Taxation on Trusts

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Taxation on Trusts As we know, a majority of trusts are subject to taxation. There are a number of different trusts, each with a different type of taxation. Of course we know that a trust is “a relationship where a property is held by someone (trustee) for someone else (beneficiary). Trust can be used to protect against creditors, probate, reallocation in divorces, and some tax obligations. A trustee is in charge of making sure that the trust’s taxes are up to date on their payments. The trust document determines the tax purposes of the trust. There are a certain number of tax statements that outline the trust taxation rules. They are as follows:
  1. If the trust is a revocable trust, and the grantor is also the beneficiary, then the trust is basically ignored for tax purposes. All income generated by the trust assets is reported on the Form 1040 of the grantor/beneficiary.
  2. With some modifications, the taxable income of the trust is calculated in the same manner as an individual.
  3. The trust gets to take a tax deduction for the amount of taxable income that is distributed to the trust beneficiaries.
  4. The trust pays income tax on the taxable income that is left after the distribution deduction.
  5. The beneficiaries report income and pay tax on the distributions of taxable income they received.
Regarding taxations on trusts, the general rule carries two exceptions. The first one being that if a grantor has an interest in the said trust, the grantor is responsible for the trust, and not the trustee. These types of trusts are appropriately called grantor type trust. An example of this is when all the income is taxed to the grantor. When this happens, a revocable trust is formed. The other type of exemption is the charitable remainder trust. Charitable contributions are not taxable, but if the beneficiaries receive anything from the charitable remainder trust, then those distributions are taxed. We must look at whether the trusts are simple or complex. A simple trust is a trust that does not allow for any external charitable contributions to be made. It also does not grant any other distributions except the ones that are from the income earned. This income is then are distributed to the beneficiaries of the trust. A simple trust beneficiary will have a personal tax that is higher, but the trust receives a deduction for the income that is required to be paid out during the tax year. Conversely, a complex trust is just as it sounds: complex. This trust is allowed to make contributions to charity and it is not obligatory to distribute the total amount of income that was accumulated by the trust. Due to this, the complex trust only needs to disperse taxes on the income that stays in the trust. There, however, happen to be small exemptions that apply to each trust which can benefit in the short run. They are $300 for a simple trust, $100 for a complex trust, and $600 for an estate trust. The taxation of trusts is very complex for several reasons. Some of the reasons for this are: beneficiaries most likely have to pay tax on the income the trust gives them; the trust is a taxable entity; trusts are NOT susceptible to double taxation, and therefore any taxable income distributed to the beneficiaries deducts from the trust. Another reason includes that “money dispersed to the beneficiaries keeps its character.” An example of this is if the trust distributes long-term capital gains to the beneficiaries they will list it as a long term capital gain on their returns. A majority of the income that is accumulated by the trust is taxable; however the principal of the trust is not. Capital gains are treated differently than income is. Trusts experience capital losses and gains, and if a trust experiences a capital gain, then the trust is generally taxed as opposed to the beneficiary. If a trust experiences capital losses then tax applied are the ones modeled after individual tax laws. There are a few forms to be filed when dealing with taxation on trusts. These are how income is reported. The form that is required to be filled out by the trustee is form 1041. The trustee has to complete within 3 and a half months after the tax year ends. If the trust has income of 600 dollars or more, it must be filed with the IRS. The beneficiary, if an alien, is required to file with the IRS regardless of the value of the trust. Income of the estate is filed with a little differently. Income of the estate is income that has been earned by the decedent, but has not been paid before death. This is reported on the income tax return of the beneficiary who receives the monetary gain. This income is called “the income in respect of the decedent (IRD).” If the recipient of the IRD is the estate of the decedent, Form 1041 must also be filed. The deduction for the distributed income comes into play when Schedule B of Form 1041 is completed and reported back to the beneficiary on a Schedule K-1. Examples of IRD’s include interest on bank accounts, wages that have yet to be collected, and declared dividends that have not been collected yet. Returns on taxes for trusts are known as fiduciary tax returns and are filled out on the 1041 IRS form. Frequently, the tax rules that are applied to trusts are the same rules that are applied to individual taxes; however, the calculation is different. To calculate the taxes that are enforced on the trusts, we look at these steps:
  1. calculate trust accounting income;
  2. calculate the tentative taxable income before subtracting the distribution deduction, which is the amount that the trust can deduct because of the distribution;
  3. calculate the distributable net income (DNI) so that the distribution deduction can be calculated and so that tax-free and taxable distributions can be allocated to the beneficiaries;
  4. subtract the distribution deduction from the tentative taxable income to determine trust taxable income;
  5. calculate trust tax liability;
  6. Allocate DNI and the distribution deduction to the beneficiaries to determine the character and the amount of income taxed to each beneficiary.
