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.
I'm a seasoned expert in the field of trusts and estate planning, with a comprehensive understanding of the intricacies involved in managing and protecting assets through trust structures. My expertise extends to federal trust income taxation and the Uniform Principal and Income Act (UPIA). Allow me to delve into the concepts addressed in the provided article.
Trust Taxation Overview: Trusts serve as effective tools for managing and safeguarding assets, potentially reducing or eliminating costs related to wealth transfer, such as probate fees and estate taxes. However, establishing and transferring assets to a trust involves trade-offs, including considerations for federal trust income taxation.
Federal Trust Income Taxation: For tax purposes, trust assets are categorized as either "principal" or "income." The trust's principal comprises assets like stocks, bonds, or real estate, while income represents what those assets earn, such as dividends, interest, or rent.
Grantor Trusts: Grantor trusts, like revocable living trusts and intentionally defective grantor trusts (IDGTs), treat the grantor (the trust creator) as responsible for paying taxes on trust-generated income. Revocable living trusts allow the grantor to maintain control over assets, while IDGTs provide some control without including the assets in the grantor's taxable estate at death.
Non-Grantor Trusts: Non-grantor trusts are either simple or complex. A simple trust mandates income distributions, prohibits principal distributions, and bars distributions to charity. Beneficiaries of simple trusts are responsible for income taxes on trust-generated income. Complex trusts afford trustees more discretion in income and principal distributions, and taxes may be paid by beneficiaries, the trust, or a combination thereof.
Tax Rates and Considerations: Trusts face more aggressive taxation than individuals. In 2023, the top marginal tax rate for trusts starts at $14,450 of income, in contrast to $578,125 for individual filers. Additionally, trusts may be subject to the net investment income tax (NIIT), further increasing their tax liability.
Lowering Taxable Liability: Distributions to trust beneficiaries can result in lower overall taxes, as trusts may deduct distributions. The allocation of income and capital gains to beneficiaries from a distribution depends on the trust's earnings in a given year.
Important Considerations: The choice of a trustee is crucial, as they are responsible for accurate record-keeping and navigating complex trust accounting rules. Trust investment management must align with overall goals, risk tolerance, and beneficiary needs, considering the impact of taxes on the trust's strategy.
Conclusion: The taxation of trusts varies based on grantor or non-grantor status and the distribution of income and principal. Careful consideration of a trust's tax implications is essential to ensure alignment with the original intent of the estate plan. Consulting with experienced professionals, including attorneys and tax advisors, is critical for effective trust planning.
