The Taxing of Trust Fund Earnings
Death and taxes. These are two things you can't avoid in life. While there are ways you can minimize your tax implication, you certainly can't get the tax collector off your back. Virtually everything we touch is taxed, from our income to the gains made on sales from stocks and property, even down to the assets we receive from an estate. The same can be true of trust funds, which have a relationship with both death and taxes. But how exactly are these estate tools taxed, and what are they? Read on to find out more about these vehicles and how they're reported to the Internal Revenue Service (IRS).
What Is a Trust Fund?
Trust funds are tools used in estate planning and are set up to help accumulate wealth for future generations. When established, a trust fund becomes a legal entity that holds either property or other assets like money, securities, personal belongings—or any combination of these—in the name of a person, people, or group. The trust is managed by a trustee, an independent third-party who has no relationship to the grantor—the person who sets up the trust—or the beneficiary.
Trust funds can be both revocable and irrevocable—the two main types of trusts. A revocable trust also referred to as a living trust, holds the grantor's assets, which can then be transferred to any beneficiaries the grantor appoints after their death. But any changes to the trust can be made while the grantor is still alive. An irrevocable trust, on the other hand, is hard to change but does avoid any issues with probate.
Other kinds of trusts include, but aren't limited to, the following:
- Blind trusts
- Charitable trusts
- Marital trusts
- Testamentary trusts
Note that a trust fund is different from a foreign trust, which has become popular recently as a way to circumvent the U.S. tax system. Foreign trust owners must report using form 3520 or form 3520-A.
Taxing Trust Funds
Trust funds are taxed differently, depending on the type of fund they are. A trust that distributes all of its income is considered a simple trust, otherwise, the trust is said to be complex. A tax deduction is made for income that is distributed to beneficiaries. In this case, the beneficiary pays the income tax on the taxable amount rather than the trust.
Trust funds are taxed differently, according to a variety of variable factors.
The amount distributed to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is usually the original contribution plus subsequent ones and is income in excess of the amount distributed. Capital gains from this amount may be taxable to either the trust or the beneficiary. All the amounts distributed to and for the benefit of the beneficiary are taxable to them to the extent of the distribution deduction of the trust.
If the income or deduction is part of a change in the principal or part of the estate's distributable income, then income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in the distribution of amounts and retains earnings pays a trust tax that is $3,011.50 plus 37% of the excess over $12,500.
Schedule K-1 is a form used for a number of different purposes. In the case of a trust, distributed amounts generated by the trust are taxed and handed over to the IRS. The IRS, in turn, delivers the document to the beneficiary to pay the tax. The trust then completes Form 1041 to determine the income distribution deduction that is accorded on the distributed amount.
- The amount distributed to the beneficiary from a trust fund is considered to be from the current-year income first, then from the accumulated principal. Capital gains from this amount may be taxable to either the trust or the beneficiary.
- If the income or deduction is part of a change in the principal or part of the estate's distributable income, then income tax is paid by the trust and not passed on to the beneficiary.
- The K-1 schedule for taxing distributed amounts is generated by the trust and handed over to the IRS.