When we design a Trust, we want to make sure that it accomplishes your goals. Our focus is usually on balancing protections with access to trust property. But it is also important to understand how a Trust will be taxed. If you are the trustee or the beneficiary of a Trust, it is imperative that you understand how it is taxed.
Trusts can be designed to be taxed to the person who established the Trust (as long as he or she is still living), to the beneficiary of the Trust, or as its own tax entity. In some cases, we go to a lot of effort to ensure that a Trust is taxed a certain way.
Sections 671 through 678 of the Internal Revenue Code set out the circumstances in which a Trust is treated as being owned by the grantor or a beneficiary. Although the beneficiary is sometimes not the grantor, we refer to any Trust that is taxed to an individual as a grantor trust. In both cases, the Trust is not a separate taxpayer. The person deemed to be the owner is responsible for the income tax liability of the Trust, regardless of whether the trust income is distributed to beneficiaries or not. Creating these types of Trusts can help move assets more quickly out of a taxable estate, reduce the amount of tax owed, and greatly simplify tax reporting.
A Trust that is not a grantor trust is a non-grantor trust. Non-grantor trusts are considered a separate tax entity. They are categorized as either simple or complex. A simple trust has three requirements. It must distribute all income to the beneficiaries. It cannot distribute principal. And it cannot make distributions to charities. Any Trust that does not meet the requirements for a simple Trust is a complex trust.
With a simple Trust, all income is distributed to the beneficiaries. The Trust reports all income, but is entitled to a deduction for the entire amount distributed to beneficiaries. The result is that the Trust only pays tax on capital gains. We do not typically prepare simple trusts, because they offer reduced asset protection and still require a separate tax return. With a complex trust, distributions can include ordinary income, dividends, capital gains and principal. The Trust could also earn income that is not distributed, and there may be a deduction for distributions to charities. The result is that the allocation of the tax and any deductions between the Trust and its beneficiaries is more complex.
In many cases, we create Trusts that become complex Trusts upon the grantor’s death. These Trusts provide valuable lifetime protections for children or other beneficiaries. But the taxation is not as simple as it could be if we did not provide those protections. We can also design Trusts that will avoid the fiduciary income tax system and offer greater asset protection than simple Trusts.
When we design a Trust, we have to balance these protections with the administrative burden of managing the Trust. If you are leaving a child $50,000, it may make sense to leave that property in a grantor Trust that allows greater access and does not require a separate tax return. But this will depend on the facts of your specific situation. If creditor protection, divorce protection, or maintaining needs-based government assistance are concerns, this may not be a good option. On the other hand, if you are leaving your child a much larger inheritance, he or she may be better off if there are more protection and flexibility, but a little extra accounting complexity.
It is important to understand what you are doing when you create an estate plan. It is more important to understand what you are doing when you are the trustee of a Trust.