Many families set up trusts to provide for family members in need of financial assistance or to further their own estate planning goals. Taxation of trusts can become extremely complicated, and the structure of a family trust plays a major role in how the trust gets taxed. Those who want to avoid complications can generally include provisions that will keep things simple for at least a portion of the trust's existence.
Grantor and non-grantor trusts
For tax purposes, the key distinction in a family trust is whether it qualifies as a grantor trust. To be a grantor trust, a trust must meet at least one condition out of a list of requirements. The most common is when the person creating the trust -- also known as the grantor -- retains the right to take assets back out of the trust. That makes most revocable trusts qualify as grantor trusts. In addition, powers like being able to take trust income, retaining a remainder or reversionary interest in the trust, or having certain administrative powers over trust assets can lead to grantor trust status.
The benefit of grantor trust treatment is that the trust doesn't have to file a separate tax return at the entity level. Instead, the person creating the trust has to include any income from trust assets on that person's individual tax return and pay tax accordingly. In some cases, a grantor trust will have to file a return on Form 1041, but the only entry will be a statement saying that all income was carried out to the grantor's tax return according to the grantor tax rules.
By contrast, if a trust doesn't qualify as a grantor trust, then it will have to file a trust tax return. In that case, more complex rules apply, some of which result in the trust itself paying tax, and others of which can lead to other trust beneficiaries having taxable income.
Taxes on non-grantor trusts
If grantor trust rules don't apply, then the key question becomes who is entitled to trust income. In general, the trust must pay income tax on any income its assets generate. But if the terms of the trust require it to pay out its income to a beneficiary, then the trust itself is entitled to get a deduction for any distributable net income. Any remaining income not distributed then gets taxed to the trust directly.
The trade-off is that if the trust gets a deduction, those receiving the income have to include that income on their own individual tax returns. To do so, the trust will create an income statement on Schedule K-1 that describes the tax aspects of the payment made to the beneficiary. For instance, if a trust earns interest and dividend income and also has long-term capital gains, then the beneficiary might pay different rates of tax on those different types of income.
Income taxes on trusts can be complicated under certain circumstances. Much of the time, though, keeping grantor trust status on a family trust will be enough to simplify tax treatment and avoid the negative consequences of having to file a separate return for the trust entity.
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