction earned by the trust will be taxed on the grantor’s individual income tax return, subject to applicable individual income tax rates. If the grantor is acting as his or her own trustee, the trust need not file a separate return as the trust’s income can be reported under the grantor’s social security number. In cases where there is an independent trustee, the trustee will typically provide the grantor with a Grantor Letter – a tax reporting document which passes income and deductions through to the grantor’s individual returns.
Non-Grantor Trusts
Any trust that is not a grantor trust is classified as a “non-grantor” trust. A trust established as a non-grantor trust is itself a taxable entity, requiring a separate income tax return to report income from assets which are owned by the trust. Most irrevocable trusts are non-grantor trusts.
In a typical scenario, the trust is required to pay income tax at the trust level for income which is retained within the trust. If the trust requires that net income be distributed to beneficiaries, the income is generally passed through to the beneficiary for tax purposes, regardless of whether it is actually distributed. For a discretionary trust where income is not required to be distributed, income flows to the beneficiary’s tax level to the extent it is actually distributed to the beneficiary, with undistributed income to be taxed at the trust level. In either case, capital gains taxes are generally paid at the trust level.
For non-grantor trusts, the trustee must file a fiduciary income tax return and issue a Schedule K-1 to the beneficiary, showing the amount and classification of trust income to be included on the beneficiary’s individual tax return.
Tax Considerations
It is important to note that trusts and individuals are subject to significantly different tax rates, which increases the importance of understanding tax treatment of grantor and non-grantor trusts. Tax brackets for trusts are compressed with trusts hitting the top tax rate (37% for 2018) for taxable income over $12,501, as compared to individual taxpayers who can report up to $500,000 of income before hitting the highest tax rate. As always, we recommend that you consult with a licensed tax professional for advice and guidance around your unique circumstances and how these rules may apply to you.