We all have heard of trusts. Perhaps you are a beneficiary of a trust or expect to be a beneficiary someday. You may have a trust yourself. Did you ever ask “who pays income tax on trust assets?” This is an important question that even many attorneys cannot answer. However, this answer can have important implications.
In order to determine how a trust is taxed, first you have to determine whether it is a “grantor” trust. The grantor is the person that set up and funded the trust. If the grantor is dead, it is not a grantor trust. If the grantor is alive, it will be a grantor trust if the grantor has retained one of many enumerated powers, including the power to revoke the trust or the power to substitute assets. If the trust is a grantor trust, all of the items of income and expense of the trust are taxable on the grantor’s income tax return. In fact, in many circumstances, the trust may even use the grantor’s social security number as its taxpayer identification number. It is treated the same as the grantor for tax purposes.
It is important to note that with a grantor trust, the income tax liability accrues to the grantor even if no distributions are made to him or her. For example, Sylvia Jones sets up the Jones Trust, which is drafted as a grantor trust. The trust has $20,000 of income for the year. The trustee makes distributions of $5,000 to each John and Mary (who are not the grantors). Sylvia will have to include the entire $20,000 on her tax return while John and Mary include none of the distributions to them.
A trust, which is not a grantor trust, is a “non-grantor” trust. Such a trust is not taxable directly to any individual. If no distributions are made from the trust, all the income earned by the trust is taxed to the trust as a separate taxpayer. In fact, it would file its own tax return just like we each do every April 15th. If the trust makes distributions to beneficiaries, those distributions are deductible to the trust and are generally taxable to the beneficiary. Thus, if the Jones Trust were a non-grantor trust, the trust tax return would report a net $10,000 and John and Mary would each report $5,000. Just as we each file a Form 1040 (or 1040A or 1040EZ) every April 15th, the trust would file a Form 1041 to report its income. Just as a bank issues a Form 1099 alerting a recipient of interest income, the trust would give each John and Mary a Form K-1 alerting them of their $5,000 of income. Of course, Sylvia would not report anything on her return.
It is important to know how any trust with which you are involved should be taxed. Otherwise, you could be reporting income that should be taxed to someone else, or vice versa. Further, in planning your own trust, you might consider the advantages and disadvantages of making it a grantor or non-grantor trust. A qualified estate planning attorney can help you.
Mr. Morrison is a board-certified estate planning attorney with experience in both simple and complex estate matters. He can prepare an estate plan for you that achieves your goals of passing your assets to whom you wish. He has been engaged in Louisiana trusts and estate law for the last 18 years. The planning can even help minimize estate taxes. To learn more about how you can achieve your estate planning goals, please call (504) 831-2348 or visit our website at www.morrisonlawplc.com