Trusts can be very useful vehicles to control assets during life and after death. During life, they can be especially helpful to control assets during periods of disability. After death, a trust can provide asset protection, remarriage protection, asset management, and many other benefits which might not be available otherwise.
Generally, trusts are income taxed in two different ways, as “grantor” trusts or “nongrantor” trusts. A grantor trust is one that is taxed to the grantor (or other substantial owner) pursuant to the rules of Section 671 and following sections of the Internal Revenue Code. For example, if you can revoke the trust, it’s a grantor trust pursuant to those rules. A grantor trust, such as revocable trust, is taxed directly to the grantor and the grantor reports the income of the trust on his or her own Form 1040. So, you can just give the grantor’s social security number to the bank or other payer of income and the income will be taxed to the grantor, just as if the grantor owned it outright. Even if the trust is irrevocable and the grantor isn’t even a beneficiary, it may still be a grantor trust. For example, if the grantor retains the power to substitute assets, the trust would be a grantor trust and taxed to the grantor. If the trust is a grantor trust, the income is taxed to the grantor even if the income and other distributions actually go to someone else.
A nongrantor trust, by comparison, is taxed as its own separate taxpaying entity. The trustee of the trust has the trust file its own tax return, Form 1041. On that return goes all the trust’s items of income and expense. The nongrantor trust has its own taxpayer identification number which it gives to payers of income. If the trust makes distributions during the tax year to beneficiaries, those distributions may carry out taxable income of the trust. In that case, the trust issues a Form K-1 to the beneficiary listing the taxable portion of the distribution. Then, the beneficiary includes the taxable portion of the distribution in their own income. The trust then takes a distribution deduction on its return. If the trust has income for which it didn’t have an offsetting distribution deduction, the trust itself is taxed on the income. Nongrantor trusts have a very steep income tax bracket structure. In other words, while an individual taxpayer reaches the top federal tax bracket on income over $500,000 (single filer), or $600,000 (married joint return), a nongrantor trust reaches the same top rate bracket on amounts over just $12,500.
Let’s look at an example. The Mary Smith Trust has income of $50,000 each year and distributes $20,000 to beneficiaries each year. If the trust is a grantor trust, the $50,000 of income gets taxed to Mary (the grantor) each year. When preparing her Form 1040, Mary adds the $50,000 income the Mary Smith Trust received for the year to the income she received individually. It doesn’t matter whether the trust’s income is actually distributed to Mary or even distributed to someone else, it’s still taxed to Mary, as the grantor.
Mary then dies. The trust continues for Mary’s children, John and Susan, as a nongrantor trust. John and Susan each receive $10,000 in income from the trust. They each receive a K-1 from the Mary Smith Trust reflecting the $10,000 distribution to each of them. Each of them must report this on their own Form 1040. The trustee of the Mary Smith Trust will file a Form 1041 for the trust and will report $50,000 of income and $20,000 of distribution deductions.
In my next blog, I’ll look at the advantages and disadvantages of grantor trusts and nongrantor trusts.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
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