When a successor trustee takes over management of a trust upon the death of the trust creator (called the settlor, grantor or trustor), one of their chief responsibilities will be distributing the money and property held by the trust to beneficiaries. As is often the case with transfers of money or property, taxes may have to be paid, but who pays them? Are trust distributions taxable to the recipient? Or, do trusts pay taxes? Are they taxable at all?
We wish we had a simple answer for you, but the subject of trust administration and taxation is a complex one. Luckily, this article can serve as a guide for trustees who need help navigating trust taxation (though it is still advisable for them to work alongside an experienced probate attorney or accountant, as not following taxation procedures could land them in trouble, not just with the IRS but also with beneficiaries of the trust, who could sue them for fiduciary misconduct).
How are trusts taxed? Before delving into this topic, let’s discuss how trusts work.
How Trusts Work
To understand trust taxation, it’s important to understand how trusts work after the death. First, let’s start by discussing what a trust is. A trust is a legal arrangement in which one party, the settlor (also sometimes called a trustor or grantor) gives property or money to another party, the trustee, to hold and oversee for the benefit of a third party, collectively called the beneficiaries.
Many settlors go the route of naming themselves as the trustee and sole beneficiary of their trust for their lifetimes, though it is not a requirement for them to do so. Upon their incapacitation or death, the party they appointed as the successor trustee will take over as the supervisor of the trust and begin carrying out their administrative duties, which consist of everything from gathering the trust assets and preparing trust accountings to paying creditors and making trust fund distributions to beneficiaries.
There are many reasons why trusts have become a popular tool for passing down assets to loved ones, including the fact that trusts don’t generally have to pass through the expensive probate process and can offer protection from creditors in some cases. For many, however, trusts are beneficial for the tax savings they provide.
As far as determining whether a particular trust comes with tax benefits or not, it may boil down to whether the trust is revocable or irrevocable. But before we dive into the tax implications of each type of trust, let’s go over some basic definitions.
What Is a Revocable Trust?
A revocable trust, also called a living trust, is a trust that can be modified and/or revoked by the settlor during their lifetime without anyone’s consent. After the settlor dies, the trust generally will become irrevocable, requiring for its provisions to be followed as they are written.
Revocable trusts generally avoid the costly and time-consuming probate process, which make them a popular estate planning tool. They also allow for the continuous management of trust assets, meaning that the money and property held by the trust can be accessed immediately upon the settlor’s death.
What Is an Irrevocable Trust?
An irrevocable trust is a trust that generally cannot be modified or revoked by the settlor once it has been established. In other words, the settlor loses control of the trust and its assets once they sign the trust agreement.
While it is difficult to do, irrevocable trusts can be modified under certain circumstances. They include:
- If all parties to the trust — the settlor (if alive), the trustee and beneficiaries — agree to modify it
- If the assets in the trust are decanted (i.e., transferred to a new trust with different provisions)
- If the trust appoints a “trust protector” with the authority to modify the trust under certain circumstances
- If a court order is obtained to make modifications to the trust. This is the most challenging of all the options and generally only resorted to if the settlor of a trust is unwilling or unable (as a result of their death or incapacity) to consent to modification of the trust
***For more information on modifying trusts, be sure to read our article: Can a Successor Trustee Change a Trust?
Like revocable trusts, irrevocable trusts typically avoid the probate process and allow for continuous management of trust assets.
Trust Tax Rates: Revocable Trust Taxes vs. Irrevocable Trust Taxes After Death of Settlor
Taxation of a revocable trust during a settlor’s lifetime is relatively simple. Typically, during the settlor’s lifetime (while the settlor retains full control of the trust), any income earned by the trust is taxable to the settlor. The tax identification number for the trust will usually be the settlor’s own social security number, and the tax rate applicable to the income will depend on the tax bracket the settlor falls into based on the income he or she earned that year.
On the other hand, with an irrevocable trust, the trust is taxed as a separate taxable entity with its own separate tax identification number. There may be no taxable income associated with the irrevocable trust as a result of its structure, or the income earned by the trust may be taxed at the highest marginal tax rates for trusts.
Because there are numerous types of trusts, each with their own set of advantages and drawbacks, it is best to discuss the tax brackets for trusts and their implications with a qualified attorney or accountant.
Taxability of Trusts: How Are Trusts Taxed?
