With the federal estate tax exemption currently at $11.58 million for individuals ($23.16 Million for married couples) and the Minnesota estate tax exemption at $3 million, non-tax considerations generally prevail when selecting a particular trust arrangement for the transfer of wealth from one generation to the next. However, income taxation is still an important and often overlooked issue in the trust context. Whether you own assets individually or through a trust, the income on those assets will be subject to state and federal income tax. The tax liability of yourself, your beneficiaries, and/or your trust can differ drastically depending on the type of trust you create and whether or not that trust retains income or distributes income to trust beneficiaries.
Types of Trusts
A trust is a separate taxable entity that comes into existence when an “grantor” transfers asset to a trustee for the purpose of protecting and conserving those assets for the beneficiaries. The assets can be transferred in trust during your life under a written declaration known as a trust agreement or after your death in accordance with your will. A trust created during the grantor’s life is known as an intern vivos trust. A trust created under a will following a person’s death is known as testamentary trust.
Trusts are also commonly described as being either revocable or irrevocable. Revocable trusts can be amended or revoked at any time by the grantor without the consent of another person, including the trustee. The grantor usually retains unrestricted control over the trust assets during his or her life and for so long as he or she is mentally competent. In comparison, irrevocable trusts typically cannot be changed, amended, or revoked by anyone after they are established. Inter vivos trusts can be revocable or irrevocable, but testamentary trusts are always irrevocable.
Taxation of Grantor Trusts
The income tax consequences of a trust depends on whether that trust is a grantor or non-grantor trust under the Internal Revenue Code (“IRC”). Grantor trusts are disregarded as a separate taxable entity to the extent the grantor or another person is treated an owner of any portion of a trust asset. All items of income, deduction and credit pass through to the grantor and are reported on the grantor’s individual tax return.
A grantor is treated as an owner for income tax purposes if he or she has sufficient control over the trust. Examples of control include: (1) a reversionary interest retained by the grantor or grantor’s spouse exceeding five percent of the value of the transferred property; (2) the power of the grantor or a non-adverse party to affect beneficial enjoyment of trust assets or income; (3) the power of the grantor or non-adverse party to revoke the trust or return the trust property to the grantor; or (4) the power of the grantor or a non-adverse party to distribute income to or for the benefit of the grantor or the grantor’s spouse. As you would expect, revocable trusts are by definition a grantor trust.
Income from grantor trust is taxed at the individual rate of the grantor. As will be discussed below, trusts are taxed using less favorable tax brackets with higher tax rates applying to lower amounts of income. As a result, income from a grantor trust is taxed less than a non-grantor trust and it usually makes the most sense to hold property in a grantor/revocable trust if the trust will be accumulating income.
Taxation of Non-Grantor Trusts
A non-grantor trust is treated as a separate taxable entity that is taxed in substantially the same manner as an individual taxpayer; however, these trusts only pay taxes on the income they accumulate. A trust that distributes income to beneficiaries is treated as a conduit passing the income to the recipient who reports it on his or her individual tax return. The character of the income, such as ordinary income, qualified dividend, etc., remains the same in the hands of the beneficiary. Beneficiaries are never taxed on more than their share of distributable net income. Distributable net income is a special calculation used to allocate income between the trust and its beneficiaries. This calculation is designed to prevent double taxation of trust income.
To the extent that the trust has accumulated income during a given year, it will be taxed on separate schedule applicable only to trusts and estates. The schedule is adjusted for inflation each year. A comparison of the tax rate schedule for trusts and individuals is as follows for the tax year beginning in 2019:
Income: Under $2,600 / Tax Rate: 10%
Income: Over $2,600 to $9,300 / Tax Rate: 24%
Income: Over $9,300 to $12,750 / Tax Rate: 35%
Income: Over $12,750 / Tax Rate: 37%
Income: Under $9,700 / Tax Rate: 10%
Income: Over $9,700 to $39,475 / Tax Rate: 12%
Income: Over $39,475 to $84,200 / Tax Rate: 22%
Income: Over $84,200 to $160,725 / Tax Rate: 25%
Income: Over $160,725 to $204,100 / Tax Rate: 32%
Income: $204,100 to $510,300 / Tax Rate: 35%
Income: Over $510,300 / Tax Rate: 37%
The fact that non-grantor trusts are taxed at a progressively higher rate than individuals and grantor trusts does not mean a non-grantor trust will automatically have a large tax liability. Often, these types of trusts spray out the income to beneficiaries who may be taxed at a lower individual rate than the grantor. Also, non-income producing assets will not be subject to tax until sold.
Determining Trust Income for Federal and State Taxes
A trust’s income, as determined by generally accepted accounting principles, is not necessarily the same thing as its income for tax purposes. Instead, a trust’s income under the Internal Revenue Code is determined by the terms of the trust agreement and applicable law. Minnesota’s Uniform Principal and Income Act (“UPIA”) authorizes the trustee, in absence of contrary terms in the trust agreement, to allocate receipts and expenses between income and principal to ensure that both income beneficiaries and remainder beneficiaries are treated impartially and fairly under the terms of the trust.
As a result, even though receipts of dividends, interest, and rents are generally allocated to income and proceeds from the sale or exchange of assets are generally allocated to principal, a different allocation of these amounts will be respected by the IRS if the allocation is a reasonable apportionment between the income and remainder beneficiaries of the trust’s total return for the year.
Minnesota also taxes income earned by trusts under the rates applied to married individuals filing separate returns. Resident trusts are taxed on all income earned by the trust with credit given in most circumstances for taxes paid to another state. Minnesota also taxes non-resident trusts on income sourced from within the state. Two examples include income derived from carrying on a trade or business conducted wholly within this state, and income or gains from tangible property located in this state that is not used in a business.
Tax Liability and Tax Returns
For non-grantor trusts, both Minnesota and federal law impose an obligation on the trustee to compute and pay for the taxes of the trust. The trustee is required to complete and file an income tax return—Form 1041. The trustee will be liable for any tax liability that he/she had notice of or could have determined with “due diligence”. Beneficiaries may also be required to pay for an uncollected tax liability of the trust to the extent they received trust assets.
In comparison, the grantor or other person deemed an owner must pay taxes on the income produced from assets held by a grantor trust. Instead of using the Form 1041, the trustee will report items of income, deduction, and credit on separate statement identifying the grantor. The grantor then reports these items on his or her individual tax return. In some circumstances, the trustee can elect an alternative reporting method. Under one such method, the trustee doesn’t need to file a return with the IRS if the trustee provides all payors of income with the trust’s address and the grantor’s name and tax identification number. The trustee must also provide the grantor with additional information unless the grantor is acting as the trustee.
Estate planning attorneys often advise clients about the benefits of various trust arrangements. One important consideration during this conversation is the income tax consequences that occur during the life of the trust. With the estate and gift tax exemptions at their highest value ever, income tax will have a greater impact on most individuals’ ability to maximize the transfer of wealth to their heirs and should be considered as part of every estate plan.
This information is general in nature and should not be construed as tax or legal advice.