Most individuals have a pretty good idea about how they are personally taxed. However, not everyone understands how trusts and estates are taxed. In fact, many have no idea if the entities are taxed at all, or how.
Taxing grantor trusts
Grantor trusts are not recognized as an entity by the IRS, this means that any gain, loss, or other tax characteristics are passed on from the trust to the Grantor. This tax treatment is hugely advantageous, as the tax rates for individuals are much better than those for non-grantor trusts.
Taxing non-grantor trusts
Unlike Grantor trusts, Non-Grantor trusts are recognized as an entity by the IRS. This means that they are taxed individually. One of the first things the Trustee of a Non-Grantor trust must do is apply for an EIN number, this number will be used on all IRS filings, and will be required to maintain bank accounts. Generally, a trust will have to file a return, known as a 1041, for any year in which it has had at least $600.00 in gross income. As mentioned above, the tax rates for Non-Grantor trusts are less advantageous than Grantor trusts. Specifically, trusts start paying the highest federal income tax rate for income higher than $12,950.00, individuals reach that same threshold at $518,400.00.
However, trusts do not pay tax on distributed income, therefore, if you have a trust that is earning income, but distributes that income then it will not pay tax on that income. Rather, the individual that receives the distribution will bear the tax burden. The trust will only pay income tax on retained income. This is why it is important to make sure a Grantor’s trust document makes active distributions, as if the income is not paid out after their death, the income will be subject to a high income tax.
Much like non-grantor trusts, estates must pay income tax on retained income. In fact, trusts and estates are taxed in a very similar fashion. They even share the same tax bracket. This is one of the reasons why an estate should be administered quickly, as any income retained by the estate will be taxed at the same high rate as income for trusts. Interestingly, it is not just the estates of the deceased that must pay income tax, bankruptcy estates are also subject to the same tax. However, should an administration run long, or short, by a short amount of time, the Estate can apply to lengthen or shorten a tax year.
Taxing specialized trusts
As mentioned in the section above, the estate tax is different than the income tax. While most of the time, these different tax structures are harmoniously synchronized, there are times when they come out of sync and planning opportunities arise. One of these opportunities deals with what is known as an Intentionally Defective Grantor Trust. This type of trust straddles the line and is considered a separate entity for estate tax purposes but a Grantor trust for income tax purposes. The dual nature of this trust allows an individual to transfer assets into the trust, while avoiding the income tax consequences of non-grantor trusts, all while helping their estate tax position. This is a highly specialized type of transaction.
Quick note on estate tax
This article has dealt with income tax, including the income tax paid by Estates. However, income taxes are not the same as estate taxes. Estate taxes apply only to those estates which are valued over $11.58 million. Income tax applies to all estates that have retained income. Additionally, the way that estate taxes are calculated are completely different than the income tax, as the estate tax looks at the overall value of an individual’s estate, while the income tax only focuses on the income generated over a year.