How Are Trust Fund Earnings Taxed?

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How Are Trust Fund Earnings Taxed?

There are two things in life that you cannot avoid: death and taxes. While there are techniques to reduce your tax liability, you can’t get rid of the tax collector.

From earned income to capital gains from the sale of stocks and property, almost everything we touch is taxed; even assets acquired from an estate are taxed. The same may be said about trust funds, which have a connection to both death and taxation.

But how are these estate planning instruments taxed, and what are they? Continue reading to discover more about these cars and how they are reported to the IRS (IRS).

Key Takeaways

  • Trust funds are legal organizations that are often utilized in estate planning to accumulate and distribute money to beneficiaries.
  • A trust fund’s distribution to a beneficiary is made up of current-year income first, followed by accumulated capital.
  • Grantor trusts are trusts in which the grantor has complete authority over the trust and is liable for tax filing and payment.
  • If the income or deduction is part of a change in the principal or part of the estate’s distributable income, the trust pays the income tax rather than the beneficiary.
  • Form 1041 discloses income generated after the grantor’s death, and Schedule K-1 reports distributions paid to trust beneficiaries.

What Is a Trust Fund?

Trust funds are estate planning strategies that are used to save money for future generations. When a trust fund is founded, it becomes a legal entity that owns property or other assets in the name of a person, individuals, or group, such as money, securities, personal possessions, or any combination of these. The trust is managed by a trustee, who is an independent third party with no ties to either the donor or the beneficiary.

Trusts are classified into two types: revocable and irrevocable. A revocable trust, often known as a living trust, is a trust that retains the grantor’s assets. These assets may be transferred to any recipient designated by the donor. While the grantor is still living, changes to the trust may be made. An irrevocable trust, on the other hand, is difficult to amend yet avoids probate complications.

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Trusts of other types include, but are not limited to, the following:

  • Blind trusts
  • Charitable trusts
  • Marital trusts
  • Testamentary trusts

Taxing Trust Funds

Depending on their structure, trust funds are taxed differently.

A trust fund is not the same as a foreign trust, which has become a popular tool to avoid paying taxes in the United States. Form 3520 or 3520-A must be used to disclose foreign trust owners.

The Internal Revenue Service allows trusts to claim a tax deduction on income given to beneficiaries. In this situation, the recipient, not the trust, pays the income tax on the taxable amount.

Beneficiaries are paid from current-year revenue first, followed by principle. Distributions from the principle are tax-free since taxes have already been paid. This amount’s capital gains may be taxed to either the trust or the recipient. Amounts given to and for the beneficiary are taxable to them up to the trust’s deduction.

If the income or deduction is part of a change in the principal or part of the estate’s distributable income, the trust pays the income tax rather than the beneficiary. An irrevocable trust that maintains profits and has distribution discretion must pay a trust tax of $3,146 plus 37% of sums in excess of $13,050.

Grantor vs. Non-Grantor Trusts

Trusts are classified as either grantor trusts or non-grantor trusts, with several sub-types within each.

Grantor Trusts

A grantor trust is one in which the grantor has complete authority over the trust’s assets and is responsible for reporting and paying taxes on the trust’s income. Grantor trusts are all revocable trusts, however not all grantor trusts are revocable.

The trust fund is established by a grantor, who is generally the owner of the assets provided. Grantors establish the terms and circumstances of the trust and have the authority to modify the beneficiaries, investments, and trustees. Because grantors have complete control over the trust, they may also cancel it or convert it to an irrevocable trust.

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Instead of the trust’s tax return, income is recorded on the grantor’s personal tax return. Because personal income tax rates are often lower than trust tax rates, many rich persons choose grantor trusts over non-grantor trusts.

Non-Grantor Trusts

Non-grantor trusts, on the other hand, are ones in which the grantor is not responsible for reporting income or paying taxes on behalf of the trust. The trust is responsible for reporting and paying income taxes as a distinct tax entity.

Beneficiaries must declare and pay taxes on income received. In exchange, the trust is entitled to a tax deduction for the amount distributed.

Non-grantor trusts may be simple or complicated. In a basic trust, all earned income must be given to a beneficiary or beneficiaries on a yearly basis. However, no distributions from the principal are permitted, and distributions cannot be made in the form of charitable contributions.

When distributing revenue from a complicated or discretionary trust, the trustee utilizes their discretion. Distributions from the principal are permitted, as are direct donations to charity.

Non-grantor trusts must have their own tax identification number (TIN) for tax reporting purposes.

Reporting Income

Schedule K-1 is an IRS tax form that records a trust or estate beneficiary’s income, credits, and deductions. Distributions from trusts are taxable to the beneficiary, and the trust is required to submit a Schedule K-1 for each beneficiary paid. The income will subsequently be reported on the beneficiary’s tax return.

The trust must also file a Form 1041 to reflect the total amount of income produced by the trust since the grantor’s death. The form also shows the total amount paid to beneficiaries for the tax year in question.

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Schedule K-1s and Form 1041 must accompany the trust’s tax return. The trust must complete and submit Schedule B of Form 1041 with the return to claim the IRS Income Distribution Deduction. The deduction is equal to the lesser of the DNI or the amounts given or needed to be disbursed to the beneficiaries. Income not dispersed through complicated or discretionary trusts cannot be deducted.

Do You Have to Pay Taxes on Money Inherited From a Trust?

Beneficiaries are liable for paying taxes on trust funds inherited. They are not, however, liable for taxes on dispersed cost base or principal.

What Are the Tax Advantages of a Trust?

Irrevocable trusts enable for yearly contributions to be made without incurring gift taxes. For 2021 and 2022, the yearly exclusion for gifts is $15,000 and $16,000, respectively. Furthermore, their assets are often exempt from estate taxes.

At What Rate Is Trust Income Taxed?

The income of a grantor trust is taxed to the grantor as ordinary income. The income of a non-grantor trust is taxable to the trust, and the highest tax rate for 2022 is 37%.

The Bottom Line

Trust funds are considered essential estate planning tools by some. Most bypass probate and provide considerable tax benefits. Depending on the kind of trust, income is either taxable to the grantor or the trust, with the former being favored since tax rates for people are lower than those for trusts. Regardless matter the sort of trust chosen, trusts may help safeguard assets and pass money on to heirs.

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