This is the final article in a three-part series on the taxation of trusts. The first part reviewed how a trust can be “substantially owned” by someone, i.e., what is commonly known among Estate Planning or Trusts & Estates attorneys as a “grantor trust.” It also looked at the advantages of using a grantor trust. Here is a link to the first article in the series. The second article in the series examined the Taxpayer Identification Number (“TIN”) which trusts, including grantor trusts, should use. Here is a link to the second article in the series. This final article in the series examines the taxation of nongrantor trusts.
Often, there is confusion regarding how a trust or a subtrust may report income and the TIN which should be used. Treasury regulations spell this out quite clearly. Treasury Regulation 1.671-4 is the relevant section.
A “nongrantor” trust is a trust which is not substantially owned by anyone pursuant to the provisions of section 671 and following. A nongrantor trust should obtain and use its own TIN. The trustee of the trust should provide the TIN of the trust and the address of the trust to banks and other institutions at which it has assets.
The income of the trust gets reported on the trust’s own tax return, Form 1041. The trust would receive a distribution deduction for distributions which carry out Distributable Net Income (“DNI”). These distributions to the beneficiary which carry out DNI then get taxed on the beneficiary’s tax return. The trustee would provide a Form K-1 to the beneficiary advising the beneficiary of the amount of income which the beneficiary must report on their tax return.
Let’s look at a quick example.
Mary set up an irrevocable trust. The trust contains nothing that would deem Mary or any other person as the substantial owner under Sections 671 and following. In other words, the trust is a nongrantor trust. The trust had $50,000 of income in the year. The trust made $20,000 of distributions to the beneficiary of the trust, Ben (Mary’s son). Those distributions were of cash and carry out DNI. Mary’s sister, Alice, is the trustee of the nongrantor trust. Alice will file a Form 1041 for the trust and report the $50,000 of income and a distribution deduction of $20,000. She’ll also provide Ben with a K-1 for the distribution of $20,000 to him. Ben will include the $20,000 of income from the K-1 on his tax return for the year.
Grantor trusts and nongrantor trusts each have their place in Estate Planning. Remember, whether a trust is a grantor trust or a nongrantor is not indicative of whether it is included in the taxable estate of the grantor for estate tax purposes, only income tax purposes.
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