How Trusts are Taxed
We can talk hours about the intricacies of trust taxation, but here are some basic concepts that will still go a very long way when it comes to how trusts get taxed.
Trusts get taxed in two different ways: a grantor trust, and a non-grantor trust.
A grantor trust refers to a “pass-through trust,” in which any income attributed to the trust is taxed directly back to the individual who created the trust (called the grantor). In a grantor trust, it does not matter if the income stays in the trust or was distributed out to the beneficiaries of the trust because the grantor is the one picking up the tab, so to speak. A common example of a grantor trust is a revocable living trust (RLT). In a RLT, even though your assets are funded (re-titled) into your trust, the IRS still regards you (the grantor) as the person who owns the trust when it comes to income taxes. This is why RLTs normally do not file their own tax returns since they use your social security number as their tax ID). Thus, any income generated in your RLT is attributed back to you on your personal tax returns.
While the RLT is a basic yet common example of a grantor trust, several irrevocable trusts are also taxed as grantor trusts. Among them, to name a few, are an ILIT and an IDGT. One common reason why some prefer to tax an irrevocable trust as a grantor trust is to reduce the size of your estate from an estate tax planning perspective. For example, if you gifted assets into an IDGT, the assets can grow inside the IDGT without being subjected to future estate taxes, while simultaneously, you can reduce your personal estate tax exposure for any assets still left in your name by paying the taxes for the IDGT. Normally, if you paid taxes on behalf of someone else, the IRS will argue that your payment qualified as a gift. But, here, because you essentially are paying taxes on behalf of yourself (recall that the IDGT is you, from an income tax perspective), you cannot make a taxable gift to yourself! In other words, you are legally able to bring down the size of your taxable estate by paying the tax on behalf of your trust, which also allows the assets in the trust to grow estate-tax free. We call this a “burn technique” since you are (legally) burning down the size of your estate such that when you pass away, less will be exposed to estate taxes on the personal side, while on the trust side, assets are going tax-free.
The grantor trust has a number of additional tax advantages. For example, you can sell assets to the trust without recognizing the gain on the sale. You can also loan money to the trust at a very low minimum interest rate called the “Applicable Federal Rate,” wherein the interest income is not taxable to you since you are paying yourself, essentially.
If at some point, the trust has enough to pay its own taxes, or if it no longer becomes feasible for you to pay the income taxes on behalf of the trust, then you can “turn off” grantor trust powers and have the tax pay its own taxes (called a non-grantor trust). Finally, once you pass away, your trust automatically will become a non-grantor trust.
As will be seen below, irrevocable trusts can also be taxed as non-grantor trusts at the outset.
By contrast, a non-grantor trust is one in which the trust itself is its own taxpayer. You, the grantor, once you fund assets into the trust will no longer be responsible personally for any of the taxes earned by the trust. Instead, any income generated from within the non-grantor trust will be taxed directly to the trust (at compressed trust tax rates), unless the income is distributed out to the beneficiaries of the trust, in which case the income will be taxed at the beneficiary’s own tax rate. If the trust income was not distributed to the beneficiaries, then the trust will accumulate the income and the tax rate is compressed. For example, if a non-grantor trust accumulated more than $12,950 in income, the trust would owe $3,129 in taxes, plus 37% on any income above $12,950.
For this reason, many prefer to distribute the income out to the beneficiaries since they may be at a lower tax bracket. Moreover, if the beneficiaries are at a lower tax bracket than the grantor, then choosing a non-grantor trust may be an efficient mechanism to bracket manage the income. Of course, this must be balanced with any asset protection risks that may be jeopardized by such distributions.
There are some trusts that must always be taxed as non-grantor trusts, the most common being 1202 Trusts (for QSBS purposes) as well as NING trusts. As stated above, all trusts at the death of the grantors become non-grantor trusts.
Determining how to tax a trust will depend on a number of factors. As noted, some trusts require a certain form of taxation to achieve the stated goals. With others, it can the choice of the grantor how to establish the trust from the outset.