If you are an accountant and you hear the phrase “trust fund taxes,” you probably think first of taxes that are withheld from employees’ paychecks to pay for Social Security, Medicare, and income tax (paid to the federal government quarterly by the employer).
But that’s not what we’re talking about today. Let’s talk about the other kind of trust fund taxes—taxes on income from trust funds.
What are income taxes on trust funds and who pays them?
Whenever you are earning income on something, it is likely taxable. The income earned from trust fund (dividends/distributions) is no exception.
A trust is taxed depending on what kind of trust it is and whether the person who created the trust (the grantor) retains power or control over the trust. If the grantor retains control over the trust and has the power to direct the income or assets of the trust, the IRS calls that a grantor trust. If the grantor does not retain control over the trust income and/or assets, the trust is a non-grantor trust.
As far as who pays the taxes, generally if a trust earns interest income and does not distribute it after year-end, then the trust pays taxes on the income. If it is distributed to beneficiaries, then the beneficiaries pay the taxes.
What are grantor trusts and how are they treated for tax purposes?
All revocable trusts (sometimes called living trusts) are grantor trusts. Most irrevocable trusts are not grantor trusts, but there are a few exceptions. If an irrevocable trust is set up to make the grantor the owner for tax purposes, the trust is called an “intentionally defective grantor trust.”
For grantor trusts, an income-earning trust is not required to file taxes. The income from the trust is taxed personally to the grantor, whether the income is distributed to grantor or to another beneficiary.
There are a few tax advantages to having a grantor trust. Tax rates are generally more favorable to individuals than to trusts. You can loan money to the trust, and the trust pays you at least a minimum interest rate required by the IRS (the AFR, applicable federal rate), and you do not have to have tax on that interest income. You can also sell assets in the grantor trust without having to recognize the gain from the sale. And if the grantor trust is owned by a U.S. taxpayer, it can be an S corporation shareholder.
For intentionally defective grantor trusts, the grantor is taxed personally on the trust distributions, but the trust retains tax advantage of not having the trust assets included in the estate for purposes of estate tax when the grantor dies (which is not the case for revocable trusts). This particular kind of tax advantage is usually only sought by the ultra-wealthy, because less than 0.1% of estates pay any estate tax.
What about non-grantor trusts?
Any non-grantor trust that earns and retains income must file Form 1041 with the IRS and pay taxes according to the brackets and rates for trusts and estates. If the trust distributes income to a beneficiary, then the trust must issue a Schedule K-1 tax form to the beneficiary. The beneficiary would them pay taxes on the distribution as part of their personal income tax, and the trust would take a distribution deduction on its own return.
If there are assets in the trust that are sold, then the beneficiary may have to pay capital gains tax if there are long-term gains on property held for more than a year before being sold.
Non-grantor trusts do have some advantages, but they may only be helpful if you are already in the highest tax bracket. Under the Tax Cuts and Jobs Act, the deduction for state income and property tax is capped at $10,000. But if you have a grantor trust, you could get an additional $10,000 state income or property tax deduction, if the trust is funded with sufficient property and/or income to offset the deduction.
Is the tax rate on trust fund income always the same?
No, the tax rate and brackets for trust fund income are subject to change by legislation or by adjustments by the IRS (based on changes in the chained Consumer Price Index). But tax rates and brackets have especially changed since the Tax Cuts and Jobs Act (TCJA) was passed in 2017. The new tax rates on estates and trusts went into effect in 2018, and will continue through 2025 unless changed by future legislation.
Although tax rates on trusts decreased from 2017 to 2018, they increased slightly for 2019 due to inflation. The number of brackets for trusts and estates also went from 5 to 4 under the TCJA, but the overall impact is low since the highest tax bracket starts at $12,500 for 2018 and $12,750 for 2019, and they remain compressed, as before.
Tax rates for trusts can be higher than for individuals because of lower deductions, compressed marginal tax rates, and a lower threshold for the net investments income tax. This makes it so the marginal rates end up being 40% or more.
What are the current tax rates and brackets for trusts?
The tax rates on income from trust funds for 2018 and 2019 are as follows:
Trust Income Tax Rates for 2018:
$255 plus 24% of any amount over $2550
$1,839 plus 35% of any amount over $9,150
More than $12,500
$3,011.50 plus 37% of any amount over $12,500
Trust Income Tax Rates for 2019:
$260 plus 24% of any amount over $2600
$1,868 plus 35% of any amount over $9,300
More than $12,751
$3,075.50 plus 37% of any amount over $12,750
There is also an alternative minimum tax for trusts, which is $24,600 for 2018/$25,000 for 2019, and an exemption phaseout starting at $81,900 in 2018/$83,500 in 2019.
Are there other taxes on trusts?
There is another tax on trusts which applies to investment income. A good portion of trust income is generally investment income, so this is generally relevant. The tax is 3.8% of the lesser of net investment income and the amount by which modified adjusted gross income (AGI) exceeds the filing status threshold amount. The income threshold is much lower than for individuals, and the top tax bracket is the same as that for taxable income ($12,500 in 2018 and $12,750 in 2019).
There are also federal estate taxes, but as of 2019, only estates over $11.4 (double that for couples) are subject to the tax. Additionally, even if your estate is very large, as long as your trust is established and funded before your death, estate taxes do not apply to the trust fund assets. On the other hand, the District of Columbia and 17 states have some sort of inheritance or estate tax. Some of them of exclusions similar to the federal tax level, but some do not.
Are there any deductions?
There is a personal and dependency exemption for trust distributions, which was suspended for individuals with the TCJA, but not for trusts and estates. The exemption is $100 or $300 for trusts and $600 for estate.
There are also miscellaneous itemized deductions, such as trustee fees, trust administration fees, tax preparation fees, and other trust expenses. This does not include investment advisory fees, however.
The TCJA provides for a new Section 199A deduction for Qualified Business Income (QBI). This is available from 2018 until 2025 for qualified trades and businesses. The deduction is the lesser of 20% of the QBI or 20% of taxable income minus capital gains.
There are some limitations—for instance, if you have income above a certain threshold (for 2019, more than $160,700 if filing single or as head of household), there is an additional limitation with regard to the maximum amount that can be deducted. There is also a limitation for individuals or businesses engaged in specified service trades (SSTBs) with income above the same threshold.
The actual QBI calculation is rather complex and depends on whether the trust distributes its income, what the income and occupation of the beneficiary is and what the trust income is.
What if a beneficiary receives a distribution from the trust’s principal?
They are in luck! If a trust distributes an amount to a beneficiary from the trust’s principal balance, not from the income, then the beneficiary does not pay taxes on it. As far as the IRS is concerned, whatever money was used to fund the trust would have been taxed before being put in the trust.
How do I file taxes on my trust fund income?
If a trust generated income during its tax year (tax year depends on the year-end for the trust, based on the grantor’s date of death), then a 1041 form will need to be filed with the IRS. If the trust is a non-grantor trust, then the trustee should provide beneficiaries with a Schedule K tax form to include on their individual return.