Taxation of Trusts and their Beneficiaries
Trusts, like estates, are a taxable entity. A trust is a fiduciary entity whose objective is to hold and invest money or property held in the trust for the benefit of the beneficiaries. Trust property consists of principal (aka corpus), which is the property transferred to the trust by the grantor, and income earned by the trust, usually from investments. If the trust retains income beyond the end of the calendar year, then it must pay taxes on it. If money is distributed to the beneficiaries, then whether it is taxable or not to the beneficiaries will depend on whether principal or income was distributed, and if it was income, then whether it was tax-free income or retained income from previous years that the trust has already paid tax on. Because trusts are not subject to double taxation, either principal or income on which the trust paid taxes can be distributed tax-free to the beneficiaries. Likewise, any taxable distribution to beneficiaries is deductible by the trust.
Gift taxes may also apply to either property transfers to a trust or distributions to beneficiaries. Property transfers to an irrevocable trust may be subject to gift tax, but for revocable trusts, gift tax liability will not be incurred until the property is transferred to a beneficiary or when the trust becomes irrevocable.
A trust must use a calendar year. If the trust has taxable income or gross income of $600 or more, or if any of the beneficiaries are non-resident aliens, then it must file Form 1041, U.S. Income Tax Return for Estates and Trusts and may also have to make estimated tax payments.
A simple trust is one that is required to distribute all of its income and no amount is paid or set aside for charitable contributions. Otherwise, the trust is a complex trust. Capital gains, under most state laws and trust documents, are allocated to corpus.
The complexity of trust taxation arises because of several factors:
- The trust is a taxable entity.
- Beneficiaries usually have to pay tax on the income that they receive from the trust.
- Trusts are not subject to double taxation, so any taxable income distributed to the beneficiaries is deductible by the trust.
- Money distributed to beneficiaries retains its character, so that, for example, if the trust distributes long-term capital gains to the beneficiaries, then they will list it as a long-term capital gains on their tax returns.
- Most income earned by the trust is taxable, but the principal is not. Therefore, if the trust distributes both principal and income, then the trust must allocate the principal and income to each beneficiary.
Generally, the tax rules that apply to trusts are the same as those that apply to individuals, but the actual calculation is more complex:
- calculate trust accounting income;
- calculate the tentative taxable income before subtracting the distribution deduction, which is the amount that the trust can deduct because of the distribution;
- calculate the distributable net income (DNI) so that the distribution deduction can be calculated and so that tax-free and taxable distributions can be allocated to the beneficiaries;
- subtract the distribution deduction from the tentative taxable income to determine trust taxable income;
- calculate trust tax liability;
- allocate DNI and the distribution deduction to the beneficiaries to determine the character and the amount of income taxed to each beneficiary.
Trust Accounting Income
When a trust earns income or pays expenses, the income or expenses are allocated either to principal or to income. In most cases, the trust document specifies which income or expenses are allocated to the principal or to income. If the trust document does not specify the allocation, then state law applies. Most states have adopted all or part of the Uniform Principal and Income Act (UPIA). The UPIA allocates:
- to accounting income:
- operating income,
- operating expenses,
- depreciation of trust assets,
- interest, dividends, rents, and royalties,
- taxes on accounting income.
- to principal:
- capital gains and losses,
- casualty gains and losses and insurance recoveries,
- extraordinary repairs and capital improvements on trust property,
- taxes on trust principal.
Example — Allocating Income or Expenses to Principal or Income
If a trust has a single beneficiary and:
- Trust principal = $100,000
- income = $10,000
- trustee fees = $2000
- the trust document stipulates that there be a 50% allocation of expenses between principal and income.
- income beneficiary receives $10,000 – ($2000 × 50%) = $10,000 – $1000 = $9000
- trust principal declines to $100,000 – $1000 = $99,000.
Trust Tentative Taxable Income
Trust taxable income is generally determined as it is for individuals. However, a trust does not usually itemize deductions, and a trust also has a personal exemption, which is $300 for trusts that are required to distribute all of their income annually to beneficiaries and $100 for all other trusts. Generally, trust income is defined as income that is earned from investments, including tax-free income, but does not include capital gains on trust assets. However, taxable income includes all income earned by the trust, including capital gains, minus tax-free income.
