Federal Income Taxation of Trusts: Part I

I’m often asked by clients what are the tax consequences of creating a trust or of being the beneficiary of a trust.  As the initial assets placed in a trust grow, they produce income and that income is either distributed out to the beneficiary or it is held in the trust.

Generally, income that is distributed to the beneficiary is reported on that beneficiary’s individual income tax return while income that remains in the trust is reported on the trust’s income tax return.  Trusts and estates are taxed at the same income tax rates as individuals; however, the brackets are greatly compressed.  See Internal Revenue Code Section 641.  For example, an individual filing as a single taxpayer reaches the top tax bracket when he or has adjusted gross income of $500,000.00 and all ordinary income above that amount is taxed at 37%.  However, the highest tax bracket for a trust taxed as a separate entity starts at only $12,500.00.  That means that all ordinary income above $12,500.00 is taxed at 37%; additionally, all long-term capital gains in excess of $12,700.00 are taxed at 20%.  In addition, the 3.8% net investment income tax that applies to individuals with income in excess of $200,000 ($250,000 for couples who are married filing joint) applies to trusts once they reach $12,500.000.  Because most trust income is considered passive, the 3.8% will often have more of an impact on trust income than on a working individual with earned income.

However, not all trusts are created equal.  If a trust is a revocable trust during the grantor’s lifetime, any income resulting from trust assets will be taxed to the grantor individually at the grantor’s individual rates.  This is because a revocable trust is essentially the alter ego of the individual grantor.  Revocable trusts are often used to avoid probate, to ensure privacy, and for incapacity planning.  Certain other trusts may be taxed to the individual grantor.  Some of the mechanics and advantages of that treatment will be discussed in my next post.