Most of the time, the terms of a trust direct the trustee to distribute percentages of trust assets to beneficiaries. For instance, a trust may read: “Trust assets should be divided 50/50 between my two children.” When this happens, the process for making distributions of trust funds after death will be slightly more complicated for the trustee. Steps trustees should follow when making trust fund distributions to beneficiaries include: Show
Find out how much the trust is worth.It is impossible to distribute percentages of trust assets without first knowing the value of the trust as a whole. To determine this, trustees should consult with professionals (e.g., accountants, appraisers, real estate agents) to figure out the approximate value of each asset. Communicate with beneficiaries and ask for their input.Once trustees know what the trust and its assets are worth, it is advisable for them to meet with beneficiaries to determine how to proceed. For example, if assets are supposed to be divided 50/50 among two beneficiaries, one beneficiary may agree to inherit a car worth $70,000 and another beneficiary may agree to inherit a home worth $70,000. An arrangement like this would eliminate the need for the trustee to sell either piece of property. If the beneficiaries would rather sell the property and divide the proceeds, the trustee can move forward with facilitating the sale. The trustee may also transfer a 50% interest in each asset to each beneficiary. While the trust may provide the trustee with discretion to proceed in whatever way they feel is best, it is always a good idea for them to take the beneficiaries’ preferences into account, and, if necessary, obtain help from a lawyer to settle any property disputes. Be sure to check state laws relating to property transfers.As previously mentioned, extra steps and additional documentation may be required to transfer certain kinds of trust property to beneficiaries. Every state has different laws regarding property transfers, so if trustees are unsure about the steps required for making a legal transfer of trust property to a beneficiary, it is crucial they solicit the help of a trust lawyer. Distribute residual assets.There will always be some trust assets that are not specifically designated to beneficiaries. The leftover property is known as the trust “residue.” Trustees can discuss these assets with beneficiaries to determine which beneficiaries want them to be included as a part of their share of the estate. The main takeaway for beneficiaries and trustees is that it is wise to have an experienced probate lawyer on hand in case any questions or concerns arise about trust distributions. A probate lawyer can help trustees ensure they are following all the necessary rules and procedures when making distributions of trust assets to beneficiaries, and beneficiaries with enforcing their rights and claiming the trust distributions they’re due. 2021-11-19 Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, the tax brackets for 2018 and afterwards have changed slightly. The new brackets are listed at the bottom of this article. Trusts, like estates, are a taxable entity. A trust is a fiduciary entity whose objective is to hold and invest money or property held in the trust for the benefit of the beneficiaries. Trust property consists of principal (aka corpus), which is the property transferred to the trust by the grantor, and income earned by the trust, usually from investments. If the trust retains income beyond the end of the calendar year, then it must pay taxes on it. If money is distributed to the beneficiaries, then whether it is taxable or not to the beneficiaries will depend on whether principal or income was distributed, and if it was income, then whether it was tax-free income or retained income from previous years that the trust has already paid tax on. Because trusts are not subject to double taxation, either principal or income on which the trust paid taxes can be distributed tax-free to the beneficiaries. Likewise, any taxable distribution to beneficiaries is deductible by the trust. Gift taxes may also apply to either property transfers to a trust or distributions to beneficiaries. Property transfers to an irrevocable trust may be subject to gift tax, but for revocable trusts, gift tax liability will not be incurred until the property is transferred to a beneficiary or when the trust becomes irrevocable. A trust must use a calendar year. If the trust has taxable income or gross income of $600 or more, or if any of the beneficiaries are non-resident aliens, then it must file Form 1041, U.S. Income Tax Return for Estates and Trusts and may also have to make estimated tax payments. A simple trust is required to distribute all its income, and no amount is paid or set aside for charitable contributions. Otherwise, the trust is a complex trust. Capital gains, under most state laws and trust documents, are allocated to corpus. The complexity of trust taxation arises because of several factors:
Generally, the tax rules that apply to trusts are the same as those that apply to individuals, but the actual calculation is more complex:
Trust Accounting IncomeWhen a trust earns income or pays expenses, the income or expenses are allocated either to principal or to income. The trust document usually specifies which income or expenses are allocated to the principal or to income. If the trust document does not specify the allocation, then state law applies. Most states have adopted all or part of the Uniform Principal and Income Act (UPIA). The UPIA allocates:
