Tax Treatment of Trusts
There are many different kinds of trusts such as grantor trusts, simple and complex trusts, and charitable remainder unitrusts. Trust taxes owed depend on the entity type of the trust and the treatment of the trust itself for tax purposes.
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Revocable Grantor Trusts
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The grantor of the revocable trust owns the trust for tax treatment purposes. The revocable grantor trust files Internal Revenue Service tax return Form 1041, which will include an attachment to the return that passes out all interest, dividends and capital gains to the trust grantor. The trust grantor reports this information on his personal income tax return Form 1040.
Simple Trusts
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Simple trusts require that 100 percent of the income earned on trust assets be distributed to the trust beneficiaries. Simple trusts file Internal Revenue Service tax return Form 1041, which creates a tax information letter Form K-1 for the trust beneficiaries. The Form K-1 states exactly what a beneficiary is to report on a personal income tax return Form 1040 and where to place the information on the return. Tax treatment of income to a simple trust beneficiary is the proportionate share of distributable net income (DNI) received by the beneficiary. DNI for tax treatment purposes is not the same as the dollar amount the beneficiary receives, as deductions for items such as trustee fees lower the taxable amount reported. Unless the trust agreement states otherwise, tax treatment for capital gains on the buying and selling of securities are typically paid out of the principal of trust assets and do not create a tax liability for the income beneficiaries of the trust.
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Complex Trusts
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Complex trusts do not require payment of 100 percent of trust income to the trust beneficiaries. Tax reporting requirements are the same as a simple trust, in that the complex trust files tax return Form 1041 and generates a tax information letter form K-1 to the beneficiaries. Complex trust beneficiaries receive a Form K-1 only if they receive funds from the trust, and the tax treatment is dependent on the type of funds received. For example, if a complex trust beneficiary receives a large cash distribution that is a combination of trust interest and principal that incurred capital gains, then beneficiaries are taxed on both the interest and capital gains up to the amount of distribution. If no distributions occur, then the trust pays any tax due on earned trust income and capital gains.
Charitable Remainder Unitrusts
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Charitable remainder unitrusts, also known as split-interest trusts, file Internal Revenue Service tax return Form 5227. A charitable remainder unitrust pays current funds to an individual based on a percentage of the trust assets, and the balance of the trust goes to charity at the end of the trust term. Tax treatment of beneficiary distributions is specifically tiered. The unitrust passes to the beneficiary for tax treatment as ordinary income and dividends first, capital gains second, tax-exempt income third and tax-free principal last. For example, if a unitrust beneficiary receives an annual $100,000 distribution that is from $20,000 in taxable income and $80,000 in capital gains, the beneficiary Form K-1 shows these amounts as taxable to the beneficiary. Any income or capital gains earned in excess of the beneficiary distributions are taxable to the trust.
Review the Trust Terms
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Trust agreement terms can override many of the tax treatments specified in the Internal Revenue Code, so a thorough review of the trust agreement is required prior to filing any trust tax returns. Trust taxation is a complicated field, and tax laws are always changing, so it is always a good idea to seek professional tax advice for trust matters.
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References
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