How Does a Trust Deed Work in Terms of Taxes?
A trust fund is a seperate legal entity used for estate planning. The trust controls a pool of assets and distributes payments to individuals according to the plan design. The trust deed establishes the trust design and investment plan. The taxation of trust income depends on whether the trust deed creates a simple or complex trust fund.
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Trust Deed
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A trust deed is a document that legally sets up a trust. The deed defines the investment plan and payout schedule of the trust fund. The deed also identifies the three key parties of a trust: the grantor, the beneficiary and the trustee. The grantor is the person who deposits assets into the trust and decides how the trust will be structured. The beneficiary is the person who receives payments from the trust. The trustee is an independent third party who is in charge of monitoring the trust's investments and makes sure payments are made according to schedule.
Types of Trusts
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The trust deed states the structure of the trust fund. A trust can be created as a simple trust or as a complex trust. A simple trust is not allowed to accumulate investment earnings. It must distribute any investment earnings to the beneficiaries in the year they are made. A complex trust is allowed to accumulate earnings. The grantor decides the percentage of trust earnings that will be retained versus distributed in the trust deed. The type of trust structure determines the taxation of the trust.
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Simple Trusts
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Simple trusts are considered pass-through entities for taxes because they never retain any income. All investment earnings in a simple trust must be distributed to the beneficiaries in the year they are earned. As a result, the simple trust never has any income tax liability. All income from a simple trust is taxable to the beneficiaries in the year they receive the income. Distributions of trust assets are not taxable because they are considered a return of capital.
Complex Trusts
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The taxation of complex trusts is more complicated as income is divided between the trust and the beneficiaries. Income that passes to beneficiaries is taxable that year just like a simple trust. Income that remains in the complex trust is taxable to the trust fund and not to the beneficiaries. The trust is allowed to exempt the first $600 of investment income. The remaining retained income must be reported as income to the trust and taxes will be due. The trust will pay the taxes out of its investment earnings and assets.
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