Are trusts tax-exempt? Many people assume they are, or that, at the very least, all trusts enjoy tax benefits and protection from creditors, but these assumptions would be false. Trusts often are subject to the same types of taxes as individuals.
Understanding Tax Brackets for Trusts
There are several types of taxes that could apply to trusts; however, since how a trust is taxed will depend on factors like the type of trust it is and the way the trust is structured, it is a good idea to enlist the help of a probate attorney or tax professional if you are the successor trustee to ensure that you not only follow the provisions of the trust, but the relevant trust tax rates as well.
In the following sections, we discuss the most common taxes that apply to a trust after the settlor dies, as well as list the most current trust tax rates and brackets.
Trust Income Tax Rates
Given that many trusts earn income, taxes will need to be paid on that income, just as most individuals and businesses have to pay taxes on the income they earn. Below, we briefly discuss the tax rates generally applicable to ordinary income tax and capital gains tax. H5: Ordinary Income Tax Rates
When a settlor dies, the responsibilities of the person or entity whom they appointed to be the successor trustee will begin. One of those responsibilities may be generating income for the trust or managing the income it already generates. Whether or not the trustee is obligated to perform this function ultimately will depend on the terms of the trust, the types of assets the trust holds and the duration for which the trustee will hold the assets.
Like individuals, a trust can own assets, such as stocks and bonds, which may earn dividends, or real estate, which may earn rental income. In the same way individuals must pay taxes on such income, trusts must do so as well.
While a settlor is living, income earned by property in a revocable living trust can be declared on the settlor’s individual tax return; however, once a trust becomes irrevocable, a separate tax ID number will need to be obtained and a separate tax return filed for all the income earned by trust assets.
What is the federal income tax rates for trusts? Are trusts taxed at a higher rate? As the chart below demonstrates, trust tax rates are higher than individual tax rates.
Federal trust income tax rates for 2024 are:
- For trust income between $0 to $3,100: 10% of income over $0
- For trust income between $3,100 to $11,150: 24% of the amount over $3,100
- For trust income between $11,150 to $15,200: 35% of the income over $11,150
- For trust income above $15,200: 37% of the amount over $15,200
Federal trust income tax rates for 2023 were:
- For trust income between $0 to $2,900: 10% of income over $0
- For trust income between $2,901 to $10,550: $290 + 24% of the amount over $2,901
- For trust income between $10,551 to $14,450: $2,126 + 35% of the amount over $10,551
- For trust income above $14,451: $3,491 + 37% of the amount over $14,451
- For trust income between $0 to $10,099: 1% of income over $0
- For trust income between $10,100 to $23,942: 2% of income over $10,100
- For trust income between $23,943 to $37,788: 4% of income over $23,943
- For trust income between $37,789 to $52,455: 6% of income over $37,789
- For trust income between $52.456 to $66,295: 8% of income over $52,456
- For trust income between $66,296 to $338,639: 9.3% of income over $66,296
- For trust income between $338,640 to $406,364: 10.3% of income over $338,640
- For trust income between $406,365 to $677,275: 11.3% of income over $406,365
- For trust income above $677,276: 12.3% of income over $677,276
It’s important to keep in mind that your county may also charge an income tax and that trust tax rates can vary considerably from year to year, so it is important for trustees to either keep themselves apprised of the latest tax rules or work with an attorney or tax professional who knows and understands them.
Trust Capital Gains Tax Rates
Trust taxation of capital gains can be complex to navigate. Taxes are levied on trusts only when their investments, such as stocks and real estate, are sold for a higher value than their base price. If a trust holds an investment for longer than a year before selling, it will be subject to the lower capital gains tax on account of it being a long-term gain. If a trust holds an investment for less than a year, the trust would pay short-term capital gains taxes at a higher rate.
The federal capital gains trust tax rates on long-term gains for 2024 are:
- Up to $3,150: 0%
- Between $3,150 – $15,450: 15%
- Over $15,450: 20%
If you live in California, you may be wondering what the long-term capital gains tax rates are in the state. As of 2024, California taxes long-term capital gains in the same way it taxes ordinary income, meaning capital gains are taxed between 1% and 13.3%, depending on your income level. There isn’t a lower capital gains tax for long-term gains in California.
