Do trusts pay taxes? It depends.
Generally speaking, the IRS divides trusts in two broad categories when it comes to the issue of taxation:
- In a grantor trust, the owner (the “grantor” in tax lingo) is treated as an individual taxpayer. All income generated by the grantor trust is reported by the trust owner’s on his/her regular individual return (Form 1040). In essence there is no difference in taxation whether the grantor owns the property in his or her own name or as part of the trust.
- In a non-grantor trust, the trust is considered a separate entity with its own tax ID number that files a fiduciary return on Form 1041 if the trust generates any income during the year.
The language used in the trust agreement determines whether a trust is considered a grantor trust. All other trusts are treated as non-grantor trusts. All living trusts because they benefit the person establishing the trust are grantor trusts during that person’s lifetime.
For non-grantor trusts, the trust gets a deduction against its income for distributions made to the beneficiary during the year. If the trust’s income is greater than its distributions, the trust pays tax on the amount of undistributed income. The concept of Distributable Net Income, or DNI—the maximum amount received by a beneficiary that is taxable—is important to keep in mind. In other words, the beneficiaries receiving distributions from a non-grantor trust will not have taxable income greater than the trust’s income.
Most of the time, trust beneficiaries will pay lower taxes on income than the non-grantor trust. Tax brackets for trusts are closer together than for individuals, which mean you end up paying the maximum rate of tax on undistributed income in a trust. For example, a married couple doesn’t hit the 33 percent income tax rate until their income is $240,000. The threshold for a trust is much lower. A trust might be at the 33 percent rate for undistributed income of $10,000 – $12,000.
You have approximately 65 days after the end of the year (until around March 5) to make a distribution to the trust beneficiary and have that distribution counted on the tax return for that year. For example, you would have until early March 2017 to make a distribution to a trust beneficiary and have that distribution offset income generated by the trust for the 2016 tax year. Don’t forget that taxes are just one factor in a trustee’s decision about trust distributions. A trustee must follow the terms of the trust agreement and pay attention to the needs of the trust beneficiaries.
If you have a non-grantor trust, you can minimize the tax burden by choosing investments wisely. If you need to invest the money of a non-grantor trust, you should consult an estate planning attorney or CPA having experience with trust taxation and a financial advisor.
If you want to understand the tax characteristics of your trust, give Drazen Law Group a call at 203.877.7511. Our experienced attorneys are ready to help.
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