Trusts
What Is A Trust?
A trust is a legal instrument meant to bifurcate (split) ownership between a trustee and a beneficiary. A grantor will put trust assets (known as the corpus) into the legal document. The trustee then maintains legal ownership and the beneficiary has equitable or beneficial ownership. So, the trustee must use the trust assets for the benefit of the beneficiary.
A trust is temporary. Once the trust terminates, the remainder (corpus left over) is distributed to a secondary beneficiary known as the remainder beneficiary.
A trust may be created for multiple reasons:
- Receive tax benefits
- Avoid probate
- Protect and name beneficiaries
- Shield beneficiaries from creditors
There are several kinds of trusts. A non-exhaustive list includes:
- Revocable trusts. These trusts are typically used as a will substitute where the trustee is also the trustor and the named beneficiary, but not the secondary beneficiary). Revocable trusts do not need to file an income return. Instead, the income is contributed to the grantor, who must report the income on their return.
- Life insurance trusts. The underlying asset in the trust is the life insurance policy. To create a life insurance policy trust, the policy needs to be owned by the trust. This kind of trust is used to remove the life insurance policy from adding to the gross estate.
- Blind trusts. In these trusts, the beneficiary is not aware of how the corpus is being invested. These trusts are often created to prevent any conflicts of interest.
- Trusts for minors
- Retirement trusts. These are typically in the form of 401K plans or IRAs.
Estate
There are two different types of estates: (1) decedent’s estate and (2) bankruptcy estate. However, the focus here is to discuss a decedent’s estate.
A decedent’s estate (also known as the probate estate) is created automatically at death and is different from the gross estate. Everything the decedent owned and owed at death is transferred to the estate (unless an asset is jointly owned with the right of survivorship). Things not included in the probate estate include life insurance policies, trusts, joint property, and retirement accounts.
The person who manages the estate is known as the administrator appointed by the court (or named as the executor in a will). The administrator or executor will distribute estate assets to heirs (if no will) or beneficiaries (if there is a will), file tax returns for the estate, etc.
Taxation
Trusts and estates are modified flow-through entities. That is, whichever individual or entity receives income that year will report income. So, a trust will report any income received and retained in the trust while a beneficiary will report any income received from a trust distribution.
Filing
Trusts will file an income tax return, form 1041. Trusts are required to use a calendar year, so the form 1041 is due on April 15 the following year.
Estates also need to file an estate tