Many families use trusts in order to do their estate planning and provide for their loved ones after a family member's death. Those who are beneficiaries of trusts have access to trust funds under the instructions set forth in the trust document. Most trusts hold investments in order to provide for growth in their assets, and when those investments produce income, there are tax consequences. Below, we'll look at some of the ways in which trust funds can be subject to income tax.

The trust as its own legal entity

Trusts are separate legal entities, and for most trust fund beneficiaries, the underlying trust has to file its own separate tax return with the IRS. That return includes the same type of information that individuals file on their 1040 tax returns, including the reporting of income from investments like stocks, bonds, mutual funds, and exchange-traded funds.

When trusts invest, they typically use an employer identification number obtained either at the inception of the trust or when it became irrevocable following the death of the person who set it up. The trust uses that EIN to file a tax return on Form 1041.

What taxes do beneficiaries pay on trust fund distributions?

When the trust makes distributions to named beneficiaries, what happens depends on the nature of the distribution. Typically, distributions of income generated by the trust are taxable to the extent that the trust would have had to pay tax on the paid income. That income includes the dividends that stocks pay. How this works mechanically is that the trust gets a deduction for distributing its net income to the beneficiary, and then the beneficiary gets a statement on Form K-1 that includes the amounts that have to be reported on the beneficiary's individual tax return for the year.

By contrast, distributions of trust principal typically do not subject the beneficiary to income tax. Traditionally, capital gains generated on the sale of stock are treated as trust principal rather than income, and so the trust itself ends up bearing the income-tax burden that capital gains generate. However, there are situations in which the trust has the option to make payments of capital gains income to beneficiaries and in turn to have those beneficiaries responsible for paying the associated capital-gains taxes. The trust document largely sets the guidelines under which the trustee can make those decisions, and the trustee will often consider whatever decision will result in the least amount of total tax being paid both from the trust and by its individual beneficiaries.

Those who are fortunate enough to get money from trust funds need to remember that they might owe tax on the distributions they receive. Otherwise, they could end up overspending and facing an unexpected tax bill come April.

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