An estate plan allows one to transfer their assets smoothly and quickly to beneficiaries after they pass away. Furthermore, one of the most common documents to include in an estate plan is a trust document that allows someone to place their assets into the care of a third party who will distribute these assets to the person’s family, friends, or favorite charity. While trusts offer great opportunities to protect and pass on assets to your loved ones, it is important to understand how different types of trusts are taxed.

Though a trust can reduce costs such as probate and gift and estate taxes, certain trusts may be subject to federal income taxes that can result in extra and unintended costs for the trust. The first important thing to understand when figuring out trust taxation is the principal and income stemming from the trust. The assets a trust owns represent its principal. The principal of trust commonly includes bonds, real estate, and stocks. As these investments earn interest, rent, or dividends, you will have to consider the income and expenses associated with the trust. Generally, trusts are taxed based on whether they are revocable or irrevocable or if they are a grantor or non-grantor trust.

Revocable Trusts

If a trust is revocable, the grantor may alter the terms of the trust as many times as they desire. These revisions can include the number of beneficiaries and trustees or the number and type of assets in the trust. The creator of the trust can at any time declare the trust irrevocable and may even provide a specific set of circumstances that if occur, make the trust irrevocable. The reason people choose to utilize a revocable trust is that this type of trust allows for greater flexibility to address the changing lives of the beneficiaries of the trust.

Revocable trusts are the simplest trusts from a tax standpoint. Any income the trust generates is taxable to the creator of the trust while they are alive. The reason for this is that the creator of the trust has full control over the trust and the assets within it. Further, revocable trusts normally take on the social security number and taxpayer identification number of the entity creating the trust. Thus, all items of income, deduction, and credit will be attached to the creator of the trust’s personal income tax return.

Irrevocable Trusts

If a trust is irrevocable, it cannot be modified or revoked in any way after it is initially established. The primary characteristic of irrevocable trusts is that the creator of the trust cannot modify or spend the assets in the trust for the benefit of anyone besides the beneficiaries of the trust. In certain cases, the grantor of the trust can create documents allowing the trustee of the trust to spend the assets in limited circumstances. The most common reason why a trustee may be able to spend assets in an irrevocable trust is that a beneficiary may move to another state with different laws, taxes, or trust requirements.

In most cases, irrevocable trusts receive their own tax identification number that is separate from the creator of the trust. Income that irrevocable trusts generate will be reported to that tax identification number and an irrevocable trust will report its income and deductions annually. Depending on how they are set up, irrevocable trusts can be grantor or non-grantor trusts.

Two Types of Trusts with Different Tax Implications

The most important tax consideration when creating a trust is whether a trust will be a grantor or non-grantor trust.

Grantor Trusts

With a grantor trust, the creator of the trust will usually pay taxes on the trust and must report all income and deductions on their individual tax returns. The most common types of grantor trusts are revocable living trusts and intentionally defective grantor trusts. A living trust is a trust created during the lifetime of the grantor. Under this instrument, the grantor acts as the trustee during their lifetime and retains complete control over the trust. While the grantor is alive and has the capacity, they have the authority to revoke the trust, change the terms of the trust, remove property from the trust, and add a property to the living revocable trust.

On the other hand, an intentionally defective grantor trust does not allow a grantor to maintain control over these assets. Instead, the documents include some form of intentional error so that the trust is revocable for tax purposes yet irrevocable for estate planning. The reason why this type of trust is considered revocable for tax purposes is that these trust documents give the grantor some control of the assets within the trust

Further, because the income tax goes onto the creator of the trust’s tax returns, there are no mandatory separate tax-filing for grantor trusts. The grantor could file a U.S. income tax return for estate and trusts for informational purposes, but you do not have to go through this step.

Non-Grantor Trusts

Non-grantor trusts are a separate taxpaying entity. Thus, income created within the trust is paid for by the trust, and must file a separate tax return. However, non-grantor trusts are not always responsible for paying the income generated in the trust.

Further, a non-grantor trust can be classified as either simple or complex for income tax purposes. A simple trust orders mandatory distributions of all income during the taxable year. Additionally, simple trusts cannot make any charitable gifts other than from current income and cannot make any distributions of principal. The most common simple trusts are material trusts. In this case, income from this trust goes to the surviving spouse of the trust. However, the spouse does not receive any principal.

A complex trust is also commonly known as an accumulation or discretionary trust. This trust allows a trustee to have discretion over distributions. However, they can only make these transactions if they are explicitly stated in the trust documents. An accumulation of trust is perpetual in nature and does not require mandatory distributions of income. Rather, this trust allows the income to accumulate and grow for a defined time period or for future generations.

Trust Income Tax Rates

Income tax rates for trusts are similar to those for individual entities. However, the thresholds for tax rate levels are different. The top tax rate for trusts is 37 percent and comes into play when a trust equals $12,950. This is almost a $500,000 difference from the top tax rate for individuals. In addition, trusts may have to pay additional taxes for undistributed investment income. Net Investment income taxes are imposed on unearned income. This tax applies to trusts with an excess of adjusted gross income over $12,950. Similar to the income tax rates, the net investment income difference between trusts and individuals is almost $200,000.

Final Thoughts

Trust and estate laws are complex. This is so no matter the type of trust you decide to establish. As such, it is extremely important to have legal representation that can help you correctly set up your trust. The Antonoplos & Associates lawyers have years of experience setting up trusts in DC, Maryland, and Virginia. With this knowledge and experience, we can help with any legal issues that occur from setting up your trust.

Furthermore, Peter Antonoplos, founder and managing partner of Antonoplos & Associates has an LLM in Taxation from Georgetown University Law Center. With this knowledge, Peter can help you decide what is the best type of trust for you and your family. Additionally, he can maximize the cost savings you receive from setting up a trust in DC, Maryland, and Virginia.

Contact our DC Law Office for More Information

Finally, for more information regarding taxes on different types of trusts, contact us at 202-803-5676. You can also directly schedule a consultation with one of our skilled attorneys. Additionally, for general information regarding trust and estate law, check out our blog.