Taxation of Non-grantor Trusts
Non-grantor trusts, are separate taxpaying entities. Income taxes generated by the trust are paid for by the trust. The trust must file fiduciary income tax return (Form 1041). In simple terms, if any portion of trust income is distributed to a beneficiary, the trust will take a deduction and the beneficiary will be responsible for the income tax on the distributions. The trustee will send the beneficiary a form K-1 who will then use that information to calculate the personal income taxes due.
For income tax purposes, non-grantor trusts are classified as either simple trusts or complex trusts. A simple trust is one that mandates that all income earned during the taxable year must be distributed to the trust beneficiary. A complex trust is sometimes referred to as an accumulation trust or a discretionary trust. The trustee of a complex trust has discretion over distributions as described in the trust document. If a trust mandates distributions of income and the trustee also makes a discretionary distribution of principal, the trust is considered a complex trust.
Understanding the income tax treatment of taxable trusts is important because trusts have highly compressed tax brackets. As of 2021, the top tax rate of 37% on ordinary income begins at the very low threshold of $13,051 for trusts. By comparison an individual single taxpayer only reaches the 37% marginal tax rate after reaching $523,601 of ordinary income. Married individuals filing jointly reach the the top marginal rate after reaching $628,301 of ordinary income. The top tax rate of long-term capital gains begins at a threshold of $13,250 for trusts, whereas the threshold for individual single filers is $445,850 and for married persons filing jointly $501,600 of income.
Like individuals, trusts are also be subject to an additional tax for any undistributed investment income, known as "net investment income tax."
If a trust's beneficiary is in a lower tax bracket than the trust and the trust's beneficiary receives distributions from the trust, such distributions could result in a lower overall tax if the beneficiary is in a lower tax bracket.
For tax purposes, we must look at so-called trust accounting income ("TAI"). TAI is calculated in conformity with the terms of the trust agreement and state law. In simple terms, TAI includes all forms of income, except long term capital gains. But note that the trust document can redefine trust accounting income to include capital gains.
The taxable income of a trust is generally calculated the same as the taxable income of an individual, but the tax may be owed by the trust or by a combination of the trust and its beneficiaries. This is true because trusts are entitled to a deduction known as the Income Distribution Deduction, which is generally defined as the lesser of Distributable Net Income ("DNI") or the total distributions. DNI is the construct used to allocate income between a non-grantor trust and its beneficiaries and assure that there is no double taxation.
DNI is the amount of income that will be taxed to the beneficiary. Distributions in excess of DNI are treated as tax-exempt income or as principal and are not taxable to the beneficiary. A complex trust does not have to distribute all of its income or make principal distributions. Regardless of how much is distributed, the distribution deduction is limited to DNI. The amount that is treated as DNI is taxed on the beneficiary’s income tax return since it is income earned by the trust or estate which then received an offsetting deduction on the fiduciary income tax return (Form 1041).