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Income Tax and Trusts! Important Questions Answered

You may have some questions as the tax season approaches. For example, you might be wondering who is responsible for filing tax returns or how trust income tax is paid. This article will address some of the most common questions that you might have regarding your trust’s taxation.

Income Tax

All Trusts Are Subject to Income Tax

It depends. A trust is an independent legal and tax entity. The trust’s ability to pay its taxes is determined by whether it is a simple or complex trust. Simple and complex trusts are responsible for their income tax. Grantor trusts DO NOT pay their taxes. The grantor pays taxes on the income of a grantor-trust.

How Can I Tell if a Particular Trust Is a Simple One?

A simple trust has the following characteristics: 

a).  It requires that all trust income be distributed annually at least, 

b).  There are no beneficiaries who are charitable, and 

c).  No trust principal is distributed.

If the trust doesn’t meet the simple definition above, it will usually be either a complex or grantor trust.

What Is a Trust Grantor?

A trust allows the grantor to retain certain powers concerning the trust assets, as specified in the trust agreement. Grantor trusts are either irrevocable or revocable. Due to these powers retained by the grantor, the grantor’s trust is not considered for income tax purposes. These powers include:

  • The grantor or the spouse of the grantor retains the right to amend or revoke the trust (i.e. Revocable Trusts), OR
  • The grantor has the right to replace trust assets with assets equal in value.
  • The grantor has the right to borrow assets from a trust without providing adequate security.
  • The grantor or the grantor’s spouse can receive distributions (i.e. Spousal Lifetime Access Trusts), OR
  • The trust income can be used to pay for premiums on policies of life insurance on the grantor, or grantor’s spouse.

There are many other powers retained by the grantor that can make a trust grantor trust. However, these are the most common.

The grantor trust, although it is a separate legal entity, is taxed as if it were the same taxpayer. The grantor trust income is reported on the grantor’s tax return, and the grantor pays taxes.

If the grantor has no grantor powers, such as the ones listed above, the trust is a complex trust.

Do Trusts File Their Own Tax Returns?

If the trust has taxable income, (gross earnings less deductions are greater than $0) or a gross income of more than $600, then the trustee is required to file a tax form (IRS 1041).

It depends on the grantor’s trust. A grantor trust can use the grantor’s Social Security Number as its taxpayer ID number or obtain its own number from the IRS. The grantor trust does not have to file a tax return if it uses the grantor’s Social Security Number as its taxpayer ID number. All tax documents, such as 1099s, will be sent directly to the grantor to report on his individual tax return. If a trust has its taxpayer identification number it may be required to file a tax return, but only for informational purposes. The pro forma tax returns identify the trusts as grantors and include a letter of grantor trust that lists the income items to be reported by the grantor on his individual tax return.

Does the Trust Have to Pay and File State Income Tax if It Is Its Taxpayer?

If a state has jurisdiction over a trust, then the trust must file a state tax return in that state and pay the state tax. Each state has different rules for determining whether or not it has jurisdiction to tax a trust. 

New York, for example, may tax a fund if it was funded by a grantor who resided in New York, provided there are no New York trustees or assets and that the income is not from New York. 

California, for example, may tax a California-resident trustee or beneficiary. It is possible that a trust can be taxed in more than one state because each state has its own rules. 

If you are familiar with these rules, there may be ways to reduce or eliminate the state tax obligation of a trust. If the grantor lived in New York at the time the trust or complex trust was created, the state tax liability for New York can be reduced or eliminated by replacing the New York trustee with one who is not from New York, provided the trust does not have any New York assets or New York income.

What Deductions Is a Trust Entitled to Claim if It Pays Its Own Taxes?

A simple or complex tax-exempt trust may claim deductions for the state tax it has paid, trustee’s fees, preparers of tax returns, and income distribution. A grantor trust cannot claim deductions because it is not a separate taxpayer.

Fees for Tax Return Preparers and Trustees

Only the part of trust expenses that is attributable to taxable income can be deducted. If the trust income is $10,000 in Dividends and $5,000 in tax-exempt interest, then only two-thirds of the trustee fees and tax preparer fees can be deducted.

Tax Deduction for Income Distribution

Calculate the trust’s net distributable income (DNI) before calculating the income distribution deduction. DNI is defined in the Internal Revenue Code. It is generally equal to total income from a trust (including tax-exempt interest, but excluding any capital gains or losses) less any deductions, such as state taxes paid, trustee fees, and tax return preparer’s fees.

The Income Distribution Deduction is equal to DNI less tax-exempt interests if the total distributions of the trust to beneficiaries exceed DNI.

Total distributions = (Total Distributions x Tax-Exempt Interest/DNI) – Total distributions

The trust beneficiary will receive the deducted amount on a schedule K-1.

What Is the Difference Between the Income Tax Rates of a Trust and an Individual?

For the 2020 taxation year, income from a simple trust or complex trust is taxed in brackets of 10%, 24%, and 35%. Income exceeding $12,950 will be taxed by 37%. Comparatively, the income of a single individual is taxed in brackets at rates of 10% 12% 22% 24% 32% 35% 37%. Income exceeding $518.401 will be taxed with this 37% rate. Trusts pay more tax than individual taxpayers because the tax brackets for trusts are more compressed. The 2020 tax brackets are below for trusts that pay their own taxes.

  • Income between $0 and $2,600: 10% tax on income
  • Income between $2,601 and $9,450: $260 plus 24 % of the amount above $2,600
  • Income between $9,450 and $12,950: $1,904 + 35% of the amount above $9,450
  • More than $12,950 of income: $3.129 plus 37%.

What Is the 65-Day Rule?

The 65-day rule allows a trustee to make distributions within 65 days of the end of the tax year and treat them as if the distributions were made during the previous year. The deadline to make the distribution is March 6, (or March 5 in leap years). On the trust’s tax return, an irrevocable selection must be made to treat distributions made during the 65-day period as if they were made in the previous tax year. If trustees distribute to beneficiaries of trusts before March 6, 2020, they may elect to treat these distributions as 2020 distributions. 

The trustee will claim a deduction on the 2020 trust tax return for the “65-day rule’ distributions and shift some income tax burden from the trust to its beneficiaries. The “65-day Rule” can be used by trustees when trust distributions are below the DNI of the trust for the year. The trustee can then make distributions under the “65-day” rule up to the DNI of the trust to maximize its income distribution deduction. This will shift tax liabilities on these distributions to beneficiaries.

If you have any questions or problems with Income tax, do not hesitate to talk to one of Tenina Law’s team or Lawyers. We have a free consultation or call 213-596-0265

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