If you included a trust in your estate plan, which most people do, then you may be wondering how trusts affect income taxes. Different types of trusts have different tax consequences. An important factor in determining what your tax consequences will be is, determining who is responsible for paying the taxes on the trust income.
The “grantor” is the person who establishes a trust, either by gift or grant. If a trust is classified as a grantor trust, it means the grantor retains power over certain aspects of the trust. It also means that you, as the grantor, will continue to pay the income taxes on the trust assets.
For purposes of income tax, a grantor trust is considered a disregarded entity. In other words, taxable income or deductions earned by the trust are included on the grantor’s tax return. Typically, you will not be required to file a trust income tax return in this situation.
Tax advantages of a grantor trust
There are several tax advantages in creating a grantor trust. One benefit is that you can sell trust assets without recognizing the gain on the sale. You can loan money to the trust, at the minimum interest rate established by the IRS, but the interest income will not be taxable to you.
Also, the trust’s income tax will not be considered an additional gift to the trust. Essentially, the trust assets will be allowed to grow for the benefit of your beneficiaries. There will be no economic burden of paying income tax, so the gift will ultimately be tax-free.
Grantor trusts are commonly used for income tax purposes
It is very likely that you established a grantor trust as a part of an effective estate planning strategy. Some common types of grantor trusts seen in many estate plans include defective grantor trusts, retained annuity trusts, irrevocable life insurance trust and spousal access trusts. Dynasty trusts can be structured as grantor trusts, as well.
Converting a grantor trust into a non-grantor trust
There may come a time when you need to consider converting your grantor trust to a non-grantor trust. Maybe your trust has acquired sufficient assets for your beneficiaries. Or, perhaps it is no longer economically feasible for you to continue paying the trust’s income taxes. In these situations, you can waive your grantor trust powers, which will effectively convert your trust from a grantor trust to a non-grantor trust.
Tax consequences of a non-grantor trust
The difference between a grantor and non-grantor trust is who pays the income tax. A non-grantor trust pays income tax at the trust level, for all taxable income retained by the trust. This means, when the trust makes a distribution to a beneficiary, the tax on the income will be paid on the beneficiary’s personal income tax return.
The trustee completes Form 1041 and issues a Schedule K-1 to the beneficiary, indicating the type and amount of income received by the beneficiary from the trust.
If you have questions regarding trusts and income taxes, or any other estate planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.
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