For all intents and purposes, a trust is considered its own entity. Trusts are legal documents, but they are also taxed separately from those to whom the assets within a trust will be distributed.
People who are in the process of planning their estates rely on trusts because trusts serve as protection over the assets that are part of said estates. Trusts are also a way by which people seek to reduce estate taxes and inheritance taxes.
It is important to understand that the person who creates a trust is known as a grantor, and grantors hold the right to transfer assets into trusts. Grantors can also designate one or more trustees who are granted the responsibilities of overseeing the trust and managing the assets within the trust.
A revocable trust is also called a grantor trust for tax purposes. This is because the grantor maintains ownership over the trust as well as all the assets within the trust.
In other words, any income that is earned as a result of the assets within the trust will be regarded as income for the grantor. From there, the grantor must report the income stemming from assets in the trust as part of the grantor's personal income tax return.
The grantor should also file Form 1041 with the IRS if the trust earned any taxable income during the tax year. Form 1041 is a document that denotes the fact that taxable trust income was accrued, and the form allows trustees to identify how much of the trust income is a taxable responsibility for the grantor.
Form 1041 also makes note of where the income originated from as well as whether any tax deductions or credits are applicable to the income. Last but not least, the information included on Form 1041 will be used by the grantor as the grantor seeks to complete his or her personal income tax return.
When reporting income sent from the trust to beneficiaries, a Schedule K-1 form will be sent to the IRS instead. So a separate tax return must be filled out, completed and filed with the IRS for an irrevocable trust as long as taxable income was earned by said irrevocable trust.
Taxable income for irrevocable trusts refers to rental payments collected from property owned by the trust as well as any interest rates or financial gains that were not distributed during the applicable tax year.
What beneficiaries should know about trusts and taxes
The beneficiaries of a trust will generally pay taxes on any distributions they receive as part of the trust's income, though this does not necessarily apply when speaking to the principal of the trust. This is due to the fact that the IRS assumes that this money has been taxed prior to being placed in the trust in the first place. However, the interest that the money within the trust accumulates is considered taxable income because it was accrued while in the trust, not before being placed in the trust.
As mentioned earlier, the trust is required to pay all applicable taxes on any income that is within the trust and remains within the trust beyond the last day of the tax year. Additionally, the interest that is earned from the funds in the trust account is also taxable on the part of the beneficiary who receives said interest, and capital gains are viewed as being taxable to either the trust itself or to the individual beneficiaries.
Speaking of capital gains, a trust must report income to the IRS on an annual basis, though the trust can claim tax deductions for the amount of money that is distributed to all the trust's beneficiaries during each tax year. But even so, the trust will be required to take on the responsibility of paying the total capital gains tax amount on said earnings from interest.
While simple trusts and complex trusts are responsible for paying their own income taxes, grantor trusts are not taxed in the same way. Instead, the grantor has to pay the income tax on the trust account, but if a grantor does not retain grantor-related powers over the trust, then the trust is considered a complex trust rather than a grantor trust.
So we know that trusts are regarded as separate, taxable entities, and as such, trusts have to file tax returns while also paying income tax on interest accrued when money remains in the trust accounts. But furthermore, expenses can be deducted on part of trusts. For context, a simple trust is legally allowed to claim an exemption of $300, while the exemption limit for a complex trust is $100.
You might be wondering when beneficiaries pay taxes on money that they receive from a trust. Ultimately, the point at which beneficiaries owe taxes on what they receive from a trust will depend on the way by which the distribution is classified. For example, if the funds in consideration are classified as income from the trust, then the beneficiary of said funds will be required to pay income tax on the funds.
Furthermore, whether funds are taxed as either capital gains or regular income will heavily depend on the category to which the funds belong, that being either cash or dividends. If the funds are regarded as part of the trust's principal, the beneficiary will not owe taxes on the funds because the funds will be deemed a return of money, which is considered to have already been taxed.
How to report your income
Beneficiaries must report any and all income that they receive from trust accounts to the IRS via Form K-1. This document allows beneficiaries to report what they receive in terms of income, credits, deductions, gains and losses from the trust.
The information that is reported via Form K-1 will be applied to the beneficiary's personal tax return, which is how income from the trust is reported to the IRS. Income from revocable trusts must be reported as part of the grantor's personal income whereas separate income tax is paid on income from irrevocable trusts if any income was accrued yet not distributed during the year in which it was accrued.
The trustee is held responsible for filing the return and must fill out Form 1041 as well as any related attachments. But if a trust disburses any amount of income to the beneficiaries of the trust, then it must provide each and every beneficiary with their own Form K-1 documents to fill out.
While income distributions will be deducted from the trust when released to beneficiaries, trusts are only required to pay taxes on the income that is not distributed during a given tax year.
So does this mean that you now know everything you possibly could about trusts and the taxes that pertain to them? Unfortunately, no! Not even close.
This is a very complex matter that involves a lot of nuances and exceptions. In other words, the situation can evolve and become complicated rather quickly. While this baseline of information can assist you in many ways, it's still important to work closely with professionals and tax experts who can help you set up a trust or receive assets from one.
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