Trust Distribution Tax Do’s and Don'ts

Trusts can be useful tools for taxpayers to manage their assets, control the future of their investments, and plan ahead to lessen tax exposure for the beneficiaries of the trust. To properly plan for the tax consequences of a trust, taxpayers should consider several key issues: what type of trust is being formed; how the income of the trust is taxed; and if the capital gains of the trust can be distributed to the beneficiaries. Here is a brief overview of the answers to these questions:

Types of Trusts

There are two main types of trusts: grantor trusts and non-grantor trust. Each trust is taxed differently. The taxation of a trust depends on which type of trust it is. Taxpayers should be aware of the type of trust to properly plan for the tax consequences.

A grantor trust is a trust that the grantor—i.e., the creator of the trust—retains certain benefits or powers over the trust. These powers or benefits may include the ability to vote on what stocks are held by the trust or who receives trust income, among other things. Notably, a trust may be deemed a grantor trust for tax purposes if the trust is controlled by a third party, like the grantor’s spouse, that is not adverse to the grantor.

A non-grantor trust is a trust where no control or power over the trust is held by the grantor. Instead, a trustee is appointed to manage the administration of the trust and the trustee is required to follow the terms laid out in the trust document. The trustee has a fiduciary duty to act in the best interest of the beneficiaries of the trust.

Grantor Trust Income Taxation

A grantor trust is treated as a disregarded entity for tax purposes, so any earnings by the trust are taxable directly to the grantor. In other words, the IRS does not differentiate between the trust’s income and the grantor’s income­—they are one and the same. Thus, the trust income will be taxed at the grantor’s individual tax rate.

Non-Grantor Trust Income Taxation

Unlike grantor trusts, non-grantor trusts are treated as their own entity, wholly separate from the beneficiaries. The non-grantor trust must report and pay taxes on any earnings and income during the year. However, if the non-grantor trust distributes income to the beneficiaries of the trust, that income will instead be included in the beneficiary’s income for the year.

What Rate Is Trust Income Taxed At?

Grantor Trust: A grantor trust is treated as a disregarded entity by the IRS. Any income from the trust will be treated as income at the level of the grantor. Thus, the tax rate for a grantor trust’s income will be the grantor’s individual income tax rate.

Non-Grantor Trust: A non-grantor trust pays taxes on any amount of income that is not distributed to beneficiaries. Non-grantor trusts are subject to a compressed tax bracket, meaning that the trust is subject to a high tax rate much more quickly than an individual is. Below are the 2022 tax brackets for non-grantor trusts compared to individual taxpayers:

Ordinary Income Tax Brackets (2022)

Capital Gains Taxes on Trusts

When trusts are formed, they are generally funded with different types of assets that the trust holds. These assets are referred to as a “principal trust.” But, can any capital gains earned on the trusts principal assets be distributed to the beneficiaries to utilize more favorable individual tax rates?

The general rule is that any capital gains earned from capital assets held by the trust are part of the trust’s principal—thus, it’s not considered income—which, by default, is not eligible to utilize individual income tax rates. However, there are several exceptions to this general rule. Capital gains may be treated as income if the capital gains are (1) paid or distributed to beneficiaries for that taxable year; or (2) paid or set-aside for use as a charitable contribution.

Because of the stark difference between trust tax rates and individual tax rates, taxpayers may prefer to have the most trust earnings possible count toward the individual taxpayer’s income rather than income of the trust. With proper tax planning, a trust can be designed to have any potential capital gains taxed at an individual income tax rate, which saves more money.

These exceptions are generally narrow in application, and state or local law may affect how these exceptions apply. Taxpayers should seek advice from their tax advisors on how best to utilize these exceptions to save taxes.

Next Steps

Trusts can provide taxpayers with the ability to manage their assets, control the future of those assets, and provide several tax planning benefits. However, taxpayers should be aware of the best ways to utilize trust income and distributions so there is minimal tax exposure. Are you making smart decisions with your trust? Get started with Corvee to find out.