Example: A trust has the following income:
- tax-free bond interest: $1000
- dividend income: $2000
- capital gains: $3000
- trust income = $1000 + $2000 = $3000
- taxable income = $3000 + $2000 = $5000.
Typical trust expenses include trust administration expenses, expenses for the production of income, depreciation, and charitable contributions. However, expenses for the production of tax-free income are not deductible and depreciation can be claimed either by the trust or by the income beneficiaries or it can be apportioned to both according to the trust document.
Only a complex trust can deduct charitable contributions, but only if the trust document specifically allows it. Charitable deductions are claimed on Form 1041-A, U.S. Information Return for Trust Accumulation of Charitable Amounts.
Example: A trust has $20,000 of accounting income and $10,000 of depreciation. The single income beneficiary of the trust receives $8000. Because the trust document does not specify an allocation of depreciation, the trust can claim $10,000/$20,000 × $10,000 = 1/2 × $10,000 = $5000 of depreciation and the income beneficiary can claim the other $5000 of depreciation, reducing the beneficiary's taxable income = $8000 – $5000 = $3000.
Direct expenses for tax-free income are not deductible, since no taxes are paid on such income. Indirect expenses, which are the expenses of administering the trust, are generally deductible, but if the trust has tax-free income, then a proportion, = tax-free income ÷ trust accounting income, of indirect expenses is not deductible.
|Nondeductible Indirect Expense Allocable to Tax-Free Income||=||Total Indirect Expenses||×||Tax-Exempt Interest|
Distributable Net Income and the Distribution Deduction
A trust is considered by tax law to be a modified conduit, because usually only some of the income and deductions pass through to the beneficiaries. The trust itself often retains some income, especially capital gains, which is usually allocated to the trust corpus. However, distributions from the trust usually have both taxable and tax-free portions. The tax-free portion of the distribution may result from tax-exempt income, such as the tax-exempt interest earned from municipal bonds, or from retained earnings of the trust on which it has already paid taxes in previous years or from trust principal which is generally not taxable because of the recovery of capital doctrine. In other words, the money or property invested in the trust is the contributed capital, so any distributions from contributed capital are simply distributions of the original investment, and, therefore, not taxable.
Generally, taxes on taxable income must be paid either by the trust or by the beneficiaries, but not both. If the trust retains income beyond year-end, then the trust must pay taxes on it. However, if the income is distributed, then the beneficiaries pay taxes on it and the trust is permitted to deduct it. If the trust accounting income consists of both tax-free and taxable income, then the tax-free and taxable portions of the income that is distributed must be allocated to each beneficiary. The trust can deduct the taxable portion of the distributions but not the tax-free portion nor any expenses that must be allocated to the tax-free portion of income. To calculate this allocation, an intermediate result must first be calculated, called the distributable net income.
The distributable net income (DNI) sets a ceiling both on the trust distribution deduction and the amount that is taxable to the trust beneficiaries. The DNI is used to calculate the trust taxable income, calculate the beneficiaries taxable income, and to characterize distributions to beneficiaries, such as between taxable and tax-free distributions.
Distributable Net Income (DNI) =
Taxable Income before the Distribution Deduction
+ Personal Exemption
+ Tax-Exempt Interest
– Expenses Allocated to Tax-Exempt Interest
+ Capital Losses Allocated to Principal
– Capital Gains Allocated to Principal
The personal exemption is added back to taxable income because, while it is a deduction, it is not an actual expense, and thus, it is available for distribution. Tax-exempt interest is added because it is not includible in taxable income, but it is available for distribution to the beneficiaries. Since the tax-exempt interest is distributed, the expenses allocable to the interest are also subtracted. Capital gains that are allocated to trust principal are subtracted from taxable income because the gains are not distributed to the beneficiaries. For the same reason, capital losses that are allocated to trust principal are added back, because the losses decrease taxable income, but do not decrease the income that is available for distribution to the beneficiaries.
So, for instance, if a trust has $100,000 of principal and earns $10,000 in taxable income plus $2000 in capital gains that is allocated to the principal, then the total taxable income equals $12,000, but $2000 of that amount goes to the trust principal, so it is subtracted from taxable income to determine what remains to be distributed to beneficiaries. On the other hand, if the trust suffers a capital loss of $2000, then its taxable income will equal $8000, but the capital loss of $2000 is absorbed by the trust, so it must be added back to taxable income to equal the amount that will be distributed to beneficiaries.
