Trusts can be effective tools to help manage and protect your assets and may reduce or even eliminate costs related to wealth transfer, such as probate fees and gift and estate taxes. But there are trade-offs to consider when establishing and transferring assets to a trust. In addition to selecting a trustee, crafting distribution provisions, and estate tax planning, families should also consider how income taxes will impact the trust’s ability to maximize their wealth-transfer goals.
This article focuses on federal trust income taxation, also known as fiduciary income, and the Uniform Principal and Income Act (UPIA). It is important to keep in mind that several states also tax fiduciary income, which should be a factor to consider when creating certain trusts. In fact, in some situations, state income tax liability can play an important role in determining the type of trust and what state the trust is incorporated in for income tax purposes. In all cases, it is best to consult with your tax professional to determine whether a trust strategy may be suitable for you.
How trusts are taxed
From a tax perspective trust assets are generally classified as either “principal” or “income.” Generally, the assets the trust owns represent its principal (e.g., stocks, bonds, or real estate) and what those assets earn or produce represent its income (e.g., dividends, interest, or rent). There are complex trust accounting rules that govern the treatment of a trust’s income, expenses, taxes, and distributions.
For income tax purposes, a trust is treated either as a grantor or a non-grantor trust.
In the case of a grantor trust, the grantor (i.e., the person who created the trust) is responsible for paying the tax on income generated by trust assets. Two common forms of grantor trusts are revocable living trusts and intentionally defective grantor trusts (IDGTs):
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For non-grantor trusts, who is responsible for paying the income tax depends on whether the trust is considered simple or complex:
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In the case of a simple non-grantor trust, the beneficiaries are responsible for paying the income taxes on the income generated by trust assets, while the trust will pay the taxes on capital gains. For complex non-grantor trusts, the tax may be paid by the beneficiaries, the trust itself, or a combination, depending on the circ*mstances in any given year.
While the maximum rates are the same for a trust and an individual, trusts are taxed more aggressively than individuals. Consider that in the 2023 tax year, the top marginal tax rate for a single filer, 37%, begins after $578,125 of ordinary income. A trust is subject to that rate after reaching only $14,450 of income. In addition, trusts, like individuals, may be subject to the net investment income tax (NIIT) for any undistributed investment income. This is a 3.8% tax on either the trust’s undistributed net investment income, or the excess of adjusted gross income over $14,450, whichever is less. In comparison, a single individual is subject to the NIIT on the lesser of net investment income, or excess modified adjusted gross income over $200,000.2
As you can see, the amount of tax paid on the same amount of income can be much greater when the trust is responsible than when an individual taxpayer is.3
Lowering the trust's taxable liability
A distribution to a trust's beneficiary could result in a lower overall tax. That may be the case because the trust will take a deduction for the distribution, and given the higher thresholds for individual filers, depending on the beneficiary’s overall income level, the beneficiary may be in a lower tax bracket. However, there are some limits on how much income, for tax purposes, may be allocated to distributions made to beneficiaries from a trust. This is an important concept since a distribution to a beneficiary can be from income and/or principal depending on the income and capital gains generated by the trust in any given year.
For example, consider the situation where a beneficiary receives $10,000 as a distribution from a trust:
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Important considerations
Although trusts are often the cornerstone of a family’s wealth-transfer strategy, failing to carefully consider a trust’s potential tax liability can impact the strategy’s effectiveness. Because of the complexity of the fiduciary income tax environment, families and their attorneys should carefully consider the trustee they select and their experience serving as a fiduciary.
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Conclusion
The taxation of trusts can vary significantly depending on whether the trust is a grantor or a non-grantor trust and whether and how much income and principal is distributed to a beneficiary. For non-grantor trusts, income distributions may greatly reduce the overall amount of income tax liability owed, depending on the tax situation of the beneficiary. It is critical to work with your attorney and tax advisor to consider the specifics when it comes to drafting and using trusts, including trust taxation, to avoid results that may differ from the original intent of your estate plan.
Sure, let's break down the concepts mentioned in the article:
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Trusts and Asset Management: Trusts are vehicles used for managing and protecting assets. They can help reduce costs related to wealth transfer, such as probate fees and estate taxes. However, setting up and transferring assets to a trust involve trade-offs.
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Trust Taxation and Classification: Trust assets are typically classified as "principal" or "income." Principal refers to the assets owned by the trust (e.g., stocks, bonds, real estate), while income represents what these assets earn (e.g., dividends, interest, rent). The treatment of income, expenses, taxes, and distributions follows complex accounting rules.
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Grantor Trust vs. Non-Grantor Trust: Grantor trusts have the grantor responsible for paying taxes on trust income. Examples include revocable living trusts (grantor maintains control) and intentionally defective grantor trusts (grantor pays taxes on income, excluding assets from taxable estate). Non-grantor trusts determine tax responsibility based on whether they're simple (mandatory income distributions) or complex (trustee discretion on distributions).
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Taxation of Trusts vs. Individuals: Trusts face more aggressive taxation compared to individuals. For instance, in 2023, the top marginal tax rate for trusts starts at a much lower income threshold compared to individual filers.
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Trust Tax Strategies: Distributing income to beneficiaries might result in lower overall tax liabilities for the trust, as beneficiaries could be in lower tax brackets. However, the allocation of income and principal from distributions made to beneficiaries depends on the trust's income and gains in a given year.
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Considerations and Expertise: Trust tax liability complexity emphasizes the importance of selecting a capable trustee who can accurately manage and report trust transactions. Professional trustees with experience in managing complex trusts might be preferable. Additionally, investment strategies should consider tax implications to align with the trust's goals and beneficiary needs.
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Conclusion and Recommendations: Understanding the taxation differences between grantor and non-grantor trusts, as well as the impact of income distributions on tax liabilities, is crucial. Collaboration with attorneys and tax advisors is essential to create and use trusts effectively in estate planning while considering trust taxation specifics.
These concepts provide a comprehensive view of how trusts are taxed, the role of trustees, and the considerations involved in managing trust assets and distributions while minimizing tax liabilities.
