With the turning of the year and our progression into spring, our thoughts turn gently to the upcoming income tax season and to the March 6 deadline for determining how much income must be distributed from your non-grantor, irrevocable trust for the 2017 tax year.
Trusts themselves are not terribly complex creatures. Someone (the settlor) gives an item to another person/company (the trustee) to manage for the benefit of a third party (the beneficiary). However, the tax laws surrounding who pays taxes on the trust’s income may or may not be more complicated.
First, some background on the income taxation of trusts. A trust will either be a grantor trust or a non-grantor trust. A grantor trust’s income is generally taxed on the grantor’s / settlor’s tax return. On the other hand, a non-grantor trust is considered to be a separate taxpayer. The Trustee will file an IRS Form 1041 to report the trust’s taxable income for the year, and allocate who is pay tax on it. Non-grantor trusts come in two flavors, complex and simple. Simple trusts are those that require the trustee to distribute all of the trust’s income to the beneficiary. With simple trusts, the beneficiary is taxed on all of the trust’s income. However, if the trustee is given discretion on how much to distribute to the beneficiary, then the trust is called a complex trust. In general, distributions from complex trusts carry out the taxable income with them. If more taxable income is earned than distributions are made, then the trust pays tax on the remaining undistributed income. It should be noted that income for trust taxation purposes normally includes ordinary taxable income items like interest, dividends, rents and royalties. In general, but not always, capital gains are not considered to be income, and therefore, are not carried out to the beneficiary. As a result, capital gains are generally taxed to the trust.
Second, why should you care who pays tax on the trust’s income? In general, trusts are subject to the same tax rates as individuals, but trusts hit the highest tax rates at a much lower level. For 2017, the top marginal income tax rate of 39.6% impacts single taxpayers with taxable income of $418,400, and married couples with taxable income of $470,700. By contrast, a trust needs only to have $12,500. A trust will also be subject to the higher long-term capital gain rates and the 3.8% Net Investment Income Tax at this same $12,500 threshold. In other words, the ability to decide who will pay tax on the trust’s income and capital gains could potentially net significant tax savings.
Third, most trusts set up by you or another settlor during life will be structured as grantor trusts, so that all of the trust’s income and capital gains will be taxed back to the grantor / settlor. However, some trusts set up during the settlor’s life and most set up after the settlor dies will be non-grantor trusts. Further, most non-grantor trusts will be complex trusts since they give the trustee discretion as to distributions.
Fourth, if you are a trustee or a beneficiary of a non-grantor, complex trust, this March 6 deadline is for you! It is time to discuss the taxation of your trust’s income and capital gains with your CPA or other tax preparer as soon as possible!
Why? Because the IRS permits the Trustee to elect on the trust’s income tax return to treat trust distributions made within 65 days after the end of the tax year (by March 6 of the next year) as being made on the last day of the tax year. This election is referred to as a Section 663(b) election and is made on page two of the IRS Form 1041. So, if you are a Trustee (with control) or a beneficiary (who will be affected) of a non-grantor, complex trust, an analysis needs to be done to determine if any additional income and capital gain should be distributed before March 6 to achieve a better income tax result. Further steps may be needed to enable the distribution of capital gains.
So, before the tax season begins in earnest, please schedule a meeting with your CPA or other tax preparer to review your irrevocable trust. The attorneys with Morgan & DiSalvo do not prepare trust income tax returns, IRS Forms 1041, but we can assist your CPA or other tax preparer with these issues. Please contact Julia at 678-720-0750 or Admin@MorganDiSalvo.com to schedule a time to review your trust taxation situation. This may also be a good time to review your overall estate plan as well.