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Recently, we discussed some of the main reasons why trusts are often used in complex estate planning strategies. We saw, for instance, how trusts confer benefits by providing certainty regarding the transfer and use of resources. Although the basic points of trusts are fairly simple to grasp, trusts can become complicated in many instances. Simply put, there is a vast amount of information to know when it comes to trusts, and so this is where the expertise of a qualified attorney can be so useful. In this post, we’re going to go over a few of the basic facts on the topic of trust taxation. Let’s start at the very beginning: taxable and nontaxable trusts.
Trust Taxation: Two Basic Categories
For tax purposes, trusts fall into two categories: taxable and nontaxable. Taxable trusts are essentially indistinguishable from other entities for tax purposes; this means, for instance, that a taxable trust will file its own tax returns with the IRS, pay taxes on its income, and be treated much the same as any other type of taxable person (i.e. individuals, C corporations, partnerships, etc.). A taxable trust is an independent entity, whereas a nontaxable trust is considered a “disregarded entity” for tax purposes. If an entity is disregarded, then that entity is not considered distinct from its owner for tax purposes; nontaxable trusts have all the same functions, but they are basically “carried” by the owner as though they weren’t independent. An example of a nontaxable trust would be a trust in which the creator and the beneficiary are one and the same; in this instance, the property owned by the trust is treated as being owned by the creator for tax purposes, rather than the trust itself. Similarly, income generated by the trust is taxed as though it were generated by the creator, not the trust itself.
The Nuances of Taxable Trusts
A taxable trust will have its own EIN, and so it will file its own returns with the IRS and be treated as a separate “person” for tax purposes; the deductions, credits and income for trusts are reported on Form 1041. Income generated by trusts will be taxable at the entity level (of the trust) unless it is distributed to beneficiaries; trusts receive deductions for distributed income, which in turn prevents double taxation at the entity level and beneficiary level. Often, the funds placed in trusts generate interest income, and that interest income is taxed at the entity level unless distributed to beneficiaries. As with other taxable persons, trusts may take advantage of certain deductions and credits as long as they report them and utilize them properly.
Part of the strategy when it comes to trust taxation relates to the differences between the trust and individual tax rates. When trust tax rates are relatively high, the financially optimal course is to pass everything to the beneficiaries in order to pay at a lower rate; if trust rates are relatively lower, then beneficiaries won’t take a hit on retained income, and so not all income may need to be distributed to beneficiaries. Subtleties such as these are one reason why Marylanders need to consult with an experienced trust attorney prior to setting up one of these entities.
Contact the Murphy Law Firm for More Information
In the future, we will come back and discuss trusts, and trust taxation, in more detail. Like wills, trusts make up a large area in the field of law, and so there is plenty to learn. For more information, reach out to one of the leading attorneys at the Murphy Law Firm today by calling 240-219-9311.
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