Trusts Pay More Tax than Individuals Beginning in 2013

One of the most common tools used in estate planning is a revocable living trust that splits into one or more irrevocable trusts upon the death of the grantor. Most often, the income earned by these irrevocable trusts is distributed to the income beneficiary during his or her lifetime and is taxed on the income beneficiary’s individual tax return. The problem is that not everything we think of as income is considered trust income. For example, capital gains are generally considered principal and not income.

Who Pays Tax on Trust Income? Income received by the trust is taxed either on the trust return (Form 1041) or on your individual income tax return (Form 1040). In order for you to pay the tax, rather than the trust, the income must be distributed to you. Please see more details about distributions later.

What Governs Taking Trust Distributions? The short answer is that most trust documents provide that income earned by the trust may be distributed to the income beneficiary at least annually. However, some receipts of a trust are considered principal rather than income. Unless the trust documents specifically permit the trustee to allocate these receipts to income, receipts such as capital gains are not permitted to be distributed to an income beneficiary and are taxed on the trust return.

Who Pays the Higher Tax? Prior to The Affordable Health Care Act and The American Taxpayer Relief Act of 2012, it made little difference to the ultimate tax bill whether the income beneficiary or the trust paid taxes. Generally, long-term capital gains and qualified dividends were taxed at 15% regardless of who paid the tax.  With the passage of these two new laws, the question of who pays the tax will become quite significant. Read more