Trust taxation basics

In short

A friend of mine once told me that moving money into a trust felt like moving it out of his own pocket and into a locked drawer, and he was surprised to learn the tax collector still had a key. If you are holding a trust or thinking about one, the first thing to know is that the label on the paper does not decide who pays tax. The way the trust is built does. Some trusts are treated as the grantor for income tax, so the person who made the trust pays the bill. Others are their own taxpayers and file their own return on Form 1041. Trust income that stays inside the trust is taxed on a very steep ladder, and the top rung comes fast. Moving income out to a beneficiary can shift it to a lower rate. Gift and estate tax is a separate system with its own forms and its own limits. Talk to a trust and estate attorney and a CPA before any signing, because the details matter a great deal.

The whole of it

What it is

I once watched a neighbor hand over the deed to his farm to a trust and then keep right on mowing the back forty. Nothing looked different. That is a fair picture of how a trust works. A trust is a legal arrangement in which one person, the trustee, holds property for the benefit of another, the beneficiary, under rules set by the person who made it, the grantor.

You have probably heard that trusts save taxes. Sometimes they do, but not by magic. Taxes follow the structure. A grantor trust is one where the tax code treats the grantor as still owning the assets for income tax. The grantor reports all the trust's income on a personal Form 1040. A non grantor trust is its own taxpayer. It gets its own taxpayer number and files Form 1041, the U.S. Income Tax Return for Estates and Trusts.

There is a second split that matters just as much. A revocable trust can be changed or canceled by the grantor. The IRS treats it as the grantor's own property, and it is included in the grantor's estate at death. An irrevocable trust generally cannot be undone, and if it is built the right way, its assets can sit outside the grantor's taxable estate. Two systems run side by side here, income tax and transfer tax, and a trust can be one thing for one system and another thing for the other.

How it works

A friend of mine who builds houses likes to say that every pipe has to go somewhere. Trust income works the same way. It comes in as interest, dividends, rent, or gains, and it has to end up taxed somewhere.

In a non grantor trust, the money has two paths. If the trustee keeps it, the trust pays tax on it. If the trustee pays it out to a beneficiary, the trust takes a deduction and the beneficiary reports the income instead. The trust sends each beneficiary a Schedule K-1 showing what was passed along. This pass through idea is why trusts file at all. The goal of the code is to tax the income once, and tax it to whoever ends up holding it.

Here is the part that surprises people. The brackets for trusts are squeezed tight. A trust reaches the top federal income tax rate at a tiny amount of income, far lower than a married couple does. So for a trust holding tens of millions, nearly all retained income lands in the top bracket.

Trusts can also owe the net investment income tax, a separate levy on investment income. The IRS reports it on Form 8960. The threshold that applies to a trust is set by law, and it is found on the form and its instructions. Read the current figure there for the year in question.

Capital gains are handled with the same logic. Gains usually stay in the trust and get taxed there, unless the trust document or the trustee's choices send them out. Whether they can be sent out depends on what the document says and what the law allows.

Then there is transfer tax. A gift into an irrevocable trust is generally treated as a gift for gift tax, reported on Form 709, the United States Gift (and Generation Skipping) Transfer Tax Return, though a gift that fits within the annual exclusion may owe no tax. It uses up part of the lifetime exemption. A trust built to skip a generation, such as one that benefits grandchildren, can also trigger the generation skipping transfer tax, a separate levy with its own exemption.

The numbers, and where to find yours

I have noticed that people like to hunt for the one magic number, and I understand it. But the figures here change, and the honest move is to read them from the source for the year in question. The IRS publishes them every year, and your preparer will use the current ones.

The income level where a trust hits the top bracket is the current figure, which the official source publishes each year. The top federal rate on ordinary income is the current figure, which the official source publishes each year. The threshold for the net investment income tax on trusts is the current figure, which the official source publishes each year, and the rate is the current figure, which the official source publishes each year. The lifetime gift and estate exemption is the current figure, which the official source publishes each year, and the annual gift exclusion is the current figure, which the official source publishes each year. The generation skipping transfer exemption is the current figure, which the official source publishes each year.

