Trusts can be useful in helping you achieve your financial goals, but when it comes to taxes, trusts can get tricky in a hurry. In particular, figuring out how much of a trust distribution is taxable can challenge even the most experienced accountants and tax professionals. However, there are some basics that anyone can understand about trust taxation and how payments that a trust makes to its beneficiaries will get treated for tax purposes.
The revocable vs. irrevocable trust distinction
Trusts get taxed differently depending on how they're classified. The most common distinction is between revocable trusts and irrevocable trusts. Most revocable trusts are treated as grantor trusts for tax purposes, meaning that those who created the trust include any income on their tax returns.
Irrevocable trusts, however, are generally separate entities for tax purposes. Any income that the trust assets generate creates potential tax liability for the trust itself, and the trust can also take related deductions to reduce its taxable income.
Where things get complicated is when an irrevocable trust makes distributions to beneficiaries. In that case, some of the taxable income gets carried outside the trust, with the beneficiary assuming responsibility for paying any resulting tax. The trust itself gets a deduction for distributions to the extent that they don't exceed the amount of net income that the trust's assets generated.
What happens in real life
As complicated as this sounds, the most common situations where the trust tax rules come up in practice are a bit simpler. That's because most trusts are structured to make distributions simple and predictable.
For instance, many trusts are set up to pay all the income the trust generates to a particular beneficiary. In that situation, the most common tax result is that all taxable income gets carried out of the trust to the beneficiary. The trust will therefore get a full deduction for the income generated, and the beneficiary will have to pay the taxes on the income.
With respect to asset sales, capital gains tax treatment depends on the provisions of the trust. State law defines whether capital gains are considered as part of income or principal for trust accounting purposes, and so if a trust provides for payments of income only, the beneficiary often has no right to receive any capital gains. In general, whoever receives the capital gains gets taxed on it, with preferential tax rates applying for long-term capital gains on property held for longer than one year.
Many cases are more complicated, with so-called complex trusts that allow for accumulation of income, permit distributions of trust principal, or provide for charitable beneficiaries. If beneficiaries receive more money from a trust than the trust's actual income, then they will typically include only the income portion in their taxable income, with other distributions being tax-free to the beneficiary.
To get answers for your particular trust situation, you'll want to consult with a tax professional. With this basic guide, though, you can at least walk into that consultation with a basic understanding of where you stand.
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