Example: Allocating Income or Expenses to Principal or IncomeIf a trust has a single beneficiary and:
Then:
Trust Tentative Taxable IncomeTrust taxable income is determined as it is for individuals. However, a trust does not usually itemize deductions, and a trust also has a personal exemption, which is $300 for trusts required to distribute all their income annually to beneficiaries (simple trusts), $4300, which is not subject to phaseout, for a qualified disability trust, and $100 for all other trusts. A qualified disability trust is any trust established solely for the benefit of a disabled individual younger than 65, who was determined by the Commissioner of Social Security to have been disabled as defined 42 U.S.C. 1382c(a). Generally, trust income is defined as income earned from investments, including tax-free income, but does not include capital gains on trust assets. However, taxable income includes all income earned by the trust, including capital gains, minus tax-free income. Example: How Trust Income Differs from Its Taxable IncomeA trust has the following income:
Therefore:
Typical trust expenses include trust administration expenses, expenses for the production of income, depreciation, and charitable contributions. However, expenses for the production of tax-free income are not deductible and depreciation can be claimed either by the trust or by the income beneficiaries or it can be apportioned to both according to the trust document. Only a complex trust can deduct charitable contributions, but only if the trust document specifically allows it. Charitable deductions are claimed on Form 1041-A, U.S. Information Return for Trust Accumulation of Charitable Amounts. Example: Allocating Depreciation between the Trust and the Beneficiary
Direct expenses for tax-free income are not deductible, since no taxes are paid on such income. Indirect expenses, which are the expenses of administering the trust, are generally deductible, but if the trust has tax-free income, then a proportion, = tax-free income ÷ trust accounting income, of indirect expenses is not deductible.
Distributable Net Income and the Distribution DeductionA trust is considered by tax law to be a modified conduit, because usually only some of the income and deductions pass through to the beneficiaries. The trust itself often retains some income, especially capital gains, which is usually allocated to the trust corpus. However, distributions from the trust usually have both taxable and tax-free portions. The tax-free portion of the distribution may result from tax-exempt income, such as the tax-exempt interest earned from municipal bonds, or from retained earnings of the trust on which it has already paid taxes in previous years or from trust principal which is generally not taxable because of the recovery of capital doctrine. In other words, the money or property invested in the trust is the contributed capital, so any distributions from contributed capital are simply distributions of the original investment, and, therefore, not taxable. Generally, taxes on taxable income must be paid either by the trust or by the beneficiaries, but not both. If the trust retains income beyond year-end, then the trust must pay taxes on it. However, if the income is distributed, then the beneficiaries pay taxes on it and the trust is permitted to deduct it. If the trust accounting income consists of both tax-free and taxable income, then the tax-free and taxable portions of the income distributed must be allocated to each beneficiary. The trust can deduct the taxable portion of the distributions but not the tax-free portion nor any expenses that must be allocated to the tax-free portion of income. To calculate this allocation, an intermediate result must first be calculated, called the distributable net income. The distributable net income (DNI) sets a ceiling both on the trust distribution deduction and on the amount taxable to the trust beneficiaries. The DNI is used to calculate the trust taxable income, calculate the beneficiaries taxable income, and to characterize distributions to beneficiaries, such as between taxable and tax-free distributions. Distributable Net Income (DNI) =
The personal exemption is added back to taxable income because, while it is a deduction, it is not an actual expense, and thus, it is available for distribution. Tax-exempt interest is added because it is not includible in taxable income, but it is available for distribution to the beneficiaries. Since the tax-exempt interest is distributed, the expenses allocable to the interest are also subtracted. Capital gains that are allocated to trust principal are subtracted from taxable income because the gains are not distributed to the beneficiaries. For the same reason, capital losses allocated to trust principal are added back, because the losses decrease taxable income, but do not decrease the income available for distribution to the beneficiaries. Example: How Capital Gains and Losses Affect the Trust Taxable Income and the Distribution to Beneficiaries
