How are Trusts Taxed?
How are trusts taxed?
In order to understand how a trust is taxed, you need to first understand that there are two types of trust for income tax purposes.
Grantor Trusts
Non-Grantor Trusts
GRANTOR TRUSTS
Any income produced by assets held within a Grantor trust are generally treated as being owned by the Grantor (or trust maker / creator of the trust) for income tax purposes. This means that Grantor trusts generally do not require a separate tax return or tax ID - you would simply use your social security number as the tax ID for the trust if a bank ever asks you for one.
So, from an income tax standpoint, there is no difference on how you would file your taxes when you have a Grantor trust.
If you have a revocable trust, then it is a Grantor trust. If you have an irrevocable trusts, then you’ll need to check with your trust attorney to see whether you retained certain powers of the trust that would make it a Grantor trust for income tax purposes.
Most of the trusts that I do for my clients are intentionally designed as Grantor trusts for income tax simplification purposes.
Please note: there are certain circumstances where practitioners will still get you a separate tax ID number even though you have a grantor trust. This is particularly applicable for irrevocable trusts designed as intentionally defective grantor trusts (IDGTs).
NON GRANTOR TRUSTS
Non-Grantor trusts are treated as separate taxable entities so these would generally require a separate tax ID number and tax return to be filed on an annual basis (unless your tax advisor determines filing is unnecessary - which is generally applicable if the trust is temporarily producing no income, but even then an informational tax return may be used).
If you have a non-grantor trust, your tax preparer will want to know whether the trust is considered a “simple trust” or a “complex trust.” In other words, does your trust distribute all the income it receives every year or does it have the ability to retain some or all of that income.
The difference can be substantial if the trust is generating a decent amount of taxable income because of the compressed marginal tax brackets associated with the trust.
In other words, at the time of this writing, a trust generally reaches the highest marginal tax bracket at $15,200 of taxable income (whereas a person filing their personal tax return as an individual filer wouldn’t hit that threshold until he or she reaches over $609,351 taxable income or $731,201 if married filing jointly).
For that reason, virtually no one wants to pay taxes at the trust level when they can pay lower taxes at the individual level when that person (or beneficiaries of that trust) are in lower tax brackets. There are of course exceptions for certain asset protection scenarios or where the client is investing assets inside the trust in a way that has minimal tax impact, but otherwise you will commonly see income distributed out of non-grantor trusts so that it is taxed a the individual tax rate rather than the trust’s tax rate.
Put differently, as long as you don’t retain the taxable income inside the trust, then it wouldn’t be taxed at the trust level and instead would be taxed at the rate of the person receiving the income from the trust.
So why would anyone want a non-grantor trust, if they could do a grantor trust?
For the reasons stated above, most clients will want a grantor trust to both simplify their taxes and to keep their tax bill as low as possible.
But, some clients with irrevocable trusts will choose the non-grantor trust if they would prefer the income to flow to other beneficiaries anyways and do not want to be personally liable for any income tax liability generated from the trust (which is completely understandable).
One other things to note: If you Google “why would you want a non-grantor trust?” you will see blog posts talking about asset protection purposes, but you can generally retain asset protection benefits even when a grantor trust is used (that’s where the intentionally defective grantor trust’s come into play) so please be careful when googling these questions.
Please also keep in mind that this is assuming practitioners are able to continue using intentionally defective grantor trusts. We are expecting tax changes to take place by 2026, and irrevocable trusts that qualify as grantor trusts but allow assets to pass outside a person’s estate for estate tax purposes has been under scrutiny for some time (because you can in effect get the best of both worlds by being treated as the tax payer for income tax purposes but not for estate tax purposes).
In summary, if you are doing a revocable living trust then you don’t have to worry about the income tax implications of a non-grantor trust, but if you are doing irrevocable trusts then you should definitely speak with your trust attorney before making any decisions as the tax implications can be substantial for both you and your family.
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