Income Taxation of Trusts — Not Just Special Needs Trusts

APRIL 6, 2015 VOLUME 22 NUMBER 13

We have previously explained the income taxation of self-settled special needs trusts and third-party special needs trusts. We focused on special needs trusts because, well, that’s what we do — and also because there seems to be so much confusion about special needs trusts. But that is not the only confusion out there. We find a lot of confusion about taxation of trusts, generally. Let’s see if we can clarify some of the issues.

The income tax issues are actually the same for trusts that are not “special needs” trusts. But the generalizations are a little harder to keep straight, since there is a much broader variety of trusts out in the world. So let’s see if we can lay out some questions and answers to help you understand the issues.

The first question: is the trust a “grantor” trust?

Why is this question the first (and probably the most important)? Because if the trust is a grantor trust it (a) does not need to have a separate taxpayer identification number (what is called an EIN, or Employer Identification Number, in tax language) and (b) should not file a separate tax return. If the trust is a grantor trust, you can (and usually should, if only for convenience purposes) use the grantor’s Social Security Number and report income on the grantor’s personal income tax return.

So how do you know if your trust is a grantor trust? Let’s ask a few qualifying questions:

• Did you create the trust, or did the money in the trust once belong to you?

• Is the trust revocable (by you)?
• Are you the trustee?
• Are you a beneficiary of the trust?

If you answer the first question “yes” and any one or more of the following questions “yes,” your trust is almost certainly a grantor trust. There are some exceptions, but they are relatively rare. Talk to your attorney and your tax preparer — and we recommend you talk with both. Why? There is a lot of misunderstanding out there, and neither lawyers nor accountants always get the answer right on this question.

What are the most common misunderstandings? You will sometimes hear accountants, bankers, stockbrokers and lawyers assure you that an irrevocable trust that names someone other than the grantor as trustee must have a separate EIN (and, presumably, file a separate tax return). That’s simply not true. It’s also not relevant to whether or not the trust is a grantor trust.

There are also some “magic” provisions in irrevocable trusts that are usually used precisely to make them grantor trusts. If, for instance, your irrevocable trust includes a provision that says the person who set it up retains the right to trade (“substitute”) property in the trust for their own property, it’s pretty likely that was included precisely to make sure the trust is a grantor trust.

What if the trust is not a grantor trust?

Then the trust will need an EIN, and it will file a separate income tax return. That does not necessarily mean it will pay any income tax, but it will need a return filed.

Depending on the language of the trust and the nature of its distributions, some or all (or, rarely, none) of its distributions will be taxed to the recipient — or to the person who benefited from the distribution. So, for instance, if a non-grantor trust sends cash to its beneficiary, the beneficiary will probably pay some income tax on the distribution. Same answer if, instead, the trust pays the beneficiary’s rent, college tuition and car payments directly — all of those distributions are for the benefit of the beneficiary.

Note that not all of the trust’s distributions will be treated as income to the beneficiary. Only the portion of the distributions that would have been taxed to the trust (that is, the trust’s income) will be subject to being passed through to the beneficiary. So, for instance, if a trust has $1,000 of interest income, and pays $15,000 in rent and tuition bills for the beneficiary, no more than that $1,000 figure will be taxable income to the beneficiary. At least some of the administrative costs will probably be deductible before calculating the tax effect.

How does the non-grantor trust report its income for tax purposes?

The federal tax form used by trusts is called the 1041 (it’s similar to, but different from, the individual’s 1040 income tax form). It actually looks a little simpler than the personal income tax return, but that’s misleading — some of the accounting and tax concepts are more complicated and less understood. We recommend that trustees get a professional to prepare the trust’s tax return.

What about state income tax returns?

The trustee will likely need to file state income tax returns that mirror the federal return. But for which state(s)? That’s a hard question to answer, and impossible to generalize about. Some states want trust income tax returns for any trust that has a trustee or co-trustee living in their state. Others look primarily to where any one beneficiary lives. Other states do not have income tax at all, and so do not require a trust to file an income tax return. Your professional tax preparer will want to consider at least: (a) the language of the trust, (b) the residence of all beneficiaries, and (c) the residence of all trustees.

Can any tax preparer handle a trust’s income tax return?

Yes. Probably. Maybe. Wait — let us ask you a question: have you asked the tax preparer how often he or she prepares trust income tax returns? If not, we suggest you might want to ask. The returns are not bewilderingly complicated, but they are unfamiliar to people — even professionals — who are not used to working with them. Your best bet: get a professional (probably a CPA, perhaps a lawyer or law firm) who does this kind of tax return on a regular basis.

Good luck getting through this tax season. We hope this helps. Be careful, though — there are exceptions and qualifications to the general rules we’ve outlined. Check with your experienced tax preparer or attorney before actually preparing returns. Better yet: let the professionals do it.