Trusts can be an incredibly helpful tool to allocate assets throughout a person’s life, as well as providing for loved ones after death. They are especially helpful for people struggling with incapacity or disability. After the person who created the trust passes on, it can protect assets in a number of ways. Creating a trust is a major step in any estate planning journey, but taxes the trust will be subject to should be considered before making a decision.
Trusts are generally taxed in two ways: as “grantor” trusts or “nongrantor” trusts. A grantor trust is one that is taxed to the grantor (or other substantial owner) according to the rules stated in Section 671 and following sections of the Internal Revenue Code. Grantor trusts can be revoked pursuant to those rules. Grantor trusts (of which revocable trusts are an example) are taxed to the grantor, who reports the trust’s income on a Form 1040. The trust can still be considered a grantor trust even if it is irrevocable and the grantor is not listed as a beneficiary, as in the case of a grantor having the ability to substitute assets. As long as the trust is a grantor trust, income is taxed to the grantor even if it goes to another person.
Conversely, a nongrantor trust is separately taxed as its own entity. In this instance, the trustee has to file a separate tax return for the trust, Form 1041, recording all the trust’s income and expenses for the year. The nongrantor trust will be issued its own taxpayer identification number as a payer of income. Distributions made to beneficiaries may carry out taxable income, in which case the trust will supply a Form K-1 to the beneficiary to record the taxable portion of the distribution. The beneficiary then adds the taxable portion of the money received from the trust to their overall income.
People thinking of creating a trust should be aware that nongrantor trusts are taxed at a higher rate than other trusts. For example, while an individual reaches the top federal tax bracket when income exceeds $500,000 for a single filer (or $600,000 for a married joint return), a nongrantor trust will be placed in the same same bracket on amounts over just $12,500. An estate planning lawyer can advise you about which type of trust is best for you and your family.
As an example, say that a given trust makes $100,000 each year and $50,000 goes to beneficiaries. If it were a grantor trust, the $100,000 would be taxed to the person who created it. After the grantor’s death it passes to their children as a nongrantor trust. Each of the two children receives $25,000, and reports this income. Then the trustee will file a form 1041 to report $100,000 in income and $50,000 in distribution deductions.
For help navigating the complex considerations that go hand in hand with trust creation, contact the law offices of Queens probate lawyer Richard Cary Spivack, and make the best choice for your family.