Given the popularity of trusts, there is a good chance that you will eventually decide to include a trust agreement in your comprehensive estate plan. If so, you need to understand what taxes are levied on trust assets and whether the trust and/or the beneficiaries of the trust are responsible for paying any taxes due. Toward that end, the Los Angeles trust attorneys at Schomer Estate & Wealth Advisors discuss taxes and trust administration.
Understanding How a Trust Works
A trust agreement is a legal arrangement wherein the individual who establishes the trust (referred to as the Settlor, Trustor, Grantor, or Maker) designates another person (the Trustee) to manage and safeguard funds or other assets on behalf of a third party (the Beneficiary). Trusts come in two main forms – living trusts and testamentary trusts. A testamentary trust is established through a provision in the Settlor’s Last Will and Testament and only becomes active upon the Settlor’s death. In contrast, a living trust becomes effective as soon as it is established, during the Settlor’s lifetime. Living trusts can be either revocable or irrevocable. All trusts are recognized as distinct legal entities, making them potentially subject to taxation by federal or state governments. Because the trust assets are distributed to designated beneficiaries, the value of those assets may also be taxable to the beneficiaries.
When Does a Trust Pay Taxes?
Just as individuals and businesses are subject to taxation by the federal and/or state government, so is a trust. The same reasoning, however, allows a trust to take advantage of many of the same credits and deductions used by individuals and businesses to lower the amount of taxes owed. With the exception of certain specialized trusts, a trust is usually required to file a federal tax return each year and pay any taxes due and owning. State taxes may also apply to a trust; however, determining which state has jurisdiction over a trust can be complicated.
Taxation of a revocable living trust is relatively straightforward. Any income generated by the trust is taxable to the Settlor (the creator of the trust) during the Settlor’s lifetime. The rationale for this is simple. Because the trust is revocable, the Settlor retains control over the trust assets, making any income generated by those assets taxable to the Settlor.
Taxation of irrevocable trusts is more complicated. An irrevocable trust with distributions and earnings is subjected to taxation pursuant to a complex schedule set by the Internal Revenue Service but the trust will pay a minimum of 15 percent in federal taxes.
When Do Trust Beneficiaries Pay Taxes?
The fundamental purpose of a trust is to protect assets designated for the benefit of the named beneficiaries. Consequently, beneficiaries receive distributions from the trust at some point. Those distributions may also be considered a taxable event. Whether or not a distribution is ultimately taxed to the beneficiary depends on various factors, starting with whether the distribution originates from the trust’s principal or the trust income.
In an ideal scenario, the assets initially transferred to the trust are invested by the Trustee in a way that produces income. The original assets transferred into a trust are considered the trust’s “principal.” Distributions stemming from the principal are not subject to taxation for beneficiaries because those assets have already been taxed. Conversely, if the distribution is from gains realized by the trust (trust income), the value of the distribution is taxable for a beneficiary because that income has not yet been taxed.
In certain instances, a beneficiary might receive distributions within the same year that represent both principal and gains from the trust. In such cases, the law deems the distributions as current-year income first, subsequently treating them as principal if the current-year income is exhausted.
Do You Have Questions about Trust Administration and Taxes?
For more information, please join us for an upcoming FREE seminar. If you have additional questions about trust administration and taxes, contact the experienced Los Angeles trust attorneys at Schomer Estate & Wealth Advisors by calling (310) 337-7696 to schedule an appointment.
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