The trust issues a Schedule K-1, Beneficiary's Share of Income, Deductions, Credits, etc. of Form 1041, U.S. Income Tax Return for Estates and Trusts to each beneficiary, listing the beneficiary's share of income and deductions. Only taxable income is listed; tax-exempt income is omitted.
The purpose of DNI is to determine what part of a distribution to beneficiaries is taxable to the beneficiary and deductible by the trust. This is achieved by multiplying each type of income, such as rent or dividends, by the total amount distributed divided by the DNI. Capital gains or losses are generally allocated to corpus unless they are distributed to the beneficiaries.
Capital gains and losses are netted out at the trust level. However, beneficiaries cannot deduct any net losses on their return except when the trust is terminated, in which case any unused capital loss carryovers can be used to offset income to the beneficiaries.
The distribution deduction cannot exceed the taxable distribution, since taxes must be paid on taxable income either by the trust or by the beneficiaries. For a complex trust, the distribution deduction can be determined by the following formula:
If Total Distributions > DNI, then:
Distribution Deduction = DNI – Tax-Exempt Income – Expenses Allocable to Tax-Exempt Income
If DNI > Total Distributions, then:
Distribution Deduction = Total Distributions – (Total Distributions × Net Tax-Exempt Income/DNI).
Example: the WCS Trust is required to distribute all income to its sole beneficiary. All capital gains and losses and expenses are allocable to the trust corpus. Income and expenses for the year are listed in the Totals column in the table below. Trust accounting income, trust taxable income, DNI, and the distribution deduction are also calculated in the table below, based on the income and expenses in the Totals column:
|Totals||Accounting Income||Taxable Income||DNI|
|Net Long-Term Capital Gains||$25,000||$25,000|
|Corpus Capital Gain/Loss|
|Income before the Distribution Deduction||$45,000||$50,700||$50,700|
|Nondeductible Expense Allocable to Tax-Free Income||= Fiduciary Fees - (Fiduciary Fees × Tax-Exempt Interest/Accounting Income)||($2,000)|
|Corpus Capital Gain/Loss||($25,000)|
|Distributable Net Income||$39,000|
|Distribution Deduction||= DNI – (Tax-Exempt Interest – Allocable Expense)|
= $39,000 – ($15,000 – $2000)
|Taxable Income for Trust||$24,700|
Note that in calculating DNI, the personal exemption is added back because it is a statutory deduction, which is not a real expense, so it is available for distribution. Note also that even though the beneficiary receives $30,000 of taxable income, the trust can only deduct $26,000 for the distribution. This is because the trust has already deducted the $4000 fiduciary fee that is allocable to taxable income to arrive at the tentative taxable income before the distribution deduction. To allow the trust to deduct the full $30,000 would allow the trust to deduct the deductible portion of the fiduciary fee twice.
Trust Taxable Income
Trusts and estates are subject to most of the same tax rules that apply to individuals. They even have the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels.
|Taxable Income (TI)||Tax Liability|
|Base Tax||Additional Tax|
|$0||< TI ≤||$2,550||$0||+||15%||×||TI|
|$2,550||< TI ≤||$5,950||$382.50||+||25%||×||(TI – $2,550)|
|$5,950||< TI ≤||$9,050||$1,232.50||+||28%||×||(TI – $5,950)|
|$9,050||< TI ≤||$12,400||$2,100.50||+||33%||×||(TI – $9,050)|
|$12,400||<||TI||$3,206||+||39.6%||×||(TI – $12,400)|
|$0||< TI ≤||$2,500||$0||+||15%||×||TI|
|$2,500||< TI ≤||$5,900||$375||+||25%||×||(TI – $2,500)|
|$5,900||< TI ≤||$9,050||$1,225||+||28%||×||(TI – $5,900)|
|$9,050||< TI ≤||$12,300||$2,107||+||33%||×||(TI – $9,050)|
|$12,300||<||TI||$3,179.50||+||39.6%||×||(TI – $12,300)|
|$0||< TI ≤||$2,500||$0||+||15%||×||TI|
|$2,500||< TI ≤||$5,800||$375||+||25%||×||(TI – $2,500)|
|$5,800||< TI ≤||$8,900||$1,200||+||28%||×||(TI – $5,800)|
|$8,900||< TI ≤||$12,150||$2,068||+||33%||×||(TI – $8,900)|
