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Trusts seem complicated, but they can help protect your assets. When it comes to tax time, though, you may wonder what you will do. How does a trust pay taxes?
While a trust is its own entity, it pays taxes much like an individual. If it earns capital gains, rental income, or dividends, it must pay taxes on the money earned. Like humans, trusts can earn tax-exempt income, can take eligible tax deductions, and get preferential tax treatment on capital gains.
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What Is a Trust?
A trust is an entity that holds your assets. It can be a revocable or irrevocable trust. In both cases, a third party, the trustee, is in charge of your assets. They no longer belong in your name but rather the name of the trustee.
Income earned in a trust still incurs a tax liability, but how it’s taxed and who owes it depends on the trust’s structure.
Revocable vs. Irrevocable Trusts
Before we get into taxation, it’s important to understand the difference between revocable and irrevocable trusts.
A revocable trust you can change. If you set it up today with certain assets but decide to change the assets or change the beneficiary, you can. It may cost money in administrative costs and other fees, but it’s possible to make changes - it’s not set in stone. You can also make yourself the trustee, even though you are the grantor.
An irrevocable trust you cannot change. Once you set it up, that’s it. So it’s important to be sure you’re 100% certain about how you set up the trust. When you set up an irrevocable trust, you must assign someone else to be the trustee - you cannot be the trustee.
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Taxation on a Revocable Trust
Since you can be the trustee on a revocable trust, the income tax it earns is your responsibility. In other words, any interest or capital gains the investments earn should be reported on your 1040.
The trust itself must still file Form 1041 to report the trust’s income. This form and its attachments show how much taxable income there was and who is responsible for its payment. This will also help you determine which tax deductions or tax credits may apply.
Taxation on an Irrevocable Trust
Since you are not the trustee on an irrevocable trust, the trust itself must file taxes. Taxable income includes any income the trust earns from interest, dividends, capital gains, or rent earned from investment properties.
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All earned income must be reported UNLESS it was distributed to a beneficiary during that year. If so, the beneficiary is usually responsible for claiming the income on his/her tax returns.
How to File a Trust’s Tax Return
All trusts - revocable or irrevocable must complete IRS Form 1041. If the trust is paid out to any beneficiaries, it must issue Form K-1 to each beneficiary detailing the funds distributed. Any funds the trust distributes can be deducted from their taxable income. All remaining income (income they didn’t distribute) must be reported on the trust’s tax return.
Like an individual, a trust can take the typical deductions and credits to lower its tax liability. It’s worth going over your trust’s taxes with a tax professional to ensure you're not missing any applicable deductions or credits.
Do Beneficiaries Pay Taxes on Trust Proceeds?
Beneficiaries typically pay taxes on the income earned from the trust based on what’s reported on the K-1 they receive. All income is added to their gross income, but the type will affect the taxation.
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For example, a trust can earn rental income, capital gains, or dividends, each of which have different tax consequences. Form K-1 will also show a beneficiary what deductions if any, they are eligible to receive.
Do Trusts Pay State Taxes?
While all trusts owe federal taxes, not all trusts owe state taxes. It depends on the state. Each state has its own rules. Some states tax trusts if at least one trustee lives in the state it’s funded, and others don’t.
Some trusts may be taxable in multiple states depending on the location of their grantor, trustees, and assets. Working with a tax advisor is important so you understand the full implication of a trust’s taxation and how it will affect the bottom line.
Trust Taxation FAQ
How can a trust avoid taxes?
Like individuals, no trust can avoid taxes. But, if you want to avoid the trust income from passing through to your individual tax returns, you must set up an irrevocable trust. Because that comes with many other ‘issues’ and differences, it’s important to talk with a financial advisor before deciding.
Is money inherited from a trust taxable?
Yes, any money earned from a revocable trust is taxable. Just like you’d pay taxes on capital gains you earned from your own investments, you’d pay the same taxes on income from trust distributions. You can offset the taxes by selling certain assets at a loss to lower the total capital gains.
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Do beneficiaries pay taxes on a trust’s principal?
No, beneficiaries only pay taxes on the income earned from the trust. Since you already paid taxes on the money to invest in the assets, the principal isn’t taxed, just the earnings.
Which states tax trusts?
Each state differs, but California, New York, Illinois, Indiana, New Jersey, and North Carolina, Pennsylvania, and Massachusetts all charge state income tax on non-grantor trusts (irrevocable trusts).
The Bottom Line
A trust is a great way to protect your assets, but it does create a more complicated tax situation. Before you file your taxes, talk with a tax advisor to ensure you’re filing your taxes correctly and the right entity (individual or trust) is paying the taxes necessary on the trust.
Just like individual taxes, there are ways to offset large tax liabilities with strategic use of the assets. Understanding the ins and outs of trust taxation can help you avoid large tax liability.