More often, trust and estate planning attorneys advise their clients about the importance of trust, trust arrangements and its benefits. This is effective especially for a family member or a friend with a disability.
Before discussing how trusts are taxed for income tax purposes, we’ll give the basics on trust.
But, first what is Trust?
Trusts, similar to estates, are a taxable entity. A trust is defined as a fiduciary entity which is used to hold and invest money or property held in the trust for the benefit of the beneficiaries. A Trust property consists of the principle which is the property transferred to the trust by the grantor, and income earned by the trust, which mostly comes from investments.
If the trust retains the income beyond the end of the year, then it must pay taxes on it. Since trusts are not subject to double taxation, either principal or the income on which the trust paid taxes can be distributed tax-free to the beneficiaries. Any taxable distribution to beneficiaries is deductible by the trust.
Categories of Trusts
There are mainly two important categories of Trusts:
1- Revocable Trusts
First on the list is the Revocable Trusts. This trust can be revoked or amended by its owner at any time, without anyone’s permission. The owner of the trust retains the unrestricted control of the trust assets so long as he or she is competent. After the owner’s death, the trust usually continues for traditional estate planning purposes.
For those people who are planning for a family member with special needs, his or her parents, or maybe relatives often create a revocable special needs trust but expect to delay funding until the owner’s death. The trust owner may declare the trust irrevocable at any time and may provide for an automatic shift to irrevocable status under a specific circumstance, such as funding by someone other than the owner. This category of trust gives the owner a significant control to address changes in the lives of those expected to be involved in the future application or use of the trust.
2- Irrevocable Trusts
Irrevocable trusts, on the other hand, are a category of trusts used in special needs estate planning. In an irrevocable trust, the owner cannot amend the provisions of the trust and cannot spend trust funds for the benefit of anyone other than the beneficiary unless the terms of the trust document specifically authorize or allow it. Sometimes the trust document grants the trustee a limited right to amend certain provisions if there are changes in the beneficiary’s life justify or require an amendment.
Estates and Trusts Income Tax Rates
Below are the estates and trusts income tax rates for this year 2018.
There are numerous changes made in the Tax Cuts and Jobs Act of 2017, signed by President Trump on Dec. 22. The new tax act was business focused and said to be helpful to most businesses, however, it has many provisions relating to the taxation of trusts and estates. Trust and estate income tax rates and brackets changed, along with deductibility of some estate and trust administrative expenses. The exemption amount for the estate, gift, and generation-skipping transfer taxes have doubled.
Below are some of the changes made:
- The new act reduces the existing five trust and estate income tax brackets to four by combining two of the brackets, increases the rate in one bracket and reduces the rates in the others.
- The initial bracket on income up to $2,550 has been lowered to 10 percent from 15 percent.
- The new second bracket combines the old second and third brackets on income up to $9,150 and lowers the rate to 24 percent from 25 percent and 28 percent.
- The rate on the next bracket on income up to $12,500 has been increased to 35 percent from 33 percent.
- The top rate on income over $12,500 has been reduced from 39.6 percent to 37 percent. These bracket dollar amounts will now be inflation-adjusted using a chained consumers’ price index.
- The 3.8 percent Medicare surtax on net investment income continues in 2018.
The effectivity of these changes in the income tax rates for trust and estates only continue through 2025. In 2026, everything will be back again which is the same last in 2017, not unless the American officials change it again.
How are Trusts Taxed for Income Tax Purposes?
The First thing that you need to know is that Trust funds are taxed differently, depending on their type of fund. A trust that distributes all its income are known to be a simple trust; otherwise, the trust is complex. A tax deduction is made for income that is distributed to beneficiaries. In this case, the beneficiary pays the income tax on the taxable amount, rather than the trust.
The trust amount distributed to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is the original contribution plus subsequent ones and is income in excess of the amount distributed. Capital gains from this amount could be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary are taxable to him or her to the extent of the distribution deduction of the trust.
If the income or deduction is part of the change in the principal or part of the estate’s distributable income, then the income tax is paid by the trust and not by or passed on to the beneficiary. An irrevocable trust that has discretion in the distribution of amounts and retains earnings pays trust tax that is 35% of annual income over $12,700.
The K-1 schedule for taxing distributed amounts is generated by the trust and handed over to the IRS. The IRS will then deliver the document to the beneficiary to pay the tax. The trust then accomplishes the Form 1041 to know the income distribution deduction that is matched on the distributed amount.