A trust can be an excellent means to manage your wealth. It allows one to control how and in what manner their assets are passed down to their heirs, as well as possibly save on taxes. Despite the prevalence of trusts (over 180,000 trusts filed a return in Texas alone in 2014), there’s a lot of confusion over how and when a trust is taxed, and what the tax implications are for beneficiaries.
Before we dive in, we need to define what a trust is, and what types of trusts exist. Simply put, a trust is a fiduciary arrangement that allows a third party (or trustee) to hold assets on behalf of a beneficiary or beneficiaries. There are many types of trusts out there, with many more variations, but most boil down to one of three types: Grantor, Simple, and Complex. Most Grantor trusts are revocable; that is, the Grantor (the person funding the trust) can revoke the trust at any time, and maintains control over the assets. Simple and Complex trusts are irrevocable; the Grantor has no control over the assets once they enter the trust, and they cannot alter or end the trust. A Simple trust must distribute all of its income each year to its beneficiaries; a Complex trust is not required to distribute its income each year, and usually has predefined conditions under which distributions are made.
Grantor trusts do not file their own return. Instead, all trust income is reported on the Grantor’s 1040. Simple and Complex trusts, however, file a separate Form 1041 tax return. Even if you plan on hiring someone to prepare the 1041 for you, there are a few items to keep in mind:
- Assets used to fund the trust are considered principal, not income. Trusts (and trust beneficiaries) are taxed on income generated by the trust’s assets; the IRS assumes that any assets contributed to the trust have already been taxed.
- Beneficiaries pay taxes on any distributions of income they receive from the trust. For example, let’s say you are the sole beneficiary of a trust that earned $1,000 of income last year. The trust will report that income on its 1041 return, but not pay any taxes on it. In turn, the trust will issue you a K-1 listing this amount, which you will need to include as income on your personal 1040 return.
- Trusts pay taxes on any income generated in the trust that is *not* distributed. Depending on if it’s a Simple or Complex trust, the first $100 or $300 of income will be exempt; the remaining amount of undistributed income will be taxed to the trust, usually as long-term capital gains.
- Distributions of principal are not taxable. The rule of thumb to use is to remember that the IRS usually only taxes income once; since the assets used to fund the trust were assumed to have already been taxed, distributions of those assets are likewise considered already taxed.
Trusts can be confusing, and the above is meant simply as an overview for a few key issues. If you have questions regarding more complex situations, you should contact a CPA, financial planner, or attorney that specializes in trusts to ensure you get the answers you need.