Basics of Estate Planning: Taxation of Trusts

Trusts may be considered substantially owned by the grantor or another person. These trusts are commonly called “grantor” trusts. A trust is considered a grantor trust due to the rules of sections 671-678 of the IRC. For example, if a trust is revocable, it is a grantor trust pursuant to section 676. However, even an irrevocable trust may be a grantor trust. If, for example, the income of the trust is payable to the grantor, the grantor controls who gets benefits from the trust, or the grantor has other administrative powers it is a grantor trust.

If the trust is a grantor trust, the income of the trust is taxed to the grantor just as though the assets of the trust were owned by the grantor themselves. For tax reporting purposes, a grantor trust may use a separate Taxpayer Identification Number (TIN) (also called an Employer Identification Number (EIN)). The grantor trust may also use the grantor’s Social Security Number (SSN) for the trust. The exact method is set forth in Treas. Reg. 1.671-4. Frequently, financial institutions will question the propriety of using the grantor’s SSN, especially for an irrevocable trust. However, if the trust is a grantor trust, the trustee may do so.

Some of the powers which trigger grantor trust status, such as the power to revoke under section 676, also cause estate tax inclusion. For example, the power to revoke causes estate tax inclusion under section 2038. Other powers which trigger grantor trust status, like the power to substitute assets under section 675, do not trigger estate tax inclusion. Thus, it’s possible to have a trust which is a grantor trust, yet which may or may not be included in the taxable estate. Similarly, it is possible to have a non-grantor trust, which may or may not be in the taxable estate.

A non-grantor trust, i.e., a trust which is not a grantor trust, has its income taxed to the trust itself. The trust reaches the top income tax rates after very little taxable income. For example, the top federal rate of 39.6% is reached after only $12,500 of taxable income in 2017. By comparison, single and married joint filers would not hit that bracket until well over $400,000 of taxable income. 

Non-grantor trusts are required to file an income tax return, Form 1041, if they have taxable income over their exemption ($100 or $300, depending on the trust). If such trusts make distributions to their beneficiaries, those distributions generally carry out the income to the beneficiaries and the trust gets a corresponding distribution deduction. Thus, it is normally beneficial to have the trust distribute its income to the beneficiaries. However, this is not always the case. If the beneficiary is in the top income tax bracket, there may be no tax advantage to distributing the income and there could be other advantages to retaining the assets in the trust. Further, distributing the income to the beneficiary may cause other consequences, like reduced financial aid or other negative results that exceed the income tax savings. Thus, from a planning perspective, it is often best to leave the distribution of income to the discretion of the trustee. Then the trustee can consider all of the information which is available, including the federal and state income tax consequences and other factors.