|$12,150||<||TI||$3,140.50||+||39.6%||×||(TI – $12,150)|
|$0||< TI ≤||$2,400||$0||+||15%||×||TI|
|$2,450||< TI ≤||$5,700||$367.50||+||25%||×||(TI – $2,450)|
|$5,700||< TI ≤||$8,750||$1,180||+||28%||×||(TI – $5,700)|
|$8,750||< TI ≤||$11,950||$2,034||+||33%||×||(TI – $8,750)|
|$11,950||<||TI||$3,090||+||39.6%||×||(TI – $11,950)|
|$0||< TI ≤||$2,400||$0||+||15%||×||TI|
|$2,400||< TI ≤||$5,600||$360||+||25%||×||(TI – $2,400)|
|$5,600||< TI ≤||$8,500||$1,160||+||28%||×||(TI – $5,600)|
|$8,500||< TI ≤||$11,650||$1,972||+||33%||×||(TI – $8,500)|
|$11,650||<||TI||$3,012||+||35%||×||(TI – $11,650)|
Looking at the above trust table, it is easy to see why capital gains are usually allocated to the trust, since long-term capital gains were taxed at 15% before 2013 and 20% thereafter, regardless of the trust's income. On the other hand, it makes sense to distribute income to the beneficiaries, since their tax brackets will be at much higher income levels, resulting in lower taxes.
Example: Calculating the Tax on Trust Income
If trust taxable income = $15,000 for 2015, then:
Tax on Undistributed Income = $3,179.50 + 39.6% × ($15,000 – $12,300) = $3,179.50 + 39.6% × $2,700 = $3,179.50 + $1,069.20 = $4,248.70
On the other hand, if the $15,000 is distributed to a beneficiary who earned only an additional $20,000 from work, then the $15,000 will be subject only to the beneficiary's 15% marginal tax rate:
- $15,000 × 15% = $2,250.00
Trusts may also be subject to the alternative minimum tax, but this is usually easy to avoid.
2013 Tax Changes
New tax changes that took effect in 2013 includes a new top tax bracket for trusts of 39.6% on income, adjusted for inflation (latest year amount is shown in the above tax table for trusts) that is not distributed and increases the long-term capital gains rate from 15% to 20% for the top tax bracket.
Trusts will also be subject to the new Net Investment Income Tax (NIIT), sometimes called the Obamacare tax, of 3.8% on undistributed investment income that exceeds the threshold for the top marginal rate for trusts. By contrast, the NIIT only applies to individuals who earn a minimum of $400,000 ($450,000 for a couple filing jointly). Hence, the total tax on undistributed capital gains in the top bracket will be 23.8%. However, the following types of trusts are not subject to the NIIT:
- trusts that are exempt from income taxes, such as charitable trusts and qualified retirement plan trusts;
- a trust for which all unexpired interests are devoted to charitable, religious, scientific, literary, or educational purposes, or some other purpose delineated in IRC §170(c)(2)(B);
- grantor trusts, since the taxes on such income is included on the grantor's tax return;
- trusts that are not classified as such for federal income tax purposes, such as real estate investment trusts (REITs) and common trust funds.
Taxation of Trust Beneficiaries
The trust is only permitted to deduct distributions that are taxable to the beneficiaries. Therefore, the total amount taxable to all trust beneficiaries cannot be less than the distribution deduction claimed by the trust. Total distributions to beneficiaries will be greater than the distribution deduction if a portion of the distribution consists of tax-exempt income, income on which the trust has already paid tax on, principal, which is not subject to taxation, or if there were deductible expenses that were allocated to corpus, and deducted to arrive at the tentative taxable income before the deduction of the distribution deduction. Multiple beneficiaries are taxed proportionately on their share of taxable amounts distributed.
Example: If a simple trust with 3 beneficiaries has $33,000 of accounting income for the year and a DNI of $30,000 that includes $15,000 of tax-exempt interest, then the trust can deduct its distribution deduction, equal to $30,000 – $15,000 = $15,000. The $33,000 is distributed to the beneficiaries, each receiving $11,000. Therefore, the portion that is taxable to each beneficiary is equal to 11,000 × 15,000/30,000 = $5500.
