Trusts can be a helpful way to avoid probate and estate taxes. However, they also have their own tax implications that you must consider before creating a trust. Trusts themselves can be taxed, or the income from the trust provided to beneficiaries may be taxed. Understanding the tax treatment of trusts can help you create a trust that is much more effective and efficient.
Taxing Trusts: The Basics
An irrevocable trust, like a corporation or LLC, is a separate legal entity for tax purposes. That means that it has its own tax rate, just like you do. It must also file its own tax forms as well.
Trusts similarly figure income and deductions to individuals or businesses. The major difference is that any distribution to beneficiaries is considered a deduction and will not be taxed at the trust level. Instead, the beneficiary, not the trust, will pay income taxes on any taxable amount of distributions that they receive.
A distribution is considered to have come out of any revenue from that year first. Then, if the distribution is more than the income, it is deducted from the capital or principal of the trust. The accumulated capital is the initial contribution plus any income that is more than the distributions.
Tax Treatment of Revocable and Irrevocable Trusts
How trust is treated for tax purposes will depend on whether it is revocable or irrevocable. This is because property in a revocable trust is still considered the assets of the grantor while property in an irrevocable trust is treated as a separate legal entity.
Because a revocable trust is really just an extension of the grantor, the maker of the trust will report any income generated by the trust on his or her Form 1040. This is true even if the trust makes no distributions and the increase in assets remains within the trust.
You should also fill out the identification section of Form 1041 and file it for a revocable trust as well. However, you do not technically have to report your trust income on a separate form because it will already be on your personal tax return.
Irrevocable trusts are treated similarly to partnerships in that you must fill out a separate form for trust income, expenses, and distributions. You use Form 1041 to report trust income, but it is only required if the trust earned more than $600 for a given year. The trustee must also file a Schedule K-1 and provide each beneficiary with a copy of this document. Beneficiaries will then use their K-1 to report income from trust distributions on their personal income tax documents.
Tax Treatment of Distributions
Not all trust distributions are treated equally when it comes to taxes. When beneficiaries receive revenue from an irrevocable trust, it will be taxed as income. However, when the recipients receive a portion or all of their distribution from the principal or capital balance, the tax treatment is different.
Generally, beneficiaries will not pay taxes on any distribution that is from the principal of the trust. This is because the IRS assumes that this money was already taxed once before it was placed into the trust. By not taxing the principal, the IRS allows trust beneficiaries to avoid being taxed twice on the same income.
In addition, the beneficiary of a revocable trust will not pay income taxes on distributions, either. Again, the IRS determines that the grantor has already paid taxes on this distribution, so double taxation is avoided.
Trust Tax Rates
Like individual tax rates, trust tax rates are progressive. As the income increases, the tax rate will increase as well. The following federal rates apply for 2017.
| Taxable income | Pay This Amount Plus | This Rate of Excess Taxable Income (over the minimum in column one) |
|---|---|---|
| $0 to $2,549 | $0 | 15% |
| $2,550 to $5,999 | $382.50 | 25% |
| $6,000 to $9,149 | $1,245.00 | 28% |
| $9,150 to $12,499 | $2,127.00 | 33% |
| $12,500 and up | $3,232.50 | 39.6% |
In addition to these tax rates, a surtax on net investment income was also added in 2013. A 3.8% surtax applies to the lesser of either undistributed net investment income or the excess of adjusted gross income that is above $12,500 for 2017.
Unlike individual filers, there is no standard deduction or personal exemption that applies to trust taxes.
As you can see, trusts end up at the highest tax levels much faster than individuals do, which means that keeping income within a trust may not be a good idea if you are looking for tax savings.
Other Taxes to Consider: Gift Taxes and Estate Taxes
When individuals contribute to irrevocable trusts, their gifts may be subject to the gift tax if it is above the gift tax exclusion for that particular year. For 2017, the annual exclusion is $14,000. To avoid this tax, you simply must contribute less than or equal to $14,000 annually. Any amount that exceeds $14,000 is taxed at a progressive rate. The highest rate is 40%, and the lowest rate is 18%.
An estate tax is imposed on any portion of the deceased individual’s estate that rises above the gift tax exclusion applicable during that person’s death. In addition, the estate tax will only “kick in” if the total value of the estate is $5,490,000 or more in 2017. The assets in a revocable trust are considered part of the estate. However, assets in an irrevocable trust are not, so they are not regarded as subject to the estate tax.
Learning More About Trusts at Protect Wealth Academy
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