Trusts and Taxes: Important Questions Answered!

As tax season nears, you may find yourself with questions regarding who should file tax returns or how trust income tax should be remitted. We aim to answer some frequently asked questions related to trusts and taxes.

No trust can escape income taxation; all trusts are taxed at various levels on income generated. Each trust operates as its own legal and tax entity and whether or not the taxes can be paid independently depends on whether it’s a simple or complex trust. These two categories pay income taxes directly while grantor-trusts do not; instead, the grantor pays on behalf of that grantor trust’s income.

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How Can I Identify Whether My Specific Trust Is Simple?

A typical simple trust contains three characteristics that help identify it:

All income must be distributed every year at least,
There must be no beneficiaries who share in it and
No principal is paid out from within it.

If the trust does not fit within this definition of simple trusts, then it falls under the complex or grantor trust category.

What Is A Trust Grantor?

Trust grants allow grantors to retain certain powers with regards to trust property as set out in its documents, whether these be revocable or irrevocable trusts; due to these retained powers of the grantor (GCons), its trust status does not count towards income tax purposes (ITC). GCOns typically retain powers such as:

The grantor or grantor’s spouse has the power to amend or revoke trusts (i.e. Revocable Trusts).
They may substitute trust assets with value-equivalent assets without providing adequate collateral and may borrow property without adequate security from trusts.
Distributes (spousal life access trusts) may be received by either the grantor or their spouse; premiums on life insurance policies ensure either can also be paid using income from trust income.

Although other grantor-retained powers could qualify a trust as donor trusts, these are usually the ones most frequently found.

Tax authorities treat grantor trusts while being separate legal entities, like one taxpayer for tax purposes; income earned through them should be reported on an individual tax return and subject to taxes at that point.

Complex trusts occur if their grantor has none of these powers; otherwise, they would be considered simple trusts.

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How Can I Identify Whether My Specific Trust Is Simple?

Yes; whether the trust is simple or complex it must file Form 1041 annually in case there is any taxable income within.

The type of tax returns that grantor trusts must file depends entirely on the nature of the grantor trust. Some trusts use their grantor’s Social Security number for taxpayer identification or apply directly with the IRS; in either case, they do not need to file tax returns, as all forms and 1099s will be sent directly to the grantor for reporting on their tax returns.

However, if the trust has its taxpayer identification number, it may file pro forma returns that provide information for the grantor to report on their tax return. These returns serve solely informational purposes, or they may include letters listing the income items attributable to the grantor. In such cases, the trust may file informational tax returns, but the responsibility for reporting remains with the grantor when filing their tax returns. Understanding trusts and taxes is crucial in determining the proper reporting requirements and ensuring compliance with IRS regulations.

Does a Trust Have to File and Pay State Income Tax Returns If It Acts as Its Taxpayer?

Depending on which state has jurisdiction over a trust, that trust will need to file and pay state income tax returns. Each state has its own set of rules to determine who they can tax; some do have jurisdiction and others do not. New York can tax a fund provided by a grantor residing within its borders – as long as no trustees, assets, or income is generated within New York state – while California taxes any beneficiary living there who serves on its board of trustees or beneficiaries.

What Tax Deductions May a Trust Claim When Filing Its Taxes?

A trust that qualifies as tax-exempt may deduct state and local taxes paid, trustee fees, the preparer of tax returns fees, and income distribution as tax expenses. A grantor trust does not qualify because it does not stand alone as an identifiable taxpayer entity.

Tax Return Preparer Fees and Trustee Fees

Only expenses attributable to taxable income can be deducted, which means only two-thirds of trustee fees and tax preparer fees can be deducted – for instance, if an income stream contains $10,000 of Dividends while $5,000 tax-exempt interest (dividends plus interest earned on capital gain securities).

Before computing an income distribution deduction, one must determine their trust’s distributable income (DNI), which is defined in the Internal Revenue Code and typically equal to total trust income minus state tax, trustee fees, and any return preparer fees that have been deducted as deductions. Understanding trusts and taxes is essential in this process, as different tax rules may apply depending on the trust’s structure and income distribution.

Bottom Line!

Dealing with the intricacies of trusts and taxation is a daunting task, especially as tax season approaches. Compliance with IRS standards and knowledge of your trust’s taxation needs are crucial if penalties are to be averted.

At Tenina Law, we trust taxation and estate planning specialists to provide specialized advice tailored to suit the specific requirements of each of our clients—whether it’s assistance in classifying or lodging proper tax returns for maximized filing deductions or gaining clarity on trusts and taxes, including the tax burdens of trusts.

Contact Tenina Law today and book a consultation so that we can illuminate trust tax obligations!