The rules regarding the taxation of trusts are complex — this guide will cover the basics, such as how trusts are taxed and who is responsible for paying the taxes on a trust.
But first, a quick refresher.
What is a trust?
A trust is a legal tool that allows the trustor, or grantor, to transfer assets to their heirs. The grantor names a trustee who is legally obligated to fulfill the terms of the trust and act in the best interest of the beneficiaries.
Some types of trusts, such as living trusts, are created during the grantor's lifetime and are valid as soon as you transfer assets into them. This is unlike wills, which only take effect when someone passes away.
Revocable living trust
One of the most popular types of trusts is a revocable living trust. An individual typically establishes a revocable living trust to avoid probate and provide specific instructions on how they want their assets distributed after they die.
One of the key characteristics of revocable living trusts is that they can be revoked or changed at any time by the grantor.
All revocable living trusts created in the MyAdvocate system are "grantor trusts."
An irrevocable trust cannot be revoked or changed by the grantor once it's created. The main benefits of an irrevocable trust are minimizing estate taxes and protecting assets from creditors.
An irrevocable trust can remove certain assets from the grantor's taxable estate. Once an asset is transferred into an irrevocable trust, the grantor no longer owns it; the trust owns it for the benefit of the trust beneficiaries.
Irrevocable trusts are particularly beneficial for those who work in high-risk professions that may leave them vulnerable to lawsuits, such as attorneys, doctors, and business owners.
How are trusts taxed?
Generally, contributions to a trust are not subject to income taxes because the person contributing has already paid taxes on the money. It is more common for a trust to pay taxes solely on the income generated from its assets.
If you are the beneficiary of a trust, you will have to pay taxes on distributions you receive from income the trust earned in the current tax year. Generally, beneficiaries do not have to pay taxes on distributions taken from the trust's principal balance.
Revocable living trust taxation
The taxation of a revocable living trust depends on whether the grantor is living or deceased.
While the grantor is alive:
- The IRS considers revocable living trusts disregarded entities for tax reporting purposes, meaning the income or capital gains of a revocable living trust pass through to the grantor’s personal tax return (IRS Form 1040).
After the grantor’s death:
- The trust becomes irrevocable and a separate taxable entity
- The trust must obtain a employer identification number (EIN), sometimes called a tax identification number, from the IRS
- When trust beneficiaries receive distributions of trust principal, they do not have to pay taxes on this distribution of principal
- The trust's income is taxable as income either to the beneficiary of the trust or the trust itself
- The trust must pay income tax on any income the trust accumulates and does not distribute to the beneficiaries. Because trust tax brackets are much more compressed, trust tax rates reach the highest bracket at lower amounts than individual ordinary income rates
- The trust's income is taxable to the beneficiary who receives it
- The trustee must file an annual tax return as long as the trust earns income and has not been terminated
Irrevocable trust taxation
Irrevocable trusts typically have separate EINs/TINs and report their income and deductions for federal income tax purposes on IRS Form 1041.
There are two primary taxation categories for trusts: grantor trusts and non-grantor trusts.
If a trust is categorized as a grantor trust, like all MyAdvocate revocable trusts, all of its income will be taxed on the grantor's income tax return. Because the grantor retains control of the trust, they are responsible for the reporting and payment of the trust's taxes. All revocable trusts are grantor trusts. Income from a grantor trust is taxed at the grantor's ordinary income tax rate.
The grantor is not responsible for reporting and paying taxes on a non-grantor trust. A non-grantor trust, like a MyAdvocate Gift Trust, functions as its own tax entity and pays taxes on its income. Income from a non-grantor trust is taxable to the trust at the trust tax rate, which ranges from 10% to 37%.
Trust tax rates
Trusts pay federal, state, and (sometimes) local taxes. State and local taxes vary widely, so we suggest researching the rates in your area.
The federal trust tax rate is adjusted for inflation each year. In 2023, the federal government taxes income generated by a trust at four levels:
- 10% ($0-$2,900)
- 24% ($2,901-$10,550)
- 35%: ($10,551-$14,450)
- 37% ($14,451 and above)
There are two tax forms to be aware of if you’re a trustee or beneficiary of a trust.
IRS Form 1041 is the income tax return for estates and trusts. A trust must report any income it earns over $600 a year. The form also includes the total amount paid to beneficiaries for that tax year.
Beneficiaries receiving trust income must report their earnings on IRS Form K-1. Deductions and credits from a trust are also reported on a K-1.
Tax deductions for trusts
A trust is typically able to deduct money it gives to charitable organizations. The charitable giving deduction is nonrefundable, meaning a trust can't deduct more than it earned in income.
Income distribution deduction
A trust gets a tax deduction on money it pays out in distributions to its beneficiaries. The deduction is based on the trust's distributable net income (DNI) — the total trust income minus deductions such as state taxes and professional fees.
Trusts can receive a tax deduction for the costs of paying a trustee to manage the trust and for other professional services such as tax preparation. The deduction is based on the proportion of trust income that is taxable.
The bottom line
Trust taxation depends on the type of trust and the income it earns. Trust taxes can be as high as 37%; however, several deductions can help minimize your tax bills, such as charitable donations and beneficiary distributions.