Trusts can be effective tools to help manage and protect your assets and may reduce or even eliminate costs related to wealth transfer, such as probate fees and gift and estate taxes. But there are trade-offs to consider when establishing and transferring assets to a trust. In addition to selecting a trustee, crafting distribution provisions, and estate tax planning, families should also consider how income taxes will impact the trust’s ability to maximize their wealth-transfer goals.
This article focuses on federal trust income taxation, also known as fiduciary income, and the Uniform Principal and Income Act (UPIA). It is important to keep in mind that several states also tax fiduciary income, which should be a factor to consider when creating certain trusts. In fact, in some situations, state income tax liability can play an important role in determining the type of trust and what state the trust is incorporated in for income tax purposes. In all cases, it is best to consult with your tax professional to determine whether a trust strategy may be suitable for you.
How trusts are taxed
From a tax perspective trust assets are generally classified as either “principal” or “income.” Generally, the assets the trust owns represent its principal (e.g., stocks, bonds, or real estate) and what those assets earn or produce represent its income (e.g., dividends, interest, or rent). There are complex trust accounting rules that govern the treatment of a trust’s income, expenses, taxes, and distributions.
For income tax purposes, a trust is treated either as a grantor or a non-grantor trust.
In the case of a grantor trust, the grantor (i.e., the person who created the trust) is responsible for paying the tax on income generated by trust assets. Two common forms of grantor trusts are revocable living trusts and intentionally defective grantor trusts (IDGTs):
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For non-grantor trusts, who is responsible for paying the income tax depends on whether the trust is considered simple or complex:
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In the case of a simple non-grantor trust, the beneficiaries are responsible for paying the income taxes on the income generated by trust assets, while the trust will pay the taxes on capital gains. For complex non-grantor trusts, the tax may be paid by the beneficiaries, the trust itself, or a combination, depending on the circumstances in any given year.
While the maximum rates are the same for a trust and an individual, trusts are taxed more aggressively than individuals. Consider that in the 2024 tax year, the top marginal tax rate for a single filer, 37%, begins after $609,350 of ordinary income. A trust is subject to that rate after reaching only $15,200 of income. In addition, trusts, like individuals, may be subject to the net investment income tax (NIIT) for any undistributed investment income. This is a 3.8% tax on either the trust’s undistributed net investment income, or the excess of adjusted gross income over $15,200, whichever is less. In comparison, a single individual is subject to the NIIT on the lesser of net investment income, or excess modified adjusted gross income over $200,000.2
As you can see, the amount of tax paid on the same amount of income can be much greater when the trust is responsible than when an individual taxpayer is.3
Lowering the trust's taxable liability
A distribution to a trust's beneficiary could result in a lower overall tax. That may be the case because the trust will take a deduction for the distribution, and given the higher thresholds for individual filers, depending on the beneficiary’s overall income level, the beneficiary may be in a lower tax bracket. However, there are some limits on how much income, for tax purposes, may be allocated to distributions made to beneficiaries from a trust. This is an important concept since a distribution to a beneficiary can be from income and/or principal depending on the income and capital gains generated by the trust in any given year.
For example, consider the situation where a beneficiary receives $10,000 as a distribution from a trust:
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Important considerations
Although trusts are often the cornerstone of a family’s wealth-transfer strategy, failing to carefully consider a trust’s potential tax liability can impact the strategy’s effectiveness. Because of the complexity of the fiduciary income tax environment, families and their attorneys should carefully consider the trustee they select and their experience serving as a fiduciary.
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Conclusion
The taxation of trusts can vary significantly depending on whether the trust is a grantor or a non-grantor trust and whether and how much income and principal is distributed to a beneficiary. For non-grantor trusts, income distributions may greatly reduce the overall amount of income tax liability owed, depending on the tax situation of the beneficiary. It is critical to work with your attorney and tax advisor to consider the specifics when it comes to drafting and using trusts, including trust taxation, to avoid results that may differ from the original intent of your estate plan.