A prior blog discussed the taxation of trusts generally and that they could be taxed as either grantor trusts or nongrantor trusts. This blog will focus on the advantages and disadvantages of taxation as a nongrantor trust.
Unlike a grantor trust, which is taxed to the grantor, a nongrantor trust 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. But, if the income is carried out to a beneficiary by Form K-1, the nongrantor trust doesn’t pay tax on it, the beneficiary does at the beneficiary’s rates.
The nongrantor trust has some tax advantages:
- The grantor is not taxed on the income of the nongrantor trust. If the grantor wants to sever ties with the trust and its beneficiaries, this would be a benefit. For example, if the grantor is setting up a trust for an ex-spouse or children from a prior marriage, they may not want to pay income tax on that trust in the future.
- The beneficiaries of the trust may be in a lower tax bracket than the grantor. If the income is being distributed and taxed to them, this would result in a lower income tax paid than if the trust were a grantor trust and taxed to the grantor.
- The nongrantor trust may be useful in planning to avoid the $10,000 limitation on state and local taxes (SALT) in current law. The nongrantor trust is a separate taxpayer and gets its own $10,000 SALT limitation. (By comparison, a grantor trust isn’t a separate taxpayer and doesn’t get its own separate SALT limitation; it shares the grantor’s $10,000 limit.) By dividing ownership of real estate among taxpayers (including nongrantor trusts), this may help make local property taxes deductible on the owners’ federal income tax returns.
- A nongrantor may be useful in obtaining a 20% Qualified Business Income (QBI) deduction. The QBI deduction may be phased out above certain income levels for owners of some businesses. Each owner, including a nongrantor trust, is analyzed separately for this purpose. If a nongrantor trust has income below the threshold and meets the other criteria, it would get the QBI deduction. By dividing the ownership, the owners may each qualify for the QBI deduction.
While a nongrantor trust has advantages, it also has disadvantages. Because it is a different taxpayer than the grantor, transactions between the grantor and the trust are recognized for income tax purposes. For example, let’s say property in the trust has appreciated in value. If the grantor purchases the property for fair market value, the trust will have to pay tax on the gain. Whereas, if the trust were a grantor trust, no gain would be recognized.
Trusts can be powerful tools. A trust may be taxed as either a grantor trust or a nongrantor trust. They both have advantages and disadvantages. In choosing a trust, it’s important to consider whether you want it taxed as a grantor trust or a nongrantor trust. What kind of trust taxation is right for your situation?
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