A trust is a legal entity in which someone acting as a fiduciary holds property for the benefit of another. Trusts are used extensively in the areas of financial and wealth management. Most people think of trusts as something only used by the “super rich” but individuals and families of modest means would find them useful in their planning. This post will explore some of the practical uses of trusts and discuss the taxation of trusts.
Purpose of trusts
Trusts can be used for various purposes including the following:
- Protect property for beneficiaries
- Provide income for minor children or others incapable of handling money
- Control the distribution of assets after the grantor’s death
- Save on estate taxes by removing appreciating assets from the grantor’s estate
- Charitable purposes
Taxation of trusts
A trust is taxed much like an individual. Trust income such as interest, dividends and capital gains must be reported on an income tax return (Form 1041). However, there are some important differences in the taxation of trusts as compared to an individual.
- Trusts do not get a standard deduction and their exemption amounts are much lower than individuals.
- The rate brackets of a trust are compressed so that a trust may pay higher taxes than an individual. For example, the top individual tax rate of 39.6% starts at an income of only $12,500 for trusts vs. $ 415,050 for a single individual or $ 466,950 for a married couple.
The high rate of taxation caused by the compressed tax rate brackets can be avoided by distributing income to the beneficiaries. In that case, the income would be taxed to the individual beneficiaries instead of to the trust. This income would be reported to the beneficiaries on a Schedule K-1.
As you can see, it is usually not wise to accumulate income within a trust because of the high tax rates on retained income. This income should instead be distributed to individuals who will usually be in lower brackets. This distribution can be a good method to shift income to minor children who will typically be taxed at lower rates but watch out for the kiddie tax rules which can limit this technique (more about the kiddie tax rules in a future post!).
David K. Raye, CPA, P.C.
*The information in this blog post is general in nature and not intended as specific advice. Please consult a tax advisor to see how this information applies to your specific situation.