For federal income tax purposes, the IRS treats trusts as taxpayers that are separate and distinct from its beneficiaries and grantors. The general framework of the tax rules requires trustees to file annual tax returns on Form 1041 to report all income and to pay the appropriate tax. However, when the trust distributes the money to beneficiaries within the same tax year, the responsibility for paying tax can shift from the trust to the beneficiaries.
Trust Income Distributions
Just like individual taxpayers, a trustee can invest the trust's “corpus”, the money and property within the trust. The ordinary income that the trust earns, such as dividends and interest, is taxable to the trust. This means that the trustee responsible for preparing Form 1041 must report it as gross income. However, if the terms of the trust require that the trust distribute all income to its beneficiaries, the trustee must still report the income on the trust’s annual tax return, but it’s the beneficiaries who pay the income tax on the distribution.
Distributions of Capital Gain
Capital gains of a trust refer to the money the trust earns from the sale of property, such as real estate, stocks and bonds. This type of income is also taxable to the beneficiaries who receive a distribution of capital gains. However, unlike the ordinary income the trust earns, the distribution is subject to the capital gains tax rules, which generally impose lower rates of tax. This means that if the trust classifies the gain it distributes to beneficiaries as a short-term capital gain, the beneficiary must treat the distribution as a short-term capital gain on his individual tax return.
Distributions of Corpus
When a trust distributes its corpus to beneficiaries, the amount of the distribution is not taxable to the beneficiaries. The corpus refers to the assets that the grantor of the trust contributes and the income and capital gains the trust accumulates. Moreover, when a trust earns any type of income and fails to distribute it to beneficiaries, it will pay income tax on those earnings. Therefore, to avoid double taxation, the IRS allows beneficiaries to receive this type of distribution without income tax implications.
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. However, just like the individual income tax return you prepare each year, the trust can reduce its taxable income with deductions. 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. Moreover, this deduction is the reason why beneficiaries of the trust must report these distributions on their personal tax returns.