When the settlor of a trust passes away, tax implications of trust distributions become important. Trust tax rates can hit beneficiaries and trustees hard. Stone & Sallus can help you break it down so you know when trust distributions are taxable and how they affect you.
Trusts Overview
A trust is a legal arrangement designed to manage and protect assets, ensuring they are distributed according to the settlor’s wishes.
Types of Trusts
- Revocable Trusts: Settlor has control during their lifetime and the trust becomes irrevocable at their death.
- Irrevocable Trusts: The settlor gives up control of assets once the trust is created.
Grantor vs. Non-Grantor Trusts
- Grantor Trusts: The settlor is responsible for taxes during their lifetime.
- Non-Grantor Trusts: Trust or beneficiaries pay taxes.
Key Parties:
- Grantor: Creates the trust.
- Trustee: Manages the trust.
- Beneficiary: Receives distributions.
How Trust Distributions Work
Trust distributions typically fall into two categories: income and principal.
Income Distributions: These are from interest, dividends or rental income of trust assets. Beneficiaries who receive income distributions pay taxes on them.
Principal Distributions: These are the original assets of the trust and are not taxable to the beneficiary unless special circumstances apply (e.g. certain inherited IRAs).
Taxation of Trust Income Distributions
Beneficiaries are often taxed on income passed through the trust. Here’s what to know:
- Taxable Income: Beneficiaries report income distributions on their individual tax returns using IRS Form K-1.
Trust Tax Rates vs. Individual Tax Rates:
Trusts reach the highest tax brackets faster than individuals. For example, in 2023, trusts hit the top federal tax rate of 37% on income over $14,450 compared to $578,125 for individuals.
Understanding these thresholds is crucial for optimizing tax outcomes.
Trust Tax Rates
Revocable Trust Taxes:
- During the settlor’s lifetime, the trust is not taxed separately. Income is reported on the settlor’s personal tax return.
- Upon the settlor’s death, the trust becomes irrevocable and is taxed as a separate entity.
Irrevocable Trust Taxes:
- Trust or beneficiaries pay taxes on income depending on whether income is retained or distributed.
Taxation of Principal Distributions
Distributions from the principal are generally not taxable to beneficiaries. However, there are exceptions:
- Inherited Retirement Accounts: Certain distributions, like those from an IRA held in a trust, may trigger tax obligations.
- Capital Gains: If the trust sells assets to fund a distribution, capital gains taxes may apply.
Special Tax Considerations for Trusts
- Capital Gains: If the trust retains capital gains, it pays taxes at trust tax rates. If distributed, beneficiaries may report the gains on their tax returns.
- State Income Taxes: Some states impose additional taxes on trust income, depending on where the trust is administered.
- Foreign Trusts: These may involve complex reporting requirements and higher tax liabilities.
Strategies to Minimize Tax Liability
- Timing Distributions: Coordinate distributions to beneficiaries in lower tax brackets to reduce overall tax exposure.
- Electing Trust Status: Choosing between a simple or complex trust can influence tax outcomes.
- Deductions: Trustees can deduct certain expenses, such as administrative costs, to offset taxable income.
When to Seek Professional Advice
Navigating trust taxes can be complicated. Consulting an attorney such as Stone & Sallus ensures that trusts are structured and administered effectively to minimize tax burdens. Our professionals can also provide guidance on compliance with federal and state tax laws, including questions like “Do trusts pay taxes?” or “Who pays property taxes in a trust?”. Contact us today to get started.