Naturally, the taxation of complex trusts is more complex. The distributions are divided into what are called first-tier distributions and second-tier distributions. First-tier distributions are required distributions from trust income, which is stipulated in the trust document; the remaining distributions are second-tier distributions. If all distributions are within either the first- or second-tier, then the taxation of beneficiaries is calculated as it is for simple trusts. However, if there is more than one level of distributions, then the taxability of beneficiary income depends on the following rules:
- If total first-tier distributions exceed DNI, then each beneficiary within that tier is taxed proportionately to their share of the taxable DNI. The remaining distributions are tax-free to the beneficiaries.
- If total DNI is greater than the total distributions, then each beneficiary is taxed on their proportionate share of taxable distributions.
- If total distributions exceed DNI, but first-tier distributions do not exceed DNI, then the following rules apply:
|×||First-Tier Distribution to the Beneficiary|
to the Beneficiary
Total Second-Tier Distribution
|×||Remaining DNI after|
Example: Allocating DNI to First- and Second-Tier Distributions
The ABC Trust has 2 beneficiaries: Amy and John, and none of the trust's income is from tax-free interest.
- Trust Income = $70,000
- Required distribution to Amy: $50,000; to John: $0
- DNI = $50,000
- The trustee distributes $50,000 to Amy and $20,000 to John.
- Since DNI = first-tier distributions, the entire $50,000 distributed to Amy is taxable, while the $20,000 distributed to John is tax-free.
Same as Case #1, except that DNI = $40,000, and the required distribution to John is $30,000.
- Total Distribution = $80,000
- DNI Allocable to Amy = $50,000 × $40,000/$80,000 =$25,000
- DNI Allocable to John = $30,000 × $40,000/$80,000 = $15,000
- Required distribution to Amy: $15,000, to John: $0
|Amount Required to be Distributed to Amy||$15,000|
|Allocation of DNI to First-Tier Distributions|
|Remaining DNI to be Distributed||$45,000||= DNI - First-Tier Distributions|
|Total Second-Tier Distributions||$70,000|
|Allocation of DNI to Second-Tier Distribution|
|to Amy||$19,286||= Remaining DNI × Distribution /Total Second-Tier Distribution|
|to John||$25,714||= Remaining DNI × Distribution /Total Second-Tier Distribution|
|Income Taxable to Beneficiaries|
|to Amy||$34,286||= Total Allocated DNI|
|to John||$25,714||= Total Allocated DNI|
|Total Taxable Income to Beneficiaries =||$60,000||= Total Distributed DNI = Distribution Deduction|
Note that the last statement is only true because there was no tax-exempt income.
If portions of taxable income differ in character, such as some being capital gains and some being ordinary income, then the character is assigned proportionately to the taxable distribution amounts using the same order as for first-tier and second-tier distributions.
A separate share rule may also apply if the trust is administered as separate shares according to the trust document. In this case, DNI is determined as if the shares are treated as separate estates or trusts in computing DNI allocable to the beneficiaries. The separate share rule generally applies to 1 trust; it does not apply to multiple trusts created by a single trust instrument. However, the separate share rule does not increase the number of deductions available to the trust nor does it increase the number of personal exemptions nor can the income be split so that it is taxed at lower rates.
Trust Property Distributions
Trust property distributions are based on the adjusted tax basis of the property rather than its fair market value (FMV) when it is distributed. The beneficiary's basis in the property is equal to the carryover basis of the trust and the beneficiary's holding period for the property includes the holding period for the trust.
However, the trustee can elect to recognize gains or losses on the distribution of appreciated property if the trust has other losses or gains that can be offset by the election. If so, then the contribution to the distribution deduction will be equal to the property's FMV on the distribution date and the beneficiary's tax basis will be equal to the FMV and the beneficiary's holding period will begin on the distribution date.
When a trust terminates, it must distribute all of its income and property to the beneficiaries. Therefore, even a simple trust must necessarily be a complex trust in its final year of existence, since it must distribute both income and principal. If the trust has operating losses that cause it to have a negative taxable income, then the proportion of the net loss to each beneficiary can be deducted as an itemized deduction on each beneficiary's return. If the trust also has capital loss carryovers, then these carryovers will be distributed to the beneficiaries in the same proportion as the final distributions from the trust.