Written by attorney Mark E Wight

An Idaho Trust Primer Part 4

Trust Primer

Taxation of Trusts

Trusts are taxable entities under the Internal Revenue Code. Depending on how the trust is set up (depending on the intention of the grantor), either the trust or the beneficiary (and sometimes the grantor) is liable for the taxes. The tax code views trusts as either simple or complex. This designation determines in large part who pays the taxes.

Simple Trusts

A simple trust is one that requires the distribution of all income each year. In the simple trust, the beneficiaries are liable for the income tax. Generally the trustee files an IRS Form 1041 and distributes an IRS Form K-1 to each of the beneficiaries showing the amount of income for each beneficiary that is reported to the IRS. The beneficiary will include the income reported on the K-1on his or her individual Form 1040. Unless the trust is also a grantor trust (see discussion below) this trust will need to obtain a unique tax identification number. See 26 CFR § 301.6109-1(a)(2)(B).

Complex Trusts

A complex trust is one that does not require the distribution of all of the income. That is, it can accumulate income. Thus, in a trust that has a discretionary standard and the trustee can withhold some or all of the income, the trust is the taxpayer. In general, trusts are taxed just like individuals. A trust can earn tax exempt income and deduct certain expenses just as an individual. While trusts are entitled to a small exemption, they are not allowed a standard deduction. Moreover, the tax brackets for trust is compressed, meaning that trust will often pay a higher percentage income tax than an individual will on the same amount of income.

Again, the trust will file an IRS Form 1041. The trust can take advantage of a handful of deductions, such as state, local and real property taxes, administrative fees, estate expenses, etc. However, the trust can generally also deduct from its income, distributions of income to the beneficiaries. (This will also result in a Form K-1 to distribute to the beneficiaries.) A complex trust will need a separate tax identification number. 26 CFR § 301.6109-1(a)(2)(B)

Non-Grantor Trusts

A non-grantor trust is one considered to be completely separate and distinct from the grantor. Once the grantor has released ownership of assets to the non-grantor irrevocable trust, these assets and the income generated thereby are no longer attributed to the grantor. Unless some other provision is included in the trust agreement, the assets of the non-grantor trust will not be considered a part of the grantor’s estate at her passing. As such, the assets of this trust do not meet the “owned by decedent at the time of death" test of IRC Section 1022(d)(1). Thus, pursuant to IRC Section 1022(e)(3), these assets will not receive a step up in basis when distributed from the decedent’s estate. [1]

Generally, any transfer by the grantor to a non-grantor trust is a completed gift and requires the filing of gift tax return. 26 CFR § 25.2511-2(b).

Grantor Trusts

For purposes of income taxes, if the grantor retains certain control over the assets or the income of the trust, those assets and the income are considered owned still by the grantor and not the trust. These are called grantor trusts and there a numerous ways that trusts can be designed to be considered a grantor trust under the Internal Revenue Code. IRC §§ 671-678. If a trust is determined to be a grantor trust, all of the income is allocated to the grantor and the grantor may not need to file a Form 1041, but in many instance can simply report the income on his Form 1040. A grantor trust such as this one can either use the grantor’s Social Security Number or obtain a TIN from the IRS. See 26 CFR § 301.6109-1(a)(2)(B).

In a grantor trust, the grantor is the lifetime income beneficiary, but not necessarily a beneficiary of the principal. Thus the gift of the income interest is not complete and no gift tax return needed. The gift of the remainder interest would be complete, thus, a gift tax return is due and there will be no step-up in basis at death. See 26 CFR § 25.2511-2(b) and § 1022(d)(1). [2]

[1] However, if when creating this non-grantor irrevocable trust, the grantor retained a special power of appointment over the principal of the trust, the step-up basis is available. Under IRC Section 1022(e)(2)(A), the step-up basis is available to a trust “with respect to which the decedent reserved the right to make any change in the enjoyment thereof through the exercise of a power to alter, amend or terminate the trust."

[2] There are additional other tax considerations for the grantor owned trust. For example, if the grantor trust owns the grantor’s residence, the grantor, will still be able to exclude up to $250,000 of capital gains from income ($500,000 for two spouses) under IRC § 121 just as he would if he owned it personally. See Revenue Ruling 84-45, a copy of which is included.

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