Taxation of Trusts and their Beneficiaries

2024-08-08Trusts, like estates, are taxable entities. A trust is a fiduciary entity whose objective is to hold and invest money or property held in the trust for the benefit of beneficiaries. Trust property consists of principal (aka corpus), the property transferred to the trust by the grantor, and income earned by the trust, usually from investments. If the trust retains income after 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 depends on whether principal or income was distributed, and if it was income, then whether it was tax-free income, retained income from previous years that the trust already paid tax on, or taxable income. 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, taxable distributions to beneficiaries are 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 required to distribute all 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 income 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 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:

1. calculate trust accounting income;
2. calculate the tentative taxable income before subtracting the distribution deduction, which is the amount that the trust can deduct because of the distribution;
3. 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;
4. subtract the distribution deduction from the tentative taxable income to determine trust taxable income;
5. calculate trust tax liability;
6. 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. The trust document usually 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.

Trust Tentative Taxable Income

Trust taxable income is 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 required to distribute all their income annually to beneficiaries (simple trusts), $4300, which is not subject to phaseout, for a qualified disability trust, and $100 for all other trusts.

A qualified disability trust is any trust established solely for the benefit of a disabled individual younger than 65, who was determined by the Commissioner of Social Security to have been disabled as defined 42 U.S.C. 1382c(a).

Trust income is defined as income 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.

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.

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.

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 allocated to the trust corpus. However, distributions from the trust may 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 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.

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 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 on the amount taxable to the trust beneficiaries. The DNI is used to calculate the trust taxable income, to 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 to distribute to beneficiaries. Since the tax-exempt interest is distributed, the expenses allocable to the interest are also subtracted. Capital gains allocated to trust principal are subtracted from taxable income because the gains are not distributed to the beneficiaries. For the same reason, capital losses allocated to trust principal are added back, because the losses decrease taxable income, but do not decrease the income available for distribution 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 allocated to corpus unless 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)

Trust Taxable Income

Trusts and estates are subject to most of the same tax rules that apply to individuals. They even share some of the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels.

• Source: Instructions for Form 1041, U.S. Income Tax Return for Estates and Trusts
• Note that the 3.8% Medicare surcharge also applies to undistributed investment income in the highest bracket. So, for instance, capital gains for the top tax bracket will be taxed at 23.8% on undistributed capital gains.
• This tax table does not apply to grantor trusts, since the trust income is included in the income of the grantor and taxed accordingly.

Trusts may also be subject to the alternative minimum tax, but this is usually easy to avoid.

2013 Tax Changes

Tax changes enacted in 2013 included a top tax bracket for trusts of 39.6% on undistributed income, adjusted for inflation (latest year amount is shown in the above tax table for trusts) and increased the long-term capital gains rate from 15% to 20% for the top tax bracket. The Tax Cuts and Jobs Act lowered the top rate to 37%.

Trusts are also subject to the Net Investment Income Tax (NIIT), sometimes called the Obamacare tax, of 3.8% on undistributed investment income exceeding the threshold for the top marginal rate for trusts. By contrast, the NIIT only applies to individuals earning a minimum of $200,000 ($250,000 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 exempt from income taxes, such as charitable trusts and qualified retirement plan trusts;
• trusts with all unexpired interests devoted to charitable, religious, scientific, literary, or educational purposes, or some other purpose delineated in IRC §170(c)(2)(B);
• grantor trusts, since taxes on such income is included in the grantor's tax return;
• trusts 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 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 exceed the distribution deduction if a portion of the distribution consists of tax-exempt income, income on which the trust has already paid tax, principal, which is not taxable, or if there were deductible expenses allocated to corpus and deducted to arrive at the tentative taxable income before deducting the distribution deduction. Multiple beneficiaries are taxed proportionately on their share of taxable amounts distributed.

Naturally, the taxation of complex trusts is more complex. 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 exceeds 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:

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 = 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 = the property's FMV on the distribution date and the beneficiary's tax basis will = the FMV and the beneficiary's holding period will start on the distribution date.

Trust Termination

When a trust terminates, it must distribute all 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 resulting in 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.

Historical Notes