Are Trust Distributions Taxable?
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When a successor trustee takes over management of a trust upon the death of the trust creator (called the settlor), one of their chief responsibilities will be distributing the money and property held by the trust to trust beneficiaries. As is often the case with transfers of money or property, taxes may have to be paid. But who pays them? Are distributions from a trust taxable to the recipient? Are they taxable to the trust? 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 distribution taxes (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).
Before getting into the weeds of how trust distributions are taxed, let’s discuss how trusts work.
How Trusts Work
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 trustee 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 delve 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 typically 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)
Like revocable trusts, irrevocable trusts typically avoid the probate process and allow for continuous management of trust assets.
***For more information on modifying trusts or trusts in general, be sure to read our articles: Can a Successor Trustee Change a Trust? and How Does a Trust Work After Someone Dies?
Tax Benefits of Revocable Trusts vs. Irrevocable Trusts After Death of Settlor
As previously mentioned, when the settlor of a revocable trust dies, the trust will become irrevocable by default. This means that it will be regarded as a separate taxable entity and will have to pay taxes on whatever income it earns. The trust may be able to claim deductions under certain circumstances (e.g., if it made charitable donations or had expenses related to trust administration), but there are limited tax benefits beyond that.
On the other hand, if the grantor of an irrevocable trust dies, how their trust is treated in terms of taxes will depend on the type of trust it is and on its terms. For example, charitable trusts and charitable remainder trusts can offer ongoing tax benefits to the trust and its beneficiaries. Similarly, there are specific kinds of irrevocable trusts, such as life insurance trusts, that can be utilized to decrease the size of the settlor’s estate, which could exclude the trust from having to pay estate taxes.
Because there are numerous types of trusts, each with their own set of advantages and drawbacks, it is best to discuss the tax implications of a trust with a qualified attorney or accountant.
Trust Administration and Taxation: What Types of Taxes Are Applicable to Trusts?
Many people assume that all trusts enjoy tax benefits and protection from creditors, but their assumption would be false. Trusts often are subject to the same types of taxes as individuals.
There are several types of taxes that could apply to trusts; nevertheless, since how a trust is taxed will depend on factors such as 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 and a tax professional if you are the successor trustee to ensure that you not only abide by the trust’s provisions, but also by relevant tax laws.
In the following subsections, we discuss the most common types of taxes that apply to a trust after the settlor dies.
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. Taxable income for trusts can be divided into two broad categories, each with its own set of rules: ordinary income tax and capital gains tax. We delve into the details of each type of income tax below.
Ordinary Income Tax
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 these functions ultimately will depend on the terms of the trust, the types of assets it holds and the duration 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 would have to pay taxes on such income, trusts have to 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 income earned by trust assets. As the table below demonstrates, trusts are subject to higher tax rates than individuals.
Federal income tax rates for trusts in 2023 are:
- 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
California state income tax rates for trusts in 2022 were:
- 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 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.
Capital Gains Tax
Capital gains 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 capital gains tax rates on long-term gains for 2023 are:
- 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, resulting in a lower capital gains tax 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.
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 asset may be subject to a gift tax, particularly if the value of the asset exceeds the gift tax exclusion amount, which is $17,000 as of 2023. If more than $17,000 is gifted to the recipient in a year, it will count against both the lifetime gift exclusion and federal estate tax exclusion of $12.92 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.
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 $12.92 million or higher per decedent (or double that amount for married couples) as of 2023.
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.
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 on 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 2023, the median property tax in California was $3,818.
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?
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 has 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.
Distributions From Trust 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.
Distributions From Trust 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.
For example, if a trust earned dividends on stocks, which were then distributed equally among beneficiaries, the trustee would provide each beneficiary with a K-1 form listing the amount of their dividend income. They also would need to submit a 1041 form to the IRS that deducts the cumulative amount of the dividends distributed from the trust’s taxable income to beneficiaries, as well as all the beneficiaries’ K-1 forms.
FAQs About Trust Distribution Tax
As you can gather from reading this article, there are a lot of nuances when it comes to the subject of trust administration and 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 the 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 scheduling a free consultation with our knowledgeable team of attorneys, who also are experienced in taxation.