Where do you find yours? The Form 1041 instructions and the Form 709 instructions both carry the current tables, and IRS Publication 559 covers how trusts and estates are taxed. The trust document itself tells you the kind of trust you hold. Your own situation also matters, since state rules differ. Some states tax trust income and some do not. Your attorney can tell you which rules reach your trust.

A worked example

Let me tell you about a woman named Marguerite. She sets up a non grantor trust and funds it with $20,000,000 of investments. It earns $800,000 in a year, which is 4 percent of $20,000,000. The example leaves out deductions so the shape of the thing stays plain.

Suppose the trustee keeps all $800,000 inside the trust. To keep the math simple, assume the whole amount is taxed at an assumed rate of 37 percent. The tax is $800,000 times 0.37, which is $296,000. Add an assumed net investment income tax of 3.8 percent on the same $800,000. That is $800,000 times 0.038, which is $30,400. The total is $296,000 plus $30,400, or $326,400. The trust keeps $800,000 minus $326,400, which is $473,600.

Now suppose the trustee pays out $400,000 to Marguerite's daughter Odile, who is a beneficiary. The trust deducts the $400,000 it distributed. It keeps $400,000 and pays tax on that. At the same assumed rates, $400,000 times 0.37 is $148,000, and $400,000 times 0.038 is $15,200. The trust owes $163,200.

Odile reports the $400,000 on her own return. Say her assumed combined rate is 24 percent. Then $400,000 times 0.24 is $96,000. The trust and Odile together owe $163,200 plus $96,000, which is $259,200. Compare that with the $326,400 from before. The difference is $326,400 minus $259,200, which is $67,200.

These rates are made up for the example. Odile's real rate depends on her other income, and a real return has deductions and more brackets. The point is only the direction. Income paid out to a lower bracket beneficiary can cost less tax than income held in the trust. Whether a payout is wise for Marguerite's family is a separate question. It depends on the trust terms and on what she wants for Odile.

Where it goes wrong

Nobody sets out to make a mess, and I do not think Marguerite would either. Still, trusts have a few places where good people trip.

The first is assuming a trust is a tax shield by itself. It is not. An irrevocable trust that holds income inside it can end up paying the top rate fast, as the example showed. The second is mixing up the two systems. A trust can be outside your estate yet still be taxed to you on income, because a grantor trust keeps the income tax tied to the grantor. Some families use that on purpose, since the grantor paying the tax lets the trust grow without being reduced by it. But it is a choice with consequences, and the grantor must be ready to write those checks.

The third is paperwork. The trustee has to get a taxpayer number, file Form 1041 on time, and send K-1 forms to beneficiaries. A late or wrong filing can bring penalties. The fourth is the state layer. A trust can owe tax in a state because of where the trustee lives, where the grantor lived, or where the beneficiary lives. The rules vary, and a trust that looks fine federally can surprise you at the state line.

The fifth is the gift side. Funding a trust may use up part of the exemption, and a missed Form 709 can cause trouble later. Keep records of every transfer. Good records save a world of grief.

Questions to answer before you leave this page

Do you know whether your trust is a grantor trust or a non grantor trust, and who the tax code says must report its income? Is the trust revocable or irrevocable, and what does that mean for your estate? Who is the trustee, and does that person know the filing dates for Form 1041? Do the trust's terms allow income to be paid out to beneficiaries, and who decides when that happens? Have you checked the current figures for the top bracket, the net investment income tax, and the exemptions on the IRS pages for the year in question? Does your state tax the trust, and on what basis? Have you kept a record of every gift into the trust and filed Form 709 where it was required? And have you sat down with a trust and estate attorney and a CPA to walk through it all?