The federal capital gains trust tax rates on long-term gains for 2023 were:
- Up to $44,625: 0%
- Between $44,626 – $492,300: 15%
- Over $492,300: 20%
Capital gains taxes often can be offset by capital losses. For example, if a trust sells one real property for a substantial profit but sells another real property for below fair market value, the capital loss the trust suffered may nullify a portion of or all of its capital gain, placing the trust in a lower capital gains trust tax bracket, or none at all.
If you are a trustee, it’s important to have a general understanding of the difference between unrealized gains and realized gains. An unrealized gain exists in theory. For instance, a trust may own stocks that have increased significantly in value since the time of their purchase, but until those stocks are sold, they are considered unrealized gains and therefore are not subject to capital gains tax. On the other hand, if a trust owns real property that it sells for a profit, it is considered a realized gain and is subject to capital gains tax
Trust Gift Tax Rates
If an asset is transferred during the life of one party to another without the gifter receiving fair market value in return, it’s possible the person making the gift may be subject to a gift tax, particularly if the value of the asset exceeds the gift tax exclusion amount, which is $18,000 as of 2024. If more than $18,000 is gifted to the recipient in a year, it will count against both the lifetime gift exclusion and federal estate tax exclusion of $13.61 million.
It’s worth mentioning that some types of trusts, depending on their provisions and how they are structured, may be exempt from gift taxes. For example, irrevocable charitable trusts that are established for the benefit of a charitable foundation may be exempt. Similarly, trusts that are designed to provide the surviving spouse with income during their lifetime, such as qualified terminable interest property trusts (QTIPs) and spousal lifetime access trusts (SLATs), may also be exempt.
It’s best to consult with an attorney or tax professional before claiming exemptions to ensure the trust you oversee qualifies for them.
Trust Estate Tax Rates
Estate taxes (also referred to as “death taxes”) are levied when assets are transferred from a deceased person to beneficiaries. If a decedent’s assets are held in a probate estate, then the executor or administrator of the estate will be responsible for paying the estate tax. Conversely, if a trust has assets that are subject to the estate tax, then the trustee will be responsible for paying this tax prior to transferring the assets to beneficiaries.
That being said, most trusts will not be responsible for paying an estate tax, as estate taxes only are levied on a decedent’s assets valued at $13.61 million or higher (or double that amount for married couples) as of 2024.
Even if a decedent’s assets have a gross value that exceeds the applicable estate tax exemption amount, the estate still may not be subject to estate tax if certain exceptions apply. For example, if the decedent’s will or trust provides substantial gifts to charitable entities, the gifts may qualify for a charitable deduction that reduces the taxable estate. Decedents who leave property to their surviving spouse may also benefit from a marital deduction that exempts property passing to a surviving spouse from estate taxes.
Trust Property Tax Rates
If a trust owns real estate (which many do), then it’s almost certain that the trustee will have to pay county and state property taxes on each of the properties it owns. The trustee must use the assets of the trust to satisfy this obligation.
Once the trustee transfers a real property to beneficiaries, it will become their responsibility to pay property taxes on it annually from that point onward until they sell or transfer it to another party.
Because property taxes are generally levied on a state and local level, it is difficult to provide specifics. However, we can say that as of 2024, the median property tax in California is $4,831.
Certain types of trusts, such as charitable trusts, religious trusts or educational trusts, may be exempt from having to pay property taxes. To determine if the trust you manage qualifies for a property tax exemption, speak with an experienced attorney or tax professional.
Do Beneficiaries Pay Taxes on Trust Distributions?
Are distributions from trusts taxable? We have covered some of the taxes a successor trustee may have to pay on behalf of a trust, but haven’t yet touched on distributions made to beneficiaries, leaving you to wonder: How are trust distributions taxed? The short answer is that it depends.
The factor that determines if a beneficiary will need to pay taxes on the distribution they receive from a trust is the source of the distribution, namely whether it originated from the trust’s principal or from the income the trust accumulated.
How Do Trust Distributions Work?
Trust distributions are governed by the terms of the trust. Some trusts may call for trust assets to be distributed outright to beneficiaries in a lump sum, while other trusts may call for trust property to be retained in trust for an extended period of time before the trust assets are fully distributed to beneficiaries.
Trust property can fit broadly into two categories: principal (i.e., property transferred to the trust by the settlor) and income (i.e., income earned by the trust on the principal). When trust property is retained for an extended period of time, it is likely that property will earn income. Whether distributions to beneficiaries are taxable to beneficiaries depends upon whether the property being distributed is taxable income, or principal of the trust.