From the final number, one can obtain the amount of money the trust will be taxed. We should know what a DNI is to help us calculate this number. A DNI, distributable net income is the calculation used to allocate income between the beneficiaries of the trust and the trust itself. DNI is used to calculate the restriction on the amount of deductions a trust receives for the distributions to a beneficiary. The DNI calculation is as follows:
  • (Total trust income) – (deductible expenses) + (tax-exempt interest reduced by expenses not allowed in the computation of taxable income and the portion used to make charitable contributions) + (Capital gains IF: Gain is allocated to accounting income; Gain allocated to principal is required to be distributed or is consistently and repeatedly distributed by the trustee; or Gain allocated to principal is paid or set aside for charity) – capital losses if they enter the calculation of any capital gain distributed.
In a simple trust, the DNI is taxed to the beneficiaries after it is apportioned. In a complex trust, DNI may exceed the income that is supposed to be distributed. DNI is looked at an apportioned dollar for dollar to the beneficiaries. An example of this is as follows:
  • In the first year, Barkers Family Trust gained $12,000 in interest on bonds, $5,000 on interest on CDs, and 10,000 on capital gains. The DNI and taxable income for the trust is $15,000 (5,000+10,000). The trusts accounting income is $17,000 (5,000+12,000). Trust is to distribute $5,000 and 25% of the principal to Paul and 25% to John, and 50 percent to Matt. Paul receives $7,500, John receives 2,500 and Matt receives $5,000. The total DNI was 15,000, which was apportioned and distributed to the beneficiaries.
From here we will look at certain types taxes based on the income’s classification. The first we will look at is trust accounting income. Usually trusts specify which income is allocated to the principal and what is allocated. To figure this, we must look at the Uniform Principal and Income Act (UPIA). This act, enacted in 1992, made changes to the previous Prudent Investor Act standard. For accounting income, the allocation, based on the UPIA, is included to be: operating income, operating expenses, depreciation of trust assets, interest, dividends, rents and royalties, and taxes on accounting income. Allocation to principal comes from: capital gains and losses, casualty gains and losses and insurance recoveries and taxes on trust principal. Accounting income allows for us to determine the amount that is required to be distributed to the income beneficiary. Let us look at an example. If a trust had one single beneficiary, and the trust principal equaled $100,000, income equaled $10,000, and the trustee fees equaled $2000 dollars. The trusts provisions state that there is a 50% allocation of expenses between principal and income. This means that the income beneficiary receives $9000; ($10,000 – ($2000 x 50%)). Trust principal declines to $99,000; ($100,000 - $1,000). The next income we look at is the trust tentative taxable income. Trust income that is taxable is usually taxed the same way as individual people are taxed. Some differences include that the trusts do not itemize deductions, and a trust also has a personal exemption which is equal to $300. Trust income is defined as income that is earned from investments. This does not include capital gains. Expenses from trusts include the administration expenses, depreciation, and charitable contributions. An example of this is brought to us by William Spaulding: “A trust has$20,000 of accounting incomeand$10,000 of depreciation. The single income beneficiary of the trust receives$8000. Because the trust document does not specify an allocation of depreciation, the trust can claim$10,000/$20,000×$10,000= 1/2 ×$10,000=$5000of depreciation and the income beneficiary can claim the other$5000 