Estate planning is always a smart move. Sometimes it is hard to even understand the difference between will and a trust. For those looking ahead, a living trust can be an excellent way to ensure financial security for the next generation or to assist in paying for future expenses like college. Of course, when it comes to anything related to finances, there’s always the question of taxes.
If you’re looking at creating or collecting benefits from a living trust, you may find yourself asking, “do trusts pay taxes?”
Ultimately, yes, trusts are taxable, but how they are taxed and when they are taxed are more complicated questions to answer. To answer, we’ll need to go over the basics of trust funds, explore complex and simple trusts, and touch on how trusts report taxable income. Read on to discover everything you need to know about trust taxation.
Before we can answer the question “Is a trust taxable?” it’s necessary to explain precisely what they are and how they work.
There are many benefits of having a trust. A resident trust fund is a legal and financial entity that is created to hold assets and trust property for a trust beneficiary or group of beneficiaries.
The three participants involved with creating and maintaining a resident trust include:
With these key figures established, a family trust can be created and modified throughout the life of the grantor. Most often, a grantor trust is designed to pay out assets to the beneficiary over a period of time, following the grantor’s death. This amount may be a monthly allowance or a specific sum designated for living, educational, or business expenses.
Every trust instrument is different and therefore has different means of taxation. To simplify these variations, it’s best to break down the two common categories of trust principal funds and explain how they are taxed.
Just as the name implies, simple trusts are fairly straightforward in their operation. The key aspects that define simple trusts include:
In the case of a simple trust, it’s the beneficiary who will pay the federal income tax on all income that they collect. This income is ultimately based on interest and investment gains, making it “new” income, in the sense that it has not been previously taxed.
The trust itself will make a federal income tax deduction for all income paid out. For example, if I beneficiary earns $500 annually from a simple trust, they will report that income on their taxes while the trust will report a $500 estate tax deduction on their taxes.
Capital gains may be added to specific trust-related investments and could fall under the beneficiary or the trust depending on the situation.
A complex trust varies from a simple trust in any of the following ways:
A simple trust may become a complex trust if it engages in any of these activities over the course of a single year. In addition, a trust may move back and forth between complex and simple depending on its annual financial actions.
While beneficiaries of complex trusts will pay taxes on income from the interest and investments of the trust, they will not pay taxes on any principle payouts. That’s because it’s assumed that taxes have already been paid on that initial principle amount before it was used to establish the trust.
The trust itself will make payments and deductions based on income distributed annually.
To fully comply with the law, there are two key tax forms required for trusts and beneficiaries:
To properly file these documents, you’ll also need the grantor’s social security number if they are alive or an EIN (employer identification number).
To avoid having to set up a trust in person, simply fill out this SS-4 form to apply for trust online right now.