When you have a trust, it’s important to understand how trusts are taxed. When you receive distributions from a trust, it’s equally important to know if the distributions are subject to tax. Trusts pay taxes in some situations, and some trust taxation laws have changed with the implementation of the Tax Cuts and Jobs Act. Here’s what you need to know about how trusts are taxed in 2019:
Different types of trusts are taxed differently
There are many different types of trusts. With the many different types of trusts come many different ways that trusts are taxed. When you start to learn about trusts and taxation, it’s critical to remember that each kind of trust has its own unique rules for taxation. If you create a trust or receive distributions for a trust, it’s important to get personalized, professional advice about the taxation of the trust. Likewise, if you’re considering creating a trust, it’s important to speak with a qualified professional about the tax implications of the trust.
Revocable and irrevocable trust taxation
The most basic way to understand trusts and taxes is to separate trusts into two categories – revocable trusts and irrevocable trusts. In a revocable trust, the grantor still owns the property in a trust. In an irrevocable trust, the property becomes a separate legal entity. In an irrevocable trust, the grantor no longer owns the property in the trust.
Trust taxes and revocable trusts
When a trust beneficiary funds their own trust and maintains control over the trust, the income from the trust is reported on the tax returns of the beneficiary. In a case of a revocable trust, the taxes pass through to the beneficiary’s tax return. There’s no separate tax return for the individual to file. In the case of a revocable trust, the taxes are carried over to the grantor’s individual tax return. The trustee uses Form 1041 – U.S. Income Tax Return for Estates and Trusts, but the taxes pass through to the grantor’s tax return.
Trust taxes and irrevocable trusts
For an irrevocable trust, the trust files its own tax return. The trustee must report all income even if the beneficiaries receive the income. Distributions that the trust makes to the beneficiaries are deductible from income that is subject to tax in the trust. The trust itself must pay taxes that it owes on income. Likewise, the individuals who receive distributions must pay taxes on the distributions. The trustee uses Schedule K-1 in order to detail payments to the beneficiaries so that the trustee, beneficiaries and the IRS are all on the same page about payments to beneficiaries and who owes taxes on the trust income. Beneficiaries pay different tax rates on different types of income like interest, dividends and capital gains.
Trust distribution classification for simple and complex trusts
A trust is a simple trust if it distributes all of its income to the beneficiaries. A trust is complex if it may not distribute all of its income to the beneficiary. When a trust is complex, distributions to the beneficiary come from the current year’s income and then from the trust’s principal assets. The distribution loses its character as income or principal upon distribution to the beneficiary.
Trust taxation and the Tax Cuts and Jobs Act
The 2018 Tax Cuts and Jobs Act brought significant changes to all income taxes including taxation of trusts. The law creates new tax brackets for trusts. There’s one set of tax brackets for income from a trust and another set of tax brackets for capital gains and qualified dividends.
The biggest difference between the two sets of tax brackets is that income tax has a much higher top tax rate than the top tax rate for capital gains and dividends. Income over $12,500 is taxed at a rate of 37 percent while capital gains and qualified dividends over $12,700 are taxed at a rate of only 20 percent. The difference is likely to keep taxes on capital gains in trusts in line with capital gains taxes for assets that are not kept in trust.
In addition to changes in tax rates, there are also rule changes that mimic the changes for non-trust assets. For example, state and local real estate and personal property tax deductions are limited to $10,000 per year. The rule doesn’t apply to taxes that come from a trust conducting business activities. In addition, a trust may no longer deduct investment fees and expenses or unreimbursed business expenses.
The net result is that taxes for many trusts are going to be higher than they would have been before the Tax Cuts and Jobs Act. However, a trust can still be an appropriate and financially beneficial legal and financial tool in many circumstances. Unless lawmakers extend the tax laws or make changes, the trust tax laws created by the Tax Cuts and Jobs Act expire in 2025.
But I thought the whole point of a trust is to avoid taxes!
You may have heard that creating a trust is an efficient way to avoid taxes. It’s true that a trust can be a good way to avoid inheritance taxes. As a way to transfer wealth from one generation to the next, a trust is an efficient way to shield assets from hefty estate taxes. However, a trust isn’t a way to avoid paying income, capital gains or dividend taxes. Beneficiaries of a trust can expect to still have these tax obligations when they benefit from a trust.
Understanding trust taxation
Taxation of trusts is complex. How a trust is taxed depends highly on the characteristics of each particular trust. If you’re involved in a trust as a trustee or beneficiary, it’s critical to understand the tax implications and obligations that go along with your role in the trust. It’s important to understand that taxation of trusts is not created equally. You must understand the type of trust and the types of income that you have in order to correctly determine how your trust is subject to tax.
Even though trust taxation may seem overwhelming, trusts are still critical and valuable financial management tools in many circumstances. An experienced trusts attorney can help you determine whether a trust is right for you. At Wilson Ratledge, we can advise you on the best course of action taking into account the legal and tax implications of a trust created for your unique situation.