How Are Trust Fund Earnings Taxed?

Trust funds are estate planning vehicles, and the proceeds are taxed, just like earned income and capital gains from the sale of stocks and property. Read on to learn how trust funds are reported to the Internal Revenue Service (IRS).

Key Takeaways

  • Trust funds are legal entities primarily used in estate planning to build and transfer wealth to beneficiaries.
  • The amount distributed to the beneficiary from a trust fund is from the current-year income first, then from the accumulated principal.
  • Grantor trusts are trusts in which the grantor controls all aspects of the trust and is responsible for reporting and paying taxes.
  • If the income or deduction is part of a change in the principal or is part of the estate's distributable income, then income tax is paid by the trust and not passed on to the beneficiary.
  • Form 1041 reports income earned from the grantor's date of death, and Schedule K-1 reports distributions made to beneficiaries of trusts.

Understanding a Trust Fund

Trust funds are estate planning tools used to accumulate wealth for future generations. When established, a trust fund becomes a legal entity that holds property or other assets such as cash, securities, personal belongings, or any combination of these in the name of a person, persons, or group. A trustee is an independent third party with no relationship with the grantor or the beneficiary and manages the trust.

There are two main types of trusts, revocable and irrevocable. A revocable trust, or living trust, holds the grantor's assets. These assets can be transferred to any beneficiary the grantor appoints. Changes can be made while the grantor is alive. An irrevocable trust cannot be modified, amended, or revoked but avoids confusion issues at probate.

Other kinds of trusts include:

Taxing Trust Funds

Trust funds are taxed differently, depending on their structure. The IRS permits trusts to claim a tax deduction for income distributed to beneficiaries, and the beneficiary pays the income tax on the taxable amount rather than the trust.

Distributions to beneficiaries come from the current-year income first and then the principal. Distributions from the principal are non-taxable. Capital gains on the principal amount may be taxable to the trust or the beneficiary. Amounts distributed to and for the beneficiary are taxable to them up to the deduction claimed by the trust.

Form 1041 is used to report income earned from the grantor's date of death, and Schedule K-1 reports distributions made to beneficiaries of trusts. For deaths that occurred in 2022 or 2023, the highest trust tax rate is 37%.

A trust fund is different from a foreign trust, which has become a popular way to circumvent the U.S. tax system. Foreign trust owners must report earnings using form 3520 or form 3520-A.

Grantor vs. Non-Grantor Trusts

Grantor Trusts

A grantor trust is a trust in which the grantor controls the trust's assets and is responsible for reporting and paying taxes on the trust's income. All revocable trusts are grantor trusts, but not all grantor trusts are revocable.

A grantor creates the trust fund and the owner of the contributed assets. Grantors set the terms and conditions of the trust and can change the beneficiaries, investments, and trustees. Because grantors have full authority to make changes, they can terminate the trust or revise it to an irrevocable trust.

Income is reported on the grantor's tax return instead of the trust's. Many wealthy people favor grantor trusts over non-grantor trusts because their income tax rates are generally lower than trust tax rates.

Non-Grantor Trusts

Non-grantor trusts are those where the grantor is not responsible for reporting income or paying taxes for the trust. The trust, operating as a separate tax entity, is responsible for reporting and paying taxes on income.

Beneficiaries must report and pay taxes on income distributions. In return, the trust claims a tax deduction for the amount distributed. Non-grantor trusts are either simple or complex. All earned income in a simple trust must be distributed annually to a beneficiary or beneficiaries. However, no distributions from the principal are allowed, and distributions cannot be made as charitable donations.

Conversely, the trustee uses discretion when distributing income from a complex or discretionary trust. Distributions from the principal and those made to charities are permitted.

Reporting Taxable Income

Schedule K-1 is an IRS tax form to report a beneficiary's income, credits, and deductions from a trust or estate. For trusts, distributions are taxable to the beneficiary, and the trust must file a Schedule K-1 for each beneficiary. The beneficiary will then report the income on their tax return.

The trust must also generate a Form 1041 to report the total amount of income the trust earned from the grantor's date of death. The form also reports the total amount paid to beneficiaries for the reportable tax year.

All Schedule K-1s and Form 1041 must be submitted with the trust's tax return. To claim the IRS Income Distribution Deduction, the trust must complete and submit Schedule B of Form 1041 with the return. The deduction is the lesser of the distributable net income (DNI) or the amounts distributed or required to be distributed to the beneficiaries. For complex or discretionary trusts, income not distributed cannot be deducted.

Do You Have to Pay Taxes on Money Inherited From a Trust?

Beneficiaries are responsible for paying taxes on money inherited from a trust. However, they are not responsible for taxes on distributed cost basis or principal.

What Are the Tax Advantages of a Trust?

Irrevocable trusts allow amounts to be contributed annually without being subject to gift taxes. The annual exclusion is $16,000 for 2022 and $17,000 for 2023. Also, their assets are generally protected from estate taxes.

At What Rate Is Trust Income Taxed?

A grantor trust's income is taxable as ordinary income to the grantor. A non-grantor trust's income is taxable to the trust, and the maximum tax rate for 2022 and 2023 is 37%.

The Bottom Line

Most trust funds can be established to avoid probate and offer significant tax advantages. Depending on the type of trust, its income is either taxable to the grantor or the trust. The tax rates are lower for individuals than for trusts. Despite the type of trust selected, trusts can help protect assets and pass on wealth to heirs.

Article Sources
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  1. Internal Revenue Service. "2023 Form 1041-ES."

  2. Internal Revenue Service. "Foreign Trust Reporting Requirements and Tax Consequences."

  3. TaxSlayer Pro. "Form 1041 - Income Distribution Deduction."

  4. Internal Revenue Service. "What's New - Estate and Gift Tax."

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