Trust funds are an essential estate planning tool that helps to smooth over the transition of assets in a manner that benefits the beneficiaries of the fund, yet they can be quite confusing financial entities, especially when it comes to taxation.
Created by a grantor, maintained by a trustee, and payable to potentially multiple beneficiaries, there are a lot of interested parties in a trust fund, so who, if anyone, fronts the bill for the taxman?
In today’s post, I’ll be giving you an in-depth breakdown of this subject. We’ll discover whether trust funds are taxable, and, if yes, what the implications for those involved might be. Let’s get started!
Contents
Cutting To The Quick: Are Trust Funds Taxable?
This is a simple question with a not-so-simple answer, in that, yes, trust fund money is indeed taxable… sometimes. To understand how and when trust funds are taxable, we must first discuss the two sides of a trust fund.
Two Sides Of The Story
The two integral components of a trust fund are referred to as principal and interest.
These terms can be quite confusing, but a simple way to look at them is to think of principle as the initial assets placed in the trust, and interest as any funds generated by the principle.
For example, let’s say that a house was placed into the trust by the grantor, and in accordance with the grantor’s wishes, the trustee rents the property out in order to build funds over time. The house is the principle, while the rent money received is the interest.
Any money the principal makes would be considered income. For instance, if the property in our example was sold by the grantor or trustee for more than the original acquisition cost, the excess would be considered interest rather than principle.
What Do Principal And Interest Have To Do With Taxation?
The reason I’m telling you all this is that principal of a trust fund is not taxable, while interest of a trust fund is taxable. Why is this exactly? Well, simply put, principal is old news.
Yep, that’s right, folks — the taxman does not care about principle because he’s already had his fill. The IRS assumes that any principal entity has already been subject to taxation when it was owned by the grantor.
Interest, on the other hand, is completely new income, and therefore, must be taxed. The question then becomes… who’s going to foot the bill?
Who Is Responsible For Paying Trust Fund Tax?
You can sort of think of trust fund tax payment as the Clue of the financial world. Who is responsible?
Is it the grantor in the study with the rope, the trustee in the ballroom with the dagger, the primary beneficiary in the hall with the lead pipe, the secondary beneficiary in the kitchen with the pistol, or is it the fund itself that forks out?
Let’s solve this mystery!
- Starting with our first suspect, the grantor.
If the trust in question is a revocable fund, and the grantor is still among the living, everything within the trust is still considered their property, and thus, they’ll foot the tax bill for income earned by the principal.
But, what if we’re dealing with an irrevocable trust, meaning the grantor has essentially transferred ownership of all assets in the fund?… the plot thickens!
- Now we put the trustee in the hot seat.
Trustees do usually receive some remuneration from the fund for their service, but other than that, they have nothing to gain from the fund, meaning it would be unfair for them to pay tax on overall interest earned.
That said, they should pay interest on their fractional share of the fund as and when it comes to them.
- So now we turn our focus to the primary beneficiary.
If you’re the beneficiary of a trust fund, any distributions the trustee forwards you from the interest side of the fund will be taxed, and you settle the bill.
If, for whatever reason, the secondary beneficiary becomes the primary, the onus will then fall on them to pay the tax on interest distributions. Having said that, any distributions derived from the principal side of the fund are not taxable.
Side Note — The nature of tax (normal income tax or capital gains tax) applied to the interest of the fund is determined by the asset class from which the interest is derived.
But What About Interest Generated By The Principle That Isn’t Paid Out To The Beneficiaries?
Well, in this instance, the fund itself can take charge and cover the tax, but there has to be a given timeframe, as we can assume that after enough time has passed the beneficiary will receive the funds.
Typically, the deadline for distributions is the end of the tax year. If they haven’t been paid out to the beneficiary, then the tax must be covered by the fund itself.
Important Tax Forms For Trust Fund Distributions
To manage the veritable spider web of taxation rules, trustees and beneficiaries are required to use two key forms…
- 1041
The 1041 form’s sole purpose is to allow the trustee to deduct the taxable interest distributed to a beneficiary from the obligations of the fund. In other words, it states that the beneficiary is now responsible for paying the tax on the noted interest distribution.
- K-1
The K-1 is more for the benefit of the beneficiary. In a nutshell, it gives the receiver of a distribution a detailed breakdown of where the funds are derived. It will tell them the percentage drawn from principle and the percentage drawn from interest, so they know exactly what they’re accepting responsibility for paying when the tax is due.
Final Thoughts
That just about covers all the essentials — Trust funds are semi-taxable entities. Composed of two discrete halves, only one of them – the interest – is taxable. However, to say the other half – the principle – is tax-exempt wouldn’t be correct.
The reason distributions from the principal aren’t taxable to the fund or beneficiary is that they were taxed long before being placed in the trust fund.