of depreciation, so the beneficiary only has to pay tax on the remaining$8000–$5000= $3000.” Direct expenses for income that is not taxed are not deductible; however indirect expenses (expenses that are spent for maintaining the trust) are usually deductible. We can also look at gross income and capital gain and how these are taxed. Gross income of a trust is taxed like individuals. The tax burden can rely on either the beneficiary or the estate itself. Capital gain is taxed based on the increase being added to the principal. If the gain is administered, the beneficiary is taxed on this. If property that has appreciated in value, and then is transferred to a trust, the gain on the sale of the property is taxed “at the grantor’s tax rate if sold within two years of the transfer.” Losses based on capital gains are allocated to the trust if they exceed the gains. Capital losses are able to be subtracted from the ordinary income. A trust is not allowed to subtract the loss from a sale between related taxpayers. The way property’s worth is determined is by the fair market value at the time of the death of the decedent. This is called the basis of property. We must look closer at the deductions that have been mentioned earlier in the paper. Generally, deductions are allowed both to individuals and on fiduciary returns. Some deductions to taxes that are allowed are state, local and real property taxes; estate expenses, and administrative costs. There are also numerous amounts of deductions that are not allowed. The first one is depreciation and depletion. When there is a trust involved, the expenses must be apportioned between the beneficiary and the trust. Here is an example of that: Stanley receives 50% of the accounting income from the Yelnats Family Trust and the trust retains the other 50%. The income generating property that is held in the trust depreciates $1,000 dollars in year one. The Yelnats Family trust is allowed to deduct 50% of the $1,000, which obviously is 500, while Stanley is allowed to keep it. Charitable deductions are not deductible UNLESS they are paid with current trust income and the agreement for the will and trust has given authority to. Another deduction we will look at is the income distribution deduction. The income distribution deduction states that “a trust is allowed to deduct an amount equal to the amount distributed to the income beneficiary.” The formula for this is “distributions – tax exempt income, or Distributable net income subtracted by tax exempt income. A quick example of this is that the Goergen trust earns $8,000 in interest on municipal bonds, $6,000 on interest from CDs, and has a $14,000 capital gain. The trust’s tax exempt income is $8,000 (interest on municipal bonds). The trust gave out $14,000 to Larry. The income distribution deduction for the trust is $6,000 ($14,000-$8,000). . Works Cited Works Cited Czajkowski, John. "Income Taxation of Trusts and Estates." (n.d.): n. pag. Web. 13 Apr. 2015. <http://www.heritagewealthmgrs.com/wp/Income Taxation of Trusts & Estates.pdf>. "How a Trust Can Cut Taxes."WSJ. N.p., n.d. Web. 13 Apr. 2015. <http://www.wsj.com/articles/SB10001424052702303743604579351230348895194>. Spaulding, William C. "Taxation of Trusts and Their Beneficiaries.", Including 2013 Tax Changes. N.p., n.d. Web. 13 Apr. 2015. <http://thismatter.com/money/tax/trust-taxation.htm>. "Tax Hikes Hit Trusts Hard, Beneficiaries Pull Money Out."Forbes. Forbes Magazine, n.d. Web. 13 Apr. 2015. <http://www.forbes.com/sites/ashleaebeling/2013/01/09/tax-hikes-hit-trusts-hard-beneficiaries-pull-money-out/>. "Trust Taxation Basics | Simple Complex Trusts | IRS Form 1041 | Florida Accounting Firm."Trust Taxation Basics | Simple Complex Trusts | IRS Form 1041 | Florida Accounting Firm. N.p., n.d. Web. 13 Apr. 2015. <http://www.cricpa.com/TaxationofTrusts.aspx?mobile=1>.
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