How Are Trusts Taxed?

Regarding trusts and taxation, three main types of taxes often come up: income taxes, estate taxes, and generation-skipping taxes. For this discussion, we’ll focus solely on how trusts are taxed for income tax purposes, as this is often the most relevant and frequently misunderstood aspect of trust taxation.

Trusts are powerful estate planning tools, but understanding how they interact with taxes can help you plan effectively and avoid surprises. The taxation of a trust depends on whether it is a grantor trust or a non-grantor trust, and this distinction is critical to understanding who pays the taxes and how they are reported.

Taxation of Revocable Trusts (Grantor Trusts)

A revocable trust is one in which the person who creates the trust—known as the grantor—retains control over it. This means the grantor can revoke or amend the trust, withdraw assets, or determine how the trust operates. Essentially, the trust and the grantor are seen as one and the same for tax purposes.

Because the grantor retains control over the trust, any income generated by the trust—such as dividends, capital gains, interest, or rental income—is taxed to the grantor personally. This setup is known as a grantor trust, a term you may hear frequently in discussions about revocable trusts.

From a tax reporting perspective:

  • The trust can use the grantor’s Social Security Number (SSN) instead of obtaining a separate tax identification number.
  • All trust income, gains, and losses are reported directly on the grantor’s personal tax return (Form 1040).
  • The trust does not file a separate tax return while it remains revocable and under the grantor’s control.

For example, if a revocable trust earns $5,000 in interest and $10,000 in dividends, this income is included on the grantor’s Form 1040 and taxed according to their tax bracket. While this makes things straightforward, the grantor is fully responsible for any taxes owed.

What Happens When a Trust Becomes Irrevocable (Non-Grantor Trusts)?

When a trust becomes irrevocable, it is no longer considered a grantor trust. This typically happens when:

  1. The grantor passes away, or
  2. The trust terms specify that the trust becomes irrevocable and does not have Grantor Trust Provisions (IRC 671-679).

At this point, the trust becomes its distinct entity for tax purposes, separate from the grantor. As a result:

  • The trust must obtain an Employer Identification Number (EIN), which is similar to a Social Security Number.
  • Any income earned by the trust after it becomes irrevocable is attributed to the trust, not the grantor or beneficiaries.
  • A separate trust tax return, Form 1041, must be filed annually for the trust.

Unlike individuals, non-grantor trusts are subject to compressed income tax brackets. This means trusts reach the highest federal tax rate (37%) faster than individuals. For 2024, the trust income tax brackets are as follows:

  • 10% on income up to $3,150
  • 24% on income between $3,151 and $10,300
  • 35% on income between $10,301 and $14,450
  • 37% on income over $14,450

To put this in perspective, an individual taxpayer would need to earn over $500,000 to hit the 37% tax bracket, but a trust would pay the same rate on income exceeding just $14,450. This compressed bracket structure often results in trusts paying significantly more taxes than individuals earning the same amount.

Why Trust Taxation Can Be Complicated

Trust taxation becomes more nuanced because of the following factors:

  1. Distributions to Beneficiaries: While trusts pay taxes on undistributed income, any income distributed to beneficiaries is generally passed through to them. The trust provides beneficiaries with a Schedule K-1 form outlining the income they must report on their personal tax returns.
  2. Timing of Income: The timing of income recognition and distributions can affect whether the trust or the beneficiaries pay the taxes. Proper planning can help minimize the overall tax burden.
  3. Capital Gains: While ordinary income and dividends are often passed through to beneficiaries, capital gains are usually taxed at the trust level unless the trust terms allow for distribution to beneficiaries.
  4. Deductions and Expenses: Trusts may deduct certain expenses, such as trustee fees, professional services, and administrative costs, which can reduce taxable income.

Given these complexities, working with a qualified accountant or estate planning attorney is crucial when dealing with trust taxation. They can help you navigate the rules, ensure proper reporting, and use tax-saving strategies.

Summary: Key Takeaways

  • Revocable Trusts (Grantor Trusts): The grantor retains control, and all income is reported on their tax return (Form 1040) using their SSN.
  • Irrevocable Trusts (Non-Grantor Trusts): The trust becomes its entity, requiring an EIN and filing a separate tax return (Form 1041). Income is taxed at compressed rates, often leading to higher taxes.
  • Proper planning and understanding of the rules around trust taxation can help minimize tax liability for the trust and its beneficiaries.

If you find this all overwhelming, don’t worry—trust taxation is tricky. The best action is to consult a knowledgeable accountant or attorney who can guide you through the process and ensure you comply with tax laws.

Trusts are powerful tools, but understanding their tax implications is essential to making the most of them.  

If you have questions or need assistance, please contact us today for a comprehensive consultation. Be sure to mention this article to focus on your specific needs.

This article is a service of Miller & Miller Law Group. We do not just draft documents; we ensure you make informed and empowered decisions about life and death for yourself and the people you love.

Related Posts