How Are Trust Fund Earnings Taxed?

There are two things you can't avoid in life: death and taxes. While there are ways you can minimize your tax implications, you certainly can't get rid of the tax collector.

Almost everything we touch is taxed, from earned income to capital gains from the sale of stocks and property; even assets received from an estate are taxed. 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 learn more about these vehicles and how they're 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.

What Is 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 like money, securities, personal belongings, or any combination of these in the name of a person, persons, or group. A trustee, an independent third party who has no relationship with the grantor or the beneficiary, 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 to the trust can be made while the grantor is alive. On the other hand, an irrevocable trust is hard to change but avoids issues with probate.

Other kinds of trusts include, but aren't limited to, the following:

  • Blind trusts
  • Charitable trusts
  • Marital trusts
  • Testamentary trusts

Taxing Trust Funds

Trust funds are taxed differently, depending on their structure.

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 using form 3520 or form 3520-A.

The IRS permits trusts to claim a tax deduction for income distributed to beneficiaries. In this case, 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 principal. Distributions from the principal and non-taxable as taxes have been paid. Capital gains from this amount may be taxable to either the trust or the beneficiary. Amounts distributed to and for the beneficiary are taxable to them up to the deduction claimed by the trust.

If the income or deduction is part of a change in the principal or part of the estate's distributable income, the income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that retains earnings and has discretion in the distributions pays a trust tax of $3,146 plus 37% of amounts exceeding $13,050.

Grantor vs. Non-Grantor Trusts

Trusts are characterized as either grantor trusts or non-grantor trusts, and within each are different sub-types.

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 is usually 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 also terminate the trust or transform it into an irrevocable trust.

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

Non-Grantor Trusts

Alternatively, non-grantor trusts are those in which 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 distributed to them. 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 to a beneficiary or beneficiaries annually. However, no distributions from the principal are allowed, and distributions cannot be made as charitable donations.

On the other hand, the trustee uses their discretion when distributing income from a complex or discretionary trust. Distributions from the principal are allowed, as well are distributions made directly to charities.

Non-grantor trusts must have their own tax identification number (TIN), which is used for tax reporting.

Reporting Income

Schedule K-1 is an IRS tax form that reports 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 paid. 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 for certain amounts to be contributed annually without being subject to gift taxes. The annual exclusion for gifts is $15,000 for 2021 and $16,000 for 2022. 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 is 37%.

The Bottom Line

For some, trust funds are an estate-planning must-have. Most avoid probate and offer significant tax advantages. Depending on the type of trust, its income is either taxable to the grantor or the trust, with the former preferred as 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. "Foreign Trust Reporting Requirements and Tax Consequences."

  2. Internal Revenue Service. "2021 Instructions for Form 1041 and Schedules A, B, G, J, and K-1," Page 30.

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

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

  5. JD Supra. "Estate Planning 2022 Federal Tax Update."

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