With tax season upon us, you may be wondering about trusts and taxes. Who is accountable for the funds in a trust, and does a trust beneficiary have to pay taxes on what they inherit?
Do Trusts Have to Pay Taxes?
As a general rule, most trusts will have to pay taxes at some point. When and how much depends largely on whether the trust was set up as a grantor trust or a non-grantor trust.
A Grantor Trust is a type of trust in which the grantor (the person creating the trust) retains control over the assets or property in the trust. They are the asset or property owner for income and estate tax purposes. Examples of common grantor trusts include revocable trusts (also known as living trusts), grantor retained annuity trusts, spousal access trusts, defector grantor trusts, and most irrevocable life insurance trusts.
With grantor trusts, because the grantor still owns and controls the trust assets, they are responsible for any taxable income earned by the trust. In most cases, the grantor will report this earned trust income directly on their personal tax return. There will not likely have to file a separate trust income tax return.
Alternatively, with a Non-Grantor Trust, the grantor is not a trustee or beneficiary of the trust. They have given up all title and interest in the principal and do not own or control any assets or property in the trust. Only the trustee may revoke or terminate a non-grantor trust. There are two basic types of non-grantor trusts: simple and complex.
When the grantor puts the assets or property into the non-grantor trust, they give up ownership and the trust assumes responsibility for any earned income. When it comes time to file taxes, the trustee is responsible for preparing and submitting the paperwork, and the trust will pay any income tax.
Do Trust Beneficiaries Have to Pay Taxes?
After a grantor sets up a trust, the trustee will make regular payments or disbursements – depending on the rules of the trust. The trustee can use the principal, interest, or a combination of both to make these payments to the beneficiary.
If a beneficiary is paid from or receives a distribution from the trust’s principal, the beneficiary is not subject to taxes on that income. That’s because the IRS assumes the money was already taxed before it was placed into the trust, and the funds do need to be taxed a second time. If the beneficiary receives a distribution from the trust’s earned income, the beneficiary will likely have to pay taxes on it. As this money is earned income, no one has paid taxes on it yet – which is why the beneficiary is responsible for any applicable capital gains and income tax.
When a beneficiary receives trust funds in a single or large distribution, they may be responsible for estate taxes. As of the 2020 tax year, the estate and gift tax exemption is $11.58 million per individual. In other words, if the beneficiary received more than $11.58 million in 2020, they will be responsible for paying federal estate taxes. If the beneficiary receives funds from a revocable trust that is part of the grantor’s estate, the beneficiary will be taxed on income that exceeds the $11.58 million. If the beneficiary receives money from an irrevocable trust that was not part of the grantor’s estate, the beneficiary may not owe estate taxes above the annual exemption.
Have Additional Questions?
When it comes to trusts and beneficiaries, the taxation process can be complex and a challenge to understand. But Brian M. Douglas & Associates is here to answer any questions you may have. If you’d like to learn more about trusts, or if you’d like to set up an estate planning appointment, please reach out to us at (770) 933-9009 or via our online contact page.