We discuss income versus principal in trust distribution taxes more extensively in the following subsections.
Trust Distribution Tax on Income
When a portion of a beneficiary’s distribution from a trust or the entirety of it originates from the trust’s interest income, they generally will be required to pay income taxes on it, unless the trust has already paid the income tax. However, beneficiaries will be subject to individual income tax rates as opposed to trust income tax rates, which are higher.
Any interest income the trust distributes to beneficiaries can be deducted from its taxes. On the other hand, any interest income it does not distribute before the close of the year usually will be subject to trust income tax rates.
Trust Distribution Tax on Principal
When a portion of a beneficiary’s distribution from a trust or the entirety of it originates from the trust’s principal, the IRS assumes that taxes had already been paid on it by the settlor before it was transferred into the trust, resulting in the beneficiary not having to pay any additional taxes on it. For example, if real estate is transferred from a trust to a beneficiary, the distribution would be considered as originating from the principal, and the beneficiary would not pay taxes on the distribution.
Tax Forms Required for Distributions
Trustees will need to submit a completed 1041 form (i.e., a trust income tax return) to the IRS in order to deduct from the trust’s taxable income the income it distributed to beneficiaries. They will also need to complete a K-1 form for each beneficiary, which details how much of the beneficiary’s distribution came from income versus principal, and provide it to them so they can use it to file their personal tax return, as well as to the IRS so the agency can ensure the amount the trustee deducted on the 1041 form is accurate.
FAQs Taxation of Trusts
As you can gather from reading this article, there are a lot of nuances when it comes to the subject of trust taxation. Therefore, if you are trustee or trust beneficiary, you should strongly consider working with a skilled probate attorney or tax professional when preparing a tax return for the trust or your personal tax return, respectively, to ensure you don’t end up in hot water with the IRS for paying less than what you owe.
In this section of our article, we’ll discuss some of the most commonly asked questions surrounding trust distribution taxes.
Are distributions from an irrevocable trust taxable to the beneficiary?
It depends. Taxes related to irrevocable trusts tend to be highly complex because of the number of variables that are at play. Because the settlor of an irrevocable trust has no control over the trust or its assets once the trust instrument is signed, these trusts, unlike revocable living trusts, are not considered a part of the settlor’s taxable estate. As a result, distributions made to beneficiaries are generally not subject to an estate tax. In terms of whether distributions are taxable to beneficiaries, it depends on whether the trust is distributing income or principal, as discussed above.
Can a beneficiary refuse a trust distribution?
Yes, beneficiaries are always entitled to refuse a distribution from a trust. If you are the trustee in such a situation, you should ask the beneficiary in question to sign a disclaimer so that you cannot later be accused of a breach of fiduciary duty.
When a beneficiary refuses a distribution, they will be generally regarded as having predeceased the settlor, which would mean their inheritance will pass to the next beneficiary in line, unless the trust provides otherwise.
You’re probably wondering: Why would a beneficiary refuse a distribution? On the surface, it seems like refusing free money; however, there are some more than valid reasons for taking such an action. They include:
- The beneficiary is financially secure and not in need of the distribution. They may wish to preserve trust assets for the benefit of the other beneficiaries or future generations.
- The beneficiary could end up in a higher tax bracket if the distribution is made from the trust income and not the trust principal — which is something they are trying to avoid.
- The beneficiary may not agree with the terms of the trust and is refusing their distribution as a display of their dissatisfaction.
- The beneficiary receives means-based benefits (e.g., Medicaid) for which they may become ineligible once they receive a distribution.
If you are a trust beneficiary who is considering refusing their distribution, we recommend consulting with an attorney first in case there may be a less drastic option available for you to use.
Are trust administration fees tax-deductible?
Unfortunately, there is no straightforward answer to this question of whether trust administration fees are deductible. As a general rule of thumb (with some exceptions), administrative expenses can be deducted so long as the fees incurred are related strictly to the administration of a trust and would not have been incurred had the property not been held in trust. As an example, trustee fees are 100% deductible since the only occasion in which they arise is trust administration.
Still confused about trust distribution taxes? We’re here to help.
Tax administration and taxation is not an easy area of the law to navigate, especially since tax laws tend to undergo changes every year. While you may be able to get away with mistakes elsewhere in administration, taxes are serious and should not be taken lightly. Get the help you need today by requesting a free consultation.
