Taxation of Trusts Simplified
Trusts are Separate Taxpayers
All trusts are
separate taxpayers. Unless disregarded under the exception for grantor
trusts discussed below, each trust has its own tax year and tax
accounting method. Trusts also receive income and pay expenses. Net
income is taxed either to the trust or to the beneficiaries, depending
upon the trust terms, local law and, in the cases of complex trusts
(defined below), whether the trust distributed the income.
If a trust permits accumulation of income and the trust does not distribute it, the trust pays tax on the income.
a trust distributes or is deemed to have distributed the income to the
beneficiaries, the trust can deduct the amount of the distribution and
the beneficiaries must include it as income.
A trust’s distributable net income (DNI) determines the amount of the
distribution the trust can deduct, and the amount the beneficiary must
report as income. Thus, DNI acts as a ceiling on the amount of the
deduction a trust can take for distributions to beneficiaries. DNI also
acts as a ceiling on the amount of the distribution that the
beneficiary must account for on his or her income tax return.
As a general rule, distributions from a trust are first taken from DNI, then from principal.
An explanation of the DNI calculation is beyond the scope of
this newsletter. However, it is important to note that this is an area
where the client’s wealth planning team must work together to ensure
that the income taxation flows as the client desires. For example, as a
general rule, capital gains will be subject to taxation at the trust
level except in the year the trust terminates. However, if the client
so desires and if it is permissible under state law, the lawyer can
draft the trust agreement so that it defines trust income to include
capital gains, thereby passing the capital gains tax liability to the
beneficiary.
It is critical that the client’s wealth planning team work together to ensure that trust income will be subject to taxation as
the client desires.
Simple vs. Complex Trusts
The Internal Revenue Code defines a simple trust as a trust that:
- By its terms must distribute all of its income (meaning fiduciary accounting income) currently;
- Makes no principal distributions; and
- Makes no distributions to charity.
The regulations to the Internal Revenue Code define a complex trust as a trust that is not a simple trust; in other words, a trust that:
- Is allowed by its terms to accumulate income;
- Makes discretionary distributions of income or mandatory or discretionary distributions of principal; or
- Makes distributions to charity.
Grantor Trusts
The Internal Revenue Code defines a grantor trust
as a trust in which the trust maker has one or more of the powers
specifically described in Sections 673 to 677. A trust can also be a
grantor trust as to a beneficiary where the beneficiary has one or more
of these same powers if the beneficiary also has or had the power over
the trust principal described in Section 678. To the extent a trust is
a grantor trust, it functions as a conduit; in other words, all of the
income, deductions, credits, etc., flow through to the trust maker or
beneficiary and are subject to tax on their own personal tax return,
regardless of whether the trustee makes distributions from the trust.
The general rules governing the income taxation of trusts and their
beneficiaries do not apply to grantor trusts due to application of
these rules.
Revocable trusts are grantor trusts as to their trust maker(s) and thus a revocable trust’s income and deductions flow
through to its trust maker(s).
Grantor trusts are powerful planning tools because of the fact that the trust is the same as the grantor for income tax
purposes. Thus, a sale by a grantor to a grantor trust does not trigger income tax.
It is now clear that with a grantor trust, the grantor’s payment of the
trust income tax does not constitute a gift to the trust beneficiaries.
Thus, for those clients who are willing to pay this tax, grantor trusts
are also excellent vehicles to leverage gifts to beneficiaries.
By paying the income tax of a grantor trust, the grantor is in essence making an additional contribution to the trust,
but one that is not subject to gift tax.
Grantor Trusts and Life Insurance
Grantor trusts also can be very useful in the context of transfers of
life insurance. When transferring life insurance (for example, from the
insured to avoid estate tax inclusion or to a "new" irrevocable life
insurance trust), consider selling the policy for full and adequate
consideration to a trust that is a grantor trust as to the insured. As
long as the sale is for the policy’s full fair market value, such a
transfer will avoid the three-year estate tax inclusion rule, and it
will not invoke the transfer-for value rules.
A sale of life insurance to a grantor trust for full and adequate consideration avoids both the three-year estate inclusion
rule for transfers of ownership and the transfer-for value rule.
Compressed Income Tax Brackets for Trusts
A frequent objection to the accumulation of trust income is the fact
that trusts pay federal income tax according to a compressed rate
schedule. In other words, trusts pay the maximum federal income tax
rate of 35% at only approximately $10,500 of income per year in 2007,
compared to approximately $350,000 for single taxpayers, heads of
household, or those married filing jointly.
On its face, it appears that it may be costly from an income tax
perspective to accumulate trust income. However, the critical questions
are, what type of income is it and, if interest or rent income, will
accumulation result in additional tax? In other words, what are the
relative tax rates of the beneficiaries?
The compressed tax rates for trusts only apply to accumulated interest and rent income. Trusts pay the same rates as
individuals for capital gains and dividend income. Thus, careful investment of trust assets can reduce or eliminate the impact
of compressed tax rates.
If the trust beneficiaries are already in the maximum federal
income tax bracket, accumulation of interest income will not cause
additional tax. In fact, with these beneficiaries, accumulation of
trust income may actually reduce their overall income tax by not
phasing out deductions and credits.
If the trust beneficiaries are not in the maximum federal income tax bracket, what are their relative tax brackets? The tax
impact of income accumulation is the difference in the tax rates, likely an additional 7% or less, not the full 35%.
Furthermore, trust makers can give a trustee the ability not only to
distribute directly to a beneficiary (which is not good for asset
protection), but also the discretion to make distributions on behalf of
a beneficiary such as to pay rent, medical expenses, tuition, credit
card bills, etc.
Distributions on behalf of a beneficiary are distributions to
the beneficiary for tax purposes and will be subject to tax at the
beneficiary’s rates. Such distributions are also good for asset
protection because the trustee does not make them directly to the
beneficiary. Thus, to the extent the trustee is able to "distribute" to
pay for these needs directly, trust income will be taxed at the
beneficiary’s income tax rate.
Conclusion
A working knowledge of the taxation of trust income is important
for the client’s entire wealth planning team. By working together, the
team can often minimize the overall tax impact and help ensure that our
plan meets the client’s unique planning objectives.
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