Family Trusts and Taxes
A family trust is set up for the benefit of the trust grantor's family members, and it is almost always an irrevocable trust. This type of trust is usually for family members other than a spouse, and the taxation of the trust depends on the terms stated in the trust agreement.
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Income Simple Trust
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Simple family trusts require that net interest and dividends earned by the trust be distributed to the trust beneficiaries named in the trust agreement. Interest and dividends are income and are taxable to the beneficiaries that receive the income. Since the income is taxable, income beneficiaries receive tax letter Form K-1 from the trust. K-1 is creation occurs after the trust tax return Form 1041 is prepared. Since Form K-1 is a tax letter the information on the letter transmits to the Internal Revenue Service for tax purposes. Thus, income beneficiaries are required to include the information on their personal income tax return Form 1040, as well as on any state income tax returns they are required to file. Capital gains and losses associated with the family trust investments tax to the trust on Form 1041.
Income Sprinkle Simple Trust
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A family sprinkle simple trust requires that net income earned by the trust be distributed to the named trust beneficiaries. This trust has special language in the trust agreement that requires the trustee to approve which beneficiaries receive income distributions. In this case, one beneficiary may receive no funds while other beneficiaries in more need may receive all of the net income funds. A family trust beneficiary of a sprinkle trust is tax assessed only on the amount disbursed, so the beneficiary will not receive a Form K-1 for inclusion on personal income tax returns if he did not receive and funds.
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Complex Trust
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A complex family trust does not require income distributions. Complex trusts require that the trustee approve of all distributions, and if beneficiaries do not receive funds from the trust the income accumulates. Accumulated income earnings are taxable at the trust tax rate on trust income tax return Form 1041. As with a sprinkle trust, if a beneficiary receives funds, he will receive a Form K-1 for any income received for inclusion on personal income tax returns.
Discretionary Distributions
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Most family trusts have language in the trust agreement that allows for disbursements of principal under certain standards named in the trust. The most common language is to allow distributions for the support, health, maintenance and education of the family trust beneficiaries. If the trustee disburses discretionary funds, the beneficiaries who receive the funds will receive a Form K-1. The taxable amount for distributions to the beneficiary will assess as ordinary income to the extent there is income. If the distribution amount exceeds accumulated ordinary income, and securities sales were required to meet the distribution amount, any capital gains associated with these sales will pass through to the beneficiary who received the distribution for tax purposes.
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