Are distributions from a trust taxable?
October 19, 2017 - Posted by: admin - In category:
Maybe. It depends. Taxable to who or what? You see, this is one of those simple questions that often does not have a simple answer. Let’s distinguish first between types of trusts, as this can make a big difference when it comes to answering the taxation of distribution question.
Revocable Trust Distributions
A revocable trust is quite often also a grantor trust, and it is easy to make the mistake that such must always be the case. Don’t make that mistake. These are two separate concepts. Revocable means just that; the trust is changeable–meaning that it can be amended or revoked (most often by the maker of the trust). This speaks to the structure and design of the trust. Grantor trust status is a tax designation that means a maker of the trust (i.e., the grantor a/k/a trustor) retains one or more rights and privileges vis-à-vis the trust and because of such retained powers, the income of such trust is taxable to the grantor. This is the most common arrangement when we are doing basic estate planning. Since the income of grantor trusts, including capital gains (which is a subset of other types of income), is taxable to the grantor/maker of the trust, such income then distributed by the grantor trust is usually not then taxable to non-grantor beneficiaries. But please keep in mind that most grantor trusts will eventually become non-grantor trusts, at which time the rules and the answers will change.
Irrevocable Trust Distributions
As we noted above, there is no required pairing of revocability and grantor trust status. While most often those two travel together, such is not always the case. While a great many irrevocable trusts are non-grantor trusts, it is possible to have an irrevocable grantor trust, such as with an Intentionally Defective Grantor Trust (IDGT). But to keep thing simple, let’s go with the general assumption that most irrevocable trusts are also non-grantor trusts. A non-grantor trust (i.e., a trust that is not a grantor trust) is a separate entity for tax purposes. Any income that such a trust receives usually creates the potential tax liability for the trust (since it is a separate tax entity). However, because it is a separate tax entity, this type of trust can claim deductions to reduce its taxable income (and there are good reasons why a non-grantor trust would want to do this).
When an irrevocable, non-grantor trust makes distributions to beneficiaries, some of the trust’s taxable income gets carried outside of the trust and passed along to such beneficiaries, each of whom is then responsible for paying their allocable share of tax on such distributed income. The trust then gets a deduction for such distribution and taxes are payable on such distributed income by the recipient beneficiaries on a pro rata basis.
The trust tax rules get even more complicated when we are dealing with asset sales, capital gains, and related matters. You will always want to involve your trusted accountant with any and all tax matters. This is, even more the case when it comes to trust distributions of income and asset sales from trusts.
To summarize, income distributions from a grantor trust (usually a revocable trust) are taxed to the grantor of said trust and therefore most often not taxable to the non-grantor beneficiary. Income distributions from a non-grantor trust may or may not be taxable to the beneficiary. Much depends on what has happened with income and tax recognition at the trust level. Discuss all of these things with your accountant, as these are certainly accountant-territory matters