1. The trust will be taxed on income that it accumulates.
2. If the trust makes a distribution during the year, or within a limited grace period thereafter, the trust may deduct that distribution from its income.
3. The beneficiary then picks up that income on his or her own income tax return. (If the distribution exceeds the trust's income for the year, the beneficiary is taxed only to the extent of the income. The excess distribution is tax-free.)
One wrinkle concerns capital gain income. In some cases that income will be taxed to the trust, rather than the beneficiary, even if it is distributed to the beneficiary.
If income is accumulated within the trust (or in the case of capital gain, sometimes even if it is distributed) it will be taxed at trust tax rates. If income is carried out to the beneficiary, it will be taxed at the beneficiary's tax rates.
Trusts of this type are subject to the same tax brackets as individuals, but they hit the highest bracket much sooner -- at a mere $11,950. So accumulated trust income over that modest level will be taxed at 39.6% (for ordinary income) or 20% (for capital gain and qualified dividend income), and will also be subject to the new 3.8% Medicare tax under the Affordable Care Act.
As always, this is not legal or tax advice, and you should consult your own advisor as to how any particular trust will be taxed.
Eric wrote:One wrinkle concerns capital gain income. In some cases that income will be taxed to the trust, rather than the beneficiary, even if it is distributed to the beneficiary.
Eric......what determines whether the CG income is taxed to the trust vs the beneficiary?
kaneohe wrote:Eric......what determines whether the CG income is taxed to the trust vs the beneficiary?
That's a complicated issue. Conveniently, I'm going to be travelling today and tomorrow, so I may not be able to explain this fully.
In technical terms, the issue is whether capital gains are included in "distributable net income" (DNI). Here are two articles discussing this issue. In the first article, start about halfway down the first page, under the heading "a. The Regulation Itself." In the second article, scroll down until you reach the heading, "When Are Capital Gains Included in DNI?"
However, to the extent you distribute the income (and to the extent you distribute the capital gains if you can do so in a way that they'll be taxable to the recipients), you lose the protection of the credit shelter (bypass) trust. The amounts distributed will be included in the recipients' estates, and will be exposed to the recipients' creditors and spouses.
The estate tax in the beneficiaries' estates won't be an issue as often as it was before, since the Federal exempt amount has been made permanent at $5.25 million (indexed), and portability has been made permanent. However, it will sometimes be a factor. Note that about 1/2 of the states have a state estate or inheritance tax, some with an exempt amount lower than the Federal exempt amount.
To the extent you make distributions to the children, the amounts distributed won't be included in the spouse's estate, but will no longer be available for the spouse if he/she ever needs the money. Similarly, to the extent you make distributions to the grandchildren, the amounts distributed won't be included in either the spouse's estate or the children's estates, but will not longer be available for the spouse or the children if they ever need the money.
The trustees have to consider these factors, and any other factors they think appropriate, in deciding how much (if anything) to distribute, and to whom.
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