The trust issues a Schedule K-1, Beneficiary's Share of Income, Deductions, Credits, etc. of Form 1041, U.S. Income Tax Return for Estates and Trusts to each beneficiary, listing the beneficiary's share of income and deductions. Only taxable income is listed; tax-exempt income is omitted. The purpose of DNI is to determine what part of a distribution to beneficiaries is taxable to the beneficiary and deductible by the trust. This is achieved by multiplying each type of income, such as rent or dividends, by the total amount distributed divided by the DNI. Capital gains or losses are generally allocated to corpus unless they are distributed to the beneficiaries. Capital gains and losses are netted out at the trust level. However, beneficiaries cannot deduct any net losses on their return except when the trust is terminated, in which case any unused capital loss carryovers can be used to offset income to the beneficiaries. The distribution deduction cannot exceed the taxable distribution, since taxes must be paid on taxable income either by the trust or by the beneficiaries. For a complex trust, the distribution deduction can be determined by the following formula: If Total Distributions > DNI, then: Distribution Deduction = DNI − Tax-Exempt Income − Expenses Allocable to Tax-Exempt Income If DNI > Total Distributions, then: Distribution Deduction = Total Distributions − (Total Distributions × Net Tax-Exempt Income/DNI). Example: the WCS Trust is required to distribute all income to its sole beneficiary. All capital gains and losses and expenses are allocable to the trust corpus. Income and expenses for the year are listed in the Totals column in the table below. Trust accounting income, trust taxable income, DNI, and the distribution deduction are also calculated in the table below, based on the income and expenses in the Totals column: Example: Calculating the DNI and the Distribution Deduction
Note that in calculating DNI, the personal exemption is added back because it is a statutory deduction, which is not a real expense, so it is available for distribution. Note also that even though the beneficiary receives $30,000 of taxable income, the trust can only deduct $26,000 for the distribution. This is because the trust has already deducted the $4000 fiduciary fee allocable to taxable income to arrive at the tentative taxable income before the distribution deduction. To allow the trust to deduct the full $30,000 would allow the trust to deduct the deductible portion of the fiduciary fee twice. Trust Taxable IncomeTrusts and estates are subject to most of the same tax rules that apply to individuals. They even share some of the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels. Trust and Estate Capital Gains Tax
Example: Calculating the Tax on Trust IncomeIf trust taxable income = $15,000 for 2019, then:
As you can see in the last row of the above table, if the $15,000 is distributed to a beneficiary who earned only an additional $20,000 from work, then the $15,000 will be subject only to the beneficiary's 12% marginal tax rate, for a total tax of $1800 instead of the trust tax of $3966.50. Trusts may also be subject to the alternative minimum tax, but this is usually easy to avoid. 2013 Tax ChangesTax changes enacted in 2013 included a top tax bracket for trusts of 39.6% on undistributed income, adjusted for inflation (latest year amount is shown in the above tax table for trusts) and increases the long-term capital gains rate from 15% to 20% for the top tax bracket. The Tax Cuts and Jobs Act has lowered the top rate to 37%. Trusts are also subject to the Net Investment Income Tax (NIIT), sometimes called the Obamacare tax, of 3.8% on undistributed investment income exceeding the threshold for the top marginal rate for trusts. By contrast, the NIIT only applies to individuals earning a minimum of $200,000 ($250,000 for a couple filing jointly). Hence, the total tax on undistributed capital gains in the top bracket will be 23.8%. However, the following types of trusts are not subject to the NIIT:
Taxation of Trust BeneficiariesThe trust is only permitted to deduct distributions taxable to the beneficiaries. Therefore, the total amount taxable to all trust beneficiaries cannot be less than the distribution deduction claimed by the trust. Total distributions to beneficiaries will exceed the distribution deduction if a portion of the distribution consists of tax-exempt income, income on which the trust has already paid tax on, principal, which is not subject to taxation, or if there were deductible expenses that were allocated to corpus, and deducted to arrive at the tentative taxable income before the deduction of the distribution deduction. Multiple beneficiaries are taxed proportionately on their share of taxable amounts distributed. Example: How to Calculate the Taxable Portion of Distributions to Beneficiaries
Naturally, the taxation of complex trusts is more complex. The distributions are divided into what are called first-tier distributions and second-tier distributions. First-tier distributions are required distributions from trust income, which is stipulated in the trust document; the remaining distributions are second-tier distributions. If all distributions are within either the first- or second-tier, then the taxation of beneficiaries is calculated as it is for simple trusts. However, if there is more than one level of distributions, then the taxability of beneficiary income depends on the following rules:
Example: Allocating DNI to First- and Second-Tier DistributionsThe ABC Trust has 2 beneficiaries: Amy and John, and none of the trust's income is from tax-free interest.
