Several types of trusts exist, created primarily for estate planning, retaining assets for beneficiaries and other specific purposes. Family trusts are designed for the benefit of members of the same family. Simple family trusts distribute all income to beneficiaries annually or more often, while complex family trusts do not distribute all income.
Any trust generating more than $600 in income annually must report this income to the IRS. States may also impose a family trust tax, although taxation depends on the laws of a particular state.
The specific format of your trust will determine how it is taxed on a federal level. For example, revocable living trusts are taxed at the income bracket of the grantor, while non-grantor trusts rely on a family trust tax.
Understanding Family Trusts
Many family trusts are revocable living trusts, also known as inter vivos trusts. Such trusts are established by a grantor who places property in the trust, controls the assets, and may buy and sell them as long as he or she is alive. The grantor is often the trustee, the person appointed to manage the trust. The grantor is considered the owner of the trust by the IRS, reports income on their tax return, and is taxed according to their income tax bracket.
Often, the only beneficiary of a revocable living trust is the grantor, but upon their death, the trust becomes irrevocable, and assets in the trust are distributed to designated beneficiaries. Revocable living trusts avoid probate and afford the family privacy when it comes to the matter of estate distribution. For the most part, revocable living trusts do not save on either income or estate taxes, meaning that the tax benefits of a trust are negligible.
Non-Grantor Trusts and Possible Deductions
Other family trusts are non-grantor trusts, in which the grantor is not a beneficiary or trustee. A non-grantor trust must obtain a taxpayer identification number for IRS purposes. In these scenarios, a family trust tax will likely be implemented.
Unlike individual tax returns, there is no standard deduction for non-grantor trusts, but they do get a deduction for distributions to beneficiaries. For 2020, trusts pay the same income tax rates as individuals. The highest trust tax rate, 37 percent, starts when the trust earns just $12,950 in income.
Obtaining Income Tax Forms
Income, gains, losses and deductions for non-grantor family trusts are reported on Form 1041, the U.S. Income Tax Return for Estates and Trusts. The same form is also used to report trust distribution to beneficiaries or held for future beneficiary distribution. Any income tax liability incurred by the trust is included on this form as well as employment tax for wages paid to household employees.
If the income was distributed to the beneficiaries, then those individuals must pay the actual tax. Each beneficiary receives a Schedule K-1 from the trust showing the distributions, which they report to the IRS on their individual income tax returns. The trust, in turn, can deduct such distributions. If the trust retained income, then it must pay the taxes.
There is a caveat. Income from a trust is taxable, but distributions from the trust’s principal are not. The IRS assumes that assets placed into the trust were already taxed. The Schedule K-1 will delineate for the beneficiary what part of their distribution was income and what was principal.
Considerations for Family Trusts
If you were thinking about creating a family trust so that you or your heirs may end up not paying taxes, think again. The IRS is well aware of those promoting family trusts as a way to evade taxes, and it looks out for such schemes. Non-grantor trusts, especially, are used for such illicit purposes. The IRS opens its explanation of non-grantor trust taxation with the words “If the trust is not a sham,” so seek professional help if you plan to establish a trust.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including Sapling, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.