When we design a trust, we want to make sure that it accomplishes your goals. Our focus is usually on balancing protections with access to trust property. But it is also important to understand how a trust will be taxed.
Trusts are categorized as either grantor trusts or non-grantor trusts, depending on how ownership and control over the trust are outlined. In some cases, we go to a lot of effort to ensure that a trust is either a grantor trust or a non-grantor trust. A grantor trust results in the grantor being responsible for the income tax liability of the trust, regardless of whether the trust income is distributed to beneficiaries or not. Grantor trusts are ignored for tax purposes.
Most of the time if we are creating a grantor trust, we want taxes allocated to the person who created the trust. But sometimes it is a good idea to tax the income to the beneficiary. We can design trusts to be grantor trusts as to the beneficiary. However, this probably weakens the creditor protection that the trust would otherwise provide.
A trust that is not a grantor trust is a non-grantor trust. Non-grantor trusts are considered a separate tax entity. They are categorized as either simple or complex. A simple trust has three requirements. It must distribute all income to the beneficiaries. It cannot distribute principal. And it cannot make distributions to charities. Any trust that does not meet the requirements for a simple trust is a complex trust.
With a simple trust, all income is distributed to the beneficiaries. The trust reports all income, but is entitled to a deduction for the entire amount distributed to beneficiaries. The result is that the trust only pays tax on capital gains. With a complex trust, distributions can include ordinary income, dividends, capital gains and principal. The trust could also earn income that is not distributed, and there may be a deduction for distributions to charities. The result is that the allocation of the tax and any deductions between the trust and its beneficiaries can be quite complex.
In many cases, we create trusts that become complex trusts upon the grantor’s death. These trusts provide valuable lifetime protections for children or other beneficiaries. But the taxation is not as simple as it could be if we did not provide those protections. We have to balance these protections with the administrative burden of managing the trust. If you are leaving a child $50,000 it may make sense to leave that property in a grantor trust that allows unrestricted access and does not require a separate tax return. But this will depend on the facts of your situation. If creditor protection, divorce protection, or maintaining needs-based government assistance is are concerns, this may not be a good option. On the other hand, if you are you are leaving your child a much larger inheritance, he or she may be better off if there are more protection and flexibility, but a little extra accounting complexity.
It is important to understand what you are doing when you create an estate plan. When our clients are fully informed, they tend to leave assets to their loved ones in trust. Understanding the basics of how a trust will be taxed should play into that decision.
If you have questions about whether or not a trust is the right tool for you, we would be happy to discuss this with you.