Case #1:
Case #2: Same as Case #1, except that DNI = $40,000, and the required distribution to John is $30,000.
Case #3:
Note that the last statement is only true because there was no tax-exempt income. If portions of taxable income differ in character, such as some being capital gains and some being ordinary income, then the character is assigned proportionately to the taxable distribution amounts using the same order as for first-tier and second-tier distributions. A separate share rule may also apply if the trust is administered as separate shares according to the trust document. In this case, DNI is determined as if the shares are treated as separate estates or trusts in computing DNI allocable to the beneficiaries. The separate share rule generally applies to 1 trust; it does not apply to multiple trusts created by a single trust instrument. However, the separate share rule does not increase the number of deductions available to the trust nor does it increase the number of personal exemptions nor can the income be split so that it is taxed at lower rates. Trust Property DistributionsTrust property distributions are based on the adjusted tax basis of the property rather than its fair market value (FMV) when it is distributed. The beneficiary's basis in the property = the carryover basis of the trust, and the beneficiary's holding period for the property includes the holding period for the trust. However, the trustee can elect to recognize gains or losses on the distribution of appreciated property if the trust has other losses or gains that can be offset by the election. If so, then the contribution to the distribution deduction will be equal to the property's FMV on the distribution date and the beneficiary's tax basis will be equal to the FMV and the beneficiary's holding period will begin on the distribution date. Trust TerminationWhen a trust terminates, it must distribute all its income and property to the beneficiaries. Therefore, even a simple trust must necessarily be a complex trust in its final year of existence, since it must distribute both income and principal. If the trust has operating losses that cause it to have a negative taxable income, then the proportion of the net loss to each beneficiary can be deducted as an itemized deduction on each beneficiary's return. If the trust also has capital loss carryovers, then these carryovers will be distributed to the beneficiaries in the same proportion as the final distributions from the trust. Historical NotesTrust and Estate Tax Table
References
Is an inheritance from a trust taxable income?The assets and legal requirements of a trust also can vary, so communication with the trustee, or with legal and tax counsel if you are the trustee, is key. The good news is inheritance is generally income tax-free.
Is a distribution from a trust considered income?That is one of the most common questions about the administration of trusts and estates The answer is, “it depends.” The beneficiaries, and perhaps the trusts themselves, are subject to the income tax. Distributions of principal are not subject to income tax. Distributions of income are subject to income tax.
Do beneficiaries pay taxes on irrevocable trust distributions?Irrevocable trust: If a trust is not a grantor trust, it is considered a separate taxpayer. Taxable income retained by the trust is taxed to the trust. Distributed income is taxed to the beneficiary who receives it.
How is a trust distribution to beneficiaries?The grantor can opt to have the beneficiaries receive trust property directly without any restrictions. The trustee can write the beneficiary a check, give them cash, and transfer real estate by drawing up a new deed or selling the house and giving them the proceeds.
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