Income Taxation of Trusts Trusts must file their own income tax returns each year just like individuals do. The rates for trusts are generally higher than rates for individuals because the “bracket creep” is much faster. The highest (39.6%) bracket on the federal level kicks in at just $11,950 of income Still, trusts can be functional income tax planning tools because the trust income is looked at by itself and is not combined with the grantor’s or beneficiary’s income. So, if the grantor is in a high tax bracket, putting assets into a trust can have income tax advantages

Simple Trusts A “simple trust” must, by its terms, distribute all of its income each year to one or more beneficiaries. Common examples of simple trusts QTIP trusts Qualified Subchapter S trusts A simple trust does not pay its own income tax. Rather, the trust beneficiary must report the trust’s income as his or her own income since the beneficiary is entitled to the income. If there are multiple beneficiaries, the income tax burden is allocated the same way the income is allocated The trust sends a “Schedule K-1” to the beneficiary to inform the beneficiary how much income to report on his or her personal tax return.

Complex Trust A complex trust may choose to distribute or accumulate trust income each year. Accumulated trust income becomes part of the trust principal for future years. The trust files an income tax return (Form 1041) each year and reports all trust income. The trust then takes an “income distribution deduction” for the amount of income distributed to the beneficiaries. The decision of how much income should be distributed should take into account the income tax brackets of the trust and the beneficiaries. You can even give the same amount to multiple beneficiaries, but allocate income to the ones in low brackets and principal to the ones in high brackets!

Trust Charitable Deduction A trust can distribute assets to charity and take a charitable deduction. It is important to draft the trust to allow charitable distributions to ensure the ability of the trust to take the charitable deduction. However, the grantor should only do this if she’s confident that the trustee will give the right amount to charity. Trusts are not limited to the 50% limit on charitable deductions as are individuals.

Grantor Trusts A “grantor” trust is, for all income tax purposes, ignored. Income of the grantor trust is considered as if it were the grantor’s income. The grantor pays income tax on the income as part of his or her regular income The purpose of these rules was to prevent high income people from transferring assets to trusts solely to avoid paying high income tax. But today, because of high trust tax rates, grantor trusts are often created intentionally to avoid trust tax rates.

Creating a Grantor Trust Rules are in §671 - §679 of the Internal Revenue Code §673: If the grantor retains a reversion that’s worth more than 5% of the trust principal §675: Certain administrative powers over the trust assets, including: Power to exchange trust assets Power to borrow trust assets without security §676: Revocable trusts §677: Power to do any of the following without the consent of an adverse party: Give a benefit to the grantor or his or her spouse Pay life insurance premiums on the grantor’s or the grantor’s spouse’s life

Creating a Grantor Trust 1 - § 674 Rules Many powers to control a trust, exercisable by the trustee without the consent of an adverse party. Subsection (b) makes exceptions for many types of powers; including: Testamentary power of appointment Power to distribute principal subject to an ascertainable standard Power to give to charity from the trust, etc. Subsections (c) and (d) allow a trust to remain a non-grantor trust if: the trustee is “independent” from the grantor and the power is simply to allocate income among the beneficiaries; or if the power of a person who is not the grantor is limited by an ascertainable standard

Adverse Parties Requiring the consent of an “adverse party” is a good way to allow a trustee many types of powers while keeping the trust a non-grantor trust. An adverse party is: Any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. The clearest example of an adverse party is a trust beneficiary. Since the distribution to one trust beneficiary depletes the trust assets for the other beneficiaries, all beneficiaries are “adverse” to each other. So, requiring the consent of one trust beneficiary before assets can be distributed to another is a good way to avoid a grantor trust.

Kiddie Tax The kiddie tax was established to prevent taxpayers with high incomes from giving assets to their children to shift income to them Children are almost always in very low tax brackets The rule: Income beyond a certain threshold ($2,000 in 2013) of children under age 19 (24 for children who are in school and who do not earn enough to pay half their own expenses) is taxed at the highest marginal rate of the parent(s). The child still files his or her own tax return though Because of this rule, it may not pay to allocate more than $2,000 of income to a child of a parent who earns a high income.

Capital Gains Earned By Trusts The same basic capital gains rules apply to trusts as to individuals 0% or 5% for lower tax brackets and 15% for higher brackets 20% for highest income brackets A step-up in cost basis can be secured (generally) by keeping the asset in the taxable estate of the grantor, even if it’s held in a trust.