Beneficiaries of a trust typically pay taxes on the distributions they receive from the trust's income, rather than the trust itself paying the tax. However, such beneficiaries are not subject to taxes on distributions from the trust's principal.

When a trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. The K-1 indicates how much of the beneficiary's distribution is interest income versus principal and, thus, how much the beneficiary is required to claim as taxable income when filing taxes.

Key Takeaways

  • Trusts are subject to different taxation than ordinary investment accounts.
  • Trust beneficiaries must pay taxes on income and other distributions that they receive from the trust, but not on returned principal.
  • IRS forms K-1 and 1041 are required for filing tax returns that receive trust disbursements.

Understanding Trusts and Beneficiaries

A trust is a fiduciary relationship whereby the trustor or grantor gives another party—the trustee—the right to hold property or assets for the benefit of a third party (usually the beneficiary).

Trusts are established to provide legal protection and to safeguard assets usually done as part of estate planning. Trusts can be used to ensure the assets are properly distributed to the beneficiaries according to the wishes of the grantor. Trusts can also help to reduce estate and inheritance taxes as well as avoid probate, which is the legal court process of distributing assets upon the death of the owner.

Although there are several types of trusts, they typically fall into one of two categories. A revocable trust can be changed or closed at any time during the grantor's lifetime.

Conversely, an irrevocable trust cannot be amended or closed once it has been opened, including those trusts that become irrevocable upon the grantor's death. The grantor—by establishing an irrevocable trust—essentially has transferred all ownership or title of the assets in the trust.

There are various tax rules for beneficiaries of income from trusts, depending on whether the trust is revocable or irrevocable—as well as the type of income received from the trust.

Interest vs. Principal Distributions

When trust beneficiaries receive distributions from the trust's principal balance, they do not have to pay taxes on the distribution. The Internal Revenue Service (IRS) assumes this money was already taxed before it was placed into the trust. Once money is placed into the trust, the interest it accumulates is taxable as income, either to the beneficiary or the trust itself.

The trust must pay taxes on any interest income it holds and does not distribute past year-end. Interest income the trust distributes is taxable to the beneficiary who receives it.

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 amount distributed to and for the benefit of the beneficiary is taxable to him or her 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, 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.

Tax Forms

The two most important tax forms for trusts are the 1041 and the K-1. Form 1041 is similar to Form 1040. On this form, the trust deducts from its own taxable income any interest it distributes to beneficiaries.

At the same time, the trust issues a K-1, which breaks down the distribution, or how much of the distributed money came from principal versus interest. The K-1 is the form that lets the beneficiary know the tax liability from the trust's distributions.

The K-1 schedule for taxing distributed amounts is generated by the trust 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.