Many people are under the impression that trusts pay taxes on a harsher schedule than individuals. However, this raises the question of why so many individuals are still setting up trusts and exposing their assets to higher taxes. In order to understand this phenomenon, let’s delve into the intricacies of trust taxation.
Understanding Trust Taxation
Trust Tax Brackets It is true that the marginal tax brackets applicable to trusts result in significantly higher taxes compared to those for individuals. For example, a single taxpayer would need taxable income exceeding $578,125 to pay taxes at the highest marginal federal rate of 37%. On the other hand, a trust only needs to surpass $14,450 to fall under that same tax bracket.
Types of Trusts It is important to note that not all trusts incur taxes at trust rates. There are numerous different types of trusts, but at a basic level, many are known as “granter” trusts. The granter, also referred to as a settlor, trustmaker, or trustor, is the person who creates the trust.
Grantor Trusts: An Overview A grantor trust is a type of trust where the granter is treated as the owner for income tax purposes. While the trust is a separate legal and taxable entity and legally owns the assets held in its name, a grantor trust allows the granter to be liable for income taxes.
Revocable Living Trusts The most commonly encountered form of grantor trust is the revocable living trust or inter vivos trust. This trust is established by the granter while they are alive, rather than through a last will and testament. Unlike other trusts, the granter retains the ability to amend or revoke the trust at any time. The assets are owned by the trust, but all income, dividends, and capital gains are taxed to the granter. Interestingly, in these cases, the tax ID number for the trust is usually the granter’s Social Security number.
It is important to note that this explanation provides a simplified overview of trust taxation, and legal advice should be sought from a qualified professional. Nonetheless, understanding the differences in trust types and their implications on taxation can help shed light on the reasoning behind setting up trusts, even with the higher taxes they may entail.
Trusts and the Calculation of Distributable Net Income
When a granter passes away, the trust they created becomes irrevocable. Consequently, it becomes subject to trust tax rates for any income that accumulates within the trust. However, it’s important to note that higher tax rates may not apply to the trust due to various deductions it can take when calculating its taxable income. One such deduction is the distributable net income (DNI).
Calculating and managing DNI can be complex, so it’s advisable to consult a qualified estate planning attorney or tax adviser for guidance. In essence, when the trust makes distributions to beneficiaries, it issues a K-1 form. These beneficiaries then report the income on their personal tax returns, paying taxes at their own individual rates rather than the trust rates.
Trusts serve as powerful tools for asset management, estate planning, and tax planning. However, it’s crucial to understand that even seemingly simple concepts can become intricate. Therefore, it is not recommended to create DIY trust documents. Instead, it is advisable to engage the services of a qualified estate planning attorney who can draft documents appropriate for your unique situation and compliant with state laws, which can vary significantly.
Please feel free to email Dan with any questions you may have regarding this topic.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo, helping clients nationwide. His comments are for informational purposes only and should not be considered personalized advice. Consult your own adviser to determine what is best for your specific circumstances. Some reader questions have been edited for clarity.