Are proceeds from a trust taxable? Yes, they usually are. But who must pay the tax can vary.
How the IRS treats trusts depends on what format a trust takes. The American Bar Association states that revocable trusts don’t have to independently file tax returns and pay taxes on their income. The grantor or creator of the trust is responsible for paying tax on their own personal tax return.
HG.org Legal Resources explains that for federal income tax purposes, the IRS treats irrevocable trusts as taxpayers that are separate and distinct from their beneficiaries and grantors. The general framework of the tax rules requires trustees to file annual tax returns on the IRS Form 1041 to report all income and to pay the appropriate tax. But responsibility for paying tax can shift from the trust to its beneficiaries when it distributes the money to beneficiaries within the same tax year.
What Is a Corpus Distribution?
A trustee can invest the trust's “corpus.” The Cornell Law School Legal Information Institute describes trust corpus as the property within the trust that forms its body. The term refers to the assets the grantor of the trust contributes, as well as the income and capital gains the trust accumulates. All the rights, titles or interests that the trust has in the property are part of the corpus.
When part of the property within the trust is distributed to a designated beneficiary, this is known as a corpus distribution. It's different from a trust income distribution.
The amount of the distribution is not taxable to the beneficiaries when a trust distributes its corpus to them. The trust – or the grantor in the case of a revocable trust – will pay income tax on those earnings when a trust earns any type of income and if it fails to distribute it to its beneficiaries. The IRS allows beneficiaries to receive this type of distribution without income tax implications to avoid double taxation.
Trust Income Distributions
Ordinary income that the trust earns, such as dividends and interest, is taxable to the trust or to its grantor if it's a revocable trust. This means that the trustee who is responsible for preparing Form 1041 must report it as gross income.
The trustee must still report the income on the trust’s annual tax return if the terms of the trust require that it must distribute all income to its beneficiaries, but the beneficiaries pay the income tax on the distribution.
Distributions of Capital Gains
Capital gains are the money a trust earns from the sale of property, such as real estate, stocks or bonds. This type of income is also taxable to the beneficiaries who receive a distribution of capital gains. But unlike the ordinary income the trust earns, this distribution is subject to the capital gains tax rules.
Capital gains are generally taxed at lower rates than ordinary income. The rate depends on how the trust reports the income. The beneficiary must treat the distribution as a short-term capital gain on their individual tax return if the trust classifies the gain as short term.
Income Distribution Deduction
The trustee who prepares the annual tax return for a trust must report all income and capital gains it earns in the income section of Form 1041, regardless of whether the trust retains the income or distributes it to beneficiaries. But the trust can reduce its taxable income with deductions, just as an individual taxpayer can.
The principal way that a trust avoids double taxation is with the income distribution deduction. This allows the trust to reduce the gross income it reports by the amount it distributes to beneficiaries within the same tax year it earns the income. This deduction is the reason why beneficiaries of the trust must report these distributions on their personal tax returns.
- American Bar Association: Death and Taxes: Estate Planning with Gift and Estate Tax Strategies
- HG.Org: Explanations of Irrevocable Trusts
- Cornell Law School Legal Information Institute: Trust Corpus
- Cornell Law School Legal Information Institute: 26 CFR § 1.651(a)-3 - Distribution of Amounts Other Than Income
- IRS: Form 1041 U.S. Income Tax Return for Estates and Trusts
Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.