A trust is a legal entity that is set up to hold assets such as cash, securities, real estate, and life insurance. A trust can be for the benefit of one or more individuals. Trusts are managed by a trustee who acts on behalf of the trust beneficiaries.
Trusts are created to provide legal protection for the trust grantor’s assets, to make sure assets are distributed according to a trustor’s wishes and to avoid or reduce estate taxes. Trusts are also created for control purposes. A trust instrument which is the governing document for the trust states who will receive distributions, when distributions will occur and on what terms. Other key reasons for establishing trusts are for privacy, incapacity planning and for possible asset protection in a bankruptcy. Once property has been transferred into a trust, the trust becomes the legal owner of the property.
The two most common types of trusts are revocable and irrevocable trusts. Revocable trusts are often referred to as living trusts. In a revocable trust the grantor of the trust property can change various aspects of the trust including the trust property itself during the grantor’s lifetime. On the other hand, an irrevocable trust is more challenging to amend once the trust is established.
A trust that is required to distribute its income currently is considered a simple trust. All trusts that are not simple trust or grantor trusts are classified as “complex” trusts. The complex trust is allowed to accumulate income. A trust is allowed a tax deduction for income it distributes to beneficiaries. Amounts distributed to beneficiaries are first considered to be from current year income, followed by trust corpus or principal. Beneficiaries are not taxed on distributions of trust principal. Income distributed to trust beneficiaries is reported on a Schedule K-1 which is then reported on the beneficiary’s personal tax return.
A trust that generates income must report that income on a Form 1041 – United States Income Tax Return for Estates and Trusts. Calendar year trust tax returns must be filed by April 15th or September 30th if extended. Trusts whose tax year is other than December 31st must file Form 1041 by the 15th day of the fourth month after the close of the tax year.
For 2020, the highest income tax rate for trusts is 37%. Trusts reach the maximum 37% bracket with undistributed taxable income of more than $12,950. In comparison, married persons filing a joint return must have taxable income of more than $622,050 to be taxed at the highest rate of 37% for 2020. Therefore, trust income that is not distributed to beneficiaries is taxed at the highest tax rate much earlier than for an individual. Careful planning is needed to manage and assess the need for trust distributions while considering the tax bracket of the trust and the trust beneficiaries.
Please let us know if you have any questions regarding trusts. You can reach us at our office by calling 615-385-0686 or by email at firstname.lastname@example.org.
Ashley W. Collignon, CPA Mark Fly, CPA/ABV & Tax Director