About Trust Fund Taxes for Beneficiaries (California & Federal)

Trust Fund Taxes for Beneficiaries (California and Federal)

Trust Fund Taxes for Beneficiaries  

When a person has an ownership or other interest in a trust, the tax implications can be somewhat overwhelming — especially when the individual is used to having a relatively straightforward tax return and is now the beneficiary of a trust fund. Depending on the type of trust and whether any distributions are being made can impact the extent and complexity of the return and reporting requirements. In general, when a person is considered a beneficiary of a trust, they may have additional tax requirements and may be required to file additional income. Especially in a situation in which a person may have become a beneficiary of an irrevocable trust upon a person’s passing, the tax implications can be complicated – but manageable. Let’s walk through the basics of trust taxation and what beneficiaries should be aware of in situations in which they may have a trust fund from which they are receiving income.

Subchapter J

• • • Part I

      • Subpart A—General Rules for Taxation of Estates and Trusts (§§ 641 – 646)

      • Subpart B—Trusts Which Distribute Current Income Only (§§ 651 – 652)

      • Subpart C—Estates and Trusts Which May Accumulate Income or Which Distribute Corpus (§§ 661 – 664) Subpart D—Treatment of Excess Distributions by Trusts (§§ 665 – 669)

      • Subpart E—Grantors and Others Treated as Substantial Owners (§§ 671 – 679)

      • Subpart F—Miscellaneous (§§ 681 – 685)

    • Part II

      • Income in Respect of a Decedent (IRD) (§§ 691 – 692)

Trust Income

The focus of this article will be non-grantor trusts. With a non-grantor trust, it is the beneficiary that is potentially taxed on the distribution and not the grantor. Conversely, when it is a grantor trust — which means that the grantor essentially still controls the trust — it is the grantor who is taxed on the income even if the distributions are made to the beneficiaries

Beneficiary Income

in a common situation, a person may have passed away and their revocable trust becomes an irrevocable non-grantor trust. Depending on the type of trust, there may be one or several beneficiaries and there may be a mandatory set distribution schedule or distributions that may occur depending on certain requirements within the trust being met. When the beneficiary receives a distribution, the distribution may be taxable depending on whether it is an income distribution or a principal distribution. It is reported to the Beneficiary (usually) on a 1041 K-1. Separately, the trust has its own tax return filing and reporting requirements.

1041 K-1

When a beneficiary receives a distribution or even just an annual accounting update, it will be on a K-1. The K-1 is used to determine how much income was received by the beneficiary in order for the beneficiary to report it on their own tax return. It also identifies other items such as deductions and basis in the trust.

What About Capital Gains?

The taxation of capital gains can be very complicated depending on what is provided for in the trust instrument and in which state the trust resides. Depending on how the trust is being administered and how distributions are being made, the capital gains may be taxable and paid either by the trust or by the beneficiary.

Paying Tax on the Trust Income

in a non-grantor trust, the beneficiary is responsible for paying the tax on income distribution they receive. If the taxpayer receives any principal distribution then this will generally avoid tax, since principal distributions are not income. There are also issues with the throwback rule which can become even more complicated when it is a foreign trust.

Trust Principal vs Trust Income

Since principal is not income, even if it is distributed to the taxpayer then it is generally not considered to be taxable because it is not income.

IRS Forms 1041/1040

When the beneficiary receives the K-1 and distribution they include the income on the regular 1040 tax return. In other words, the taxpayer receives the distribution, along with the K-1 or other instrument provided by the trust, explaining what type of income they received, and then the taxpayer includes this information on their regular tax return — and pays tax on the income. The trust files its own separate Form (Form 1041) to report the trust income and deductions.

Form 1041 (Federal Tax Rate for Trust Taxation)

Unlike the general income tax brackets, when it comes to trusts, the tax brackets are relatively small and with relatively low thresholds. Essentially, for any income that exceeds $13,451, the trust is taxed at the 37% tax rate. The tax rates are identified below:

• • • 10%: $0 – $2,750

    • 24%: $2,751 – $9,850

    • 35%: $9,851 – $13,450

    • 37%: $13,451 and higher

Form 541 (California Tax Rate for Trust Taxation)

The income generated from a trust in California (and sometimes other trusts that may have migrated) is reported on the California tax return. There are certain limitations in the threshold requirements to determine whether or not the trust has to be filed which is based on net/gross income.

As provided by the FTB:

Decedent’s Estate

The fiduciary (or one of the fiduciaries) must file Form 541 for a decedent’s estate if any of the following apply:

• • • Gross income for the taxable year of more than $10,000 (regardless of the amount of net income)

    • Net income for the taxable year of more than $1,000

    • An alternative minimum tax liability

Trust

The fiduciary (or one of the fiduciaries) must file Form 541 for a trust if any of the following apply:

• • • Gross income for the taxable year of more than $10,000 (regardless of the amount of net income)

    • Net income for the taxable year of more than $100

    • An alternative minimum tax liability

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