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. One major consideration is the income taxation of the trust itself and how such taxation may result in unintended consequences for an estate plan.
To appreciate trust taxation, it's important to have an understanding of a trust’s principal and income. Generally speaking, 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). Trust accounting sets the rules by which income and expenses are allocated to the trust and what dollar amount may ultimately be available for distribution from the trust.
This article focuses on federal trust income taxation and the Uniform Principal and Income Act (UPIA), but it’s important to understand that individual states may have different rules causing the taxation of a trust to differ from what is outlined here. In all cases, it is best to consult with your tax professional to determine whether a trust strategy may be suitable for you.
Two distinct types of trusts with very different federal income tax implications
Not all trusts are created equal and tax considerations are often a major factor when drafting them. For income tax purposes, a trust is treated as either a grantor or non-grantor trust.
With grantor trusts, the individual who created the trust (also known as the grantor) generally remains the taxpayer with respect to the trust and is responsible for reporting all income and deductions on their individual tax return (Form 1040). 1 Examples of grantor trusts are revocable living trusts and intentionally defective grantor trusts (IDGTs). A revocable living trust allows the grantor to transfer assets into the trust while still maintaining complete control over and access to the assets. The IDGT, on the other hand, does not allow the grantor full control over the assets. Rather it includes some "defects" in the drafting which cause the IDGT to be revocable for income tax purposes, yet irrevocable for estate planning purposes. As an example, trust language may allow the grantor to substitute trust assets with assets of equal value. The trust language gives the grantor some control so that the income is taxed to them, but not enough so that the transfer is deemed completed and irrevocable for transfer tax purposes.
Because the income tax is reported on the individual grantor's tax return, there is often no mandatory separate tax-filing for grantor trusts.2 The activity that is reportable may be summarized on a separate statement known as a grantor tax information letter. The grantor could file a US Income Tax Return for Estates and Trusts (Form 1041) purely for informational purposes but it is not required.
Non-grantor trusts, on the other hand, are treated as separate taxpaying entities. Income taxes generated by the trust are paid for by the trust, and a separate Form 1041 must be filed. The trust's return is filed on a calendar year-end basis and due by the tax deadline of the following year, similar to individual income tax returns. 3
But non-grantor trusts are not always responsible for paying income taxes on all the income generated by the trust. If any portion of the income is distributed to a beneficiary, the trust will take a deduction and the beneficiary will be responsible for the income tax on the distributions. The trust will issue a form K-1 to the beneficiary who will then use that information to calculate the personal income taxes due.
For income tax purposes, non-grantor trusts can be classified as either simple or complex. A simple trust is one that requires mandatory distributions of all income during the taxable year. Simple trusts cannot make any charitable gifts other than from current income and cannot make any distributions of principal.4 A common example of a simple trust is a marital trust, where income is required to be paid to a surviving spouse and the surviving spouse does not receive any principal.
A complex trust is often referred to as an accumulation trust or a discretionary trust. The trustee of a complex trust has discretion over distributions but can only make distributions allowed in the trust document. If a trust's language requires mandatory distributions of income and the trustee also makes a discretionary distribution of principal, it is considered a complex trust. An example of a complex trust is an accumulation trust or a trust which is perpetual in nature and does not require mandatory distributions of income, but instead allows the income to accumulate and grow for a defined time period or for future generations. In the simple trust example above, if the surviving spouse received a distribution of principal, the trust would be treated as complex for the income tax year in which the principal distribution was made.
The table below highlights different types of trusts and the person or entity responsible for the income tax liability.
Trust income tax rates
While income tax rates for trusts are similar to those for individuals, the thresholds differ significantly, and have for a number of years. As of 2020, the top tax rate of 37% on ordinary income (e.g., interest, nonqualified dividends, and business income) begins after reaching a threshold of only $12,950. The top tax rate of 20% for preferential income, such as long-term capital gains (LTCG) and qualified dividends, begins after reaching a threshold of $13,150. Compare these thresholds to those for single filers, where the top marginal tax rate begins after reaching $518,401 of ordinary income— more than a $500,000 difference. There is an even greater disparity between thresholds for married individuals filing jointly, where the top marginal rate begins at $622,051.
Trusts may also be subject to an additional tax for any undistributed investment income, known as net investment income tax (NIIT). Think of this tax as one imposed on "unearned income." While NIIT also applies to individuals, the threshold defining the amount of investment income subject to this tax is extremely low for trusts. For 2020, a trust is subject to NIIT on the lesser of the undistributed net investment income, or the excess of adjusted gross income over of $12,950. 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 for single filers and $250,000 for married couples filing jointly.5
For example, if a single taxpayer has $250,000 of dividends and no other income, $50,000 will be subject to the 3.8% NIIT which is an additional tax of $1,900. If a trust has undistributed dividend income of $250,000 and no other income, $237,050 will be subject to the 3.8% NIIT, which is an additional tax of $9,008.
As you can see, the amount of tax paid on the same amount of income can be much greater when taxed at the trust level rather than the individual taxpayer level.6
How is income reported on the Form 1041?
Form 1041 must report all income generated in the non-grantor trust for the specific tax year. Assuming there are no distributions from the trust, all income will be taxed in the trust. For example, assume that for the tax year ending December 31, 2019, The XYZ Trust has $150,000 of interest, $100,000 of nonqualified dividends, and $100,000 of realized LTCGs. Again, assuming no distributions or deductible expenses, the trust would have total taxable income of $350,000. Since the taxable income of $350,000 is over $12,950 for the trust, the highest ordinary rate and LTCG rate, along with the NIIT, will all apply on the amount in excess of the thresholds.
See the chart below for the initial tax liability without taking into account any deductions for expenses or distributions:
How can we lower the trust's taxable liability?
If a trust's beneficiary is in a lower tax bracket and receives distributions from the trust, such a distribution 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 may be distributed to beneficiaries from a trust.
To calculate the maximum amount that can be distributed to beneficiaries, a concept known as trust accounting income (TAI) must be applied.7 TAI typically includes all forms of income, with the exception of LTCG. Income can also be offset by certain expenses, such as trustee fees, which could result in a deduction to TAI available for distribution to the beneficiary. Essentially, expenses incurred are divided between trust income and trust principal.8
The taxable income of a trust is generally calculated in the same manner as the taxable income of an individual, but the tax may be paid by the trust or by a combination of the trust and its beneficiaries. This is true because trusts are entitled to a deduction known as the Income Distribution Deduction (IDD). IDD is generally defined as the lesser of Distributable Net Income (DNI)9 or the total distributions.10 DNI is a concept used to allocate income between a trust and its beneficiaries.11
In essence, DNI caps the amount of tax a beneficiary may have to pay on a trust distribution. Beneficiaries may receive a distribution that is larger than the trust's DNI but will only be responsible to pay tax on the amount of DNI. This ensures that total taxable income is taxed only once to the trust, the beneficiary, or a combination of both.
Assume, for simplicity purposes, that a trust only generates ordinary income and LTCGs. Even though LTCGs are included in the total or gross taxable income for tax purposes, LTCGs are normally allocated to the principal of the trust and are not part of DNI for distribution purposes. Therefore, if all DNI is paid to the beneficiary, the trust will only pay income tax on LTCGs, while the beneficiary will pay the income tax on the ordinary income.
As mentioned earlier, the income tax on income retained and paid by a trust can be much higher than it would be if it were distributed and taxed to a beneficiary, depending on the beneficiary’s overall tax bracket. As a result, many trustees will consider distributing at least all of a trust’s DNI from a complex trust in a given year.12 It may be logical to assume that since the year end of the trust is December 31, the distributions must be made by then. But the Internal Revenue Service (IRS) provides some extra time, which is referred to as the "65-day rule" or "65-day election" to make the distribution.13 This allows a trustee to make a distribution through the 65th day of the next calendar year.
If this election is made, the distribution would be considered to have been made by the end of the previous tax year. Note that this rule does not apply to simple trusts because the distribution of income is mandatory. Whether the income is distributed by December 31 from either a simple or a complex trust or the trustee makes a 65-day election in a complex trust, the distribution will be considered to have been made by the end of the previous tax year, passing out DNI to the beneficiary. This DNI would then be taxed at the beneficiary or individual level rather than at the trust level.
Below is an example of how TAI and DNI are calculated, along with different distribution scenarios. In all cases you will notice that the same total income is being taxed, but the differences lie in whether the income is being taxed to the trust, to the beneficiary, or to a combination of both.
Relevant tax information:
Interest & nonqualified dividends: $250,000
Trustee fees*: ($50,000)
Adjusted gross income: $300,000
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 all of 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.