Federal Income Tax and Trusts

A trust is not taxed on income distributed in the year earned. Rather, the beneficiary who receives the income is liable for the tax. If the income is accumulated, the trust is taxed on the income. In addition, the beneficiary generally must pay tax on the income when it is distributed. The beneficiary does receive a credit for any taxes paid by the trust on the distributed income.

Four categories of taxpayers may be taxed on the trust income. These are:

  1. the trust,

  2. the grantor,

  3. the beneficiaries and

  4. any person with the unrestricted right to vest the corpus or income in himself or herself.

The following rules generally determine who is taxed:

  1. Trust income is taxable to the trust whenever it is accumulated for the benefit of a person other than the grantor or his/her spouse.

  2. Trust income is taxable to the grantor when it is paid or accumulated for the benefit of the grantor or his/her spouse. In addition, the income is taxable to the grantor if the grantor has the right to revoke the trust and re-vest title in the trust property, or if the corpus or the income of the trust will return to the grantor or his/her spouse and the value of this "reversionary interest" exceeds 5 percent of the trust assets.

  3. Trust income is taxable to the beneficiaries when it is distributed to them. If the trust has paid tax on the income, then the beneficiary is entitled to a tax credit.

  4. Trust income is taxable to a third person (someone other than the grantor or a beneficiary), if the grantor is not treated as the owner and the third person has the unrestricted power to vest the corpus or income in himself.

When trust income is taxed to the grantor or another person is deemed the owner of the trust, the tax law treats such income as if the taxpayer had received it directly.

Income retains its original character when distributed. For instance, if the trust receives capital gain income, then the beneficiary is entitled to treat this income as capital gain.

The taxation of trusts differs for "simple trusts" and "complex trusts." A simple trust is required to distribute all of its income currently, does not provide for charitable contributions and makes no distribution of principal during the year. All other trusts are complex trusts.

What is a Grantor Trust?

Even though a grantor may have conveyed legal title in property to a trust and the trustee receives the income, that income may still be taxable to the grantor. The Internal Revenue Code taxes trust income to the grantor if he retains the right to revoke the trust or receive its income, or if he retains certain other powers over the trust property or income. For transfers after March 1, 1986, any power held by the grantor's spouse is treated as being held by the grantor. Such trusts are often referred to as " defective " for income tax purposes.

Generally, the income of a trust will be taxed to the grantor under any of the following circumstances:

  1. The grantor retains a reversionary interest that is worth more than 5 percent of the initial value of the trust assets;

  2. The grantor retains the power to control the beneficial enjoyment of the trust property or income;

  3. The grantor retains administrative powers exercisable for his own personal benefit;

  4. The grantor retains the power to revoke the trust; or

  5. The trust income may be used for the personal benefit of the grantor or his spouse (such as the payment of premiums on policies of life insurance on the life of the grantor or his spouse).

The elements governing taxation under the above circumstances are complex and are set forth in Internal Revenue Code Sections 671-678.

Robert Adler, Esq. is an attorney who focuses his practice on wills, trusts and estates. He can be reached at 212-843-4059 or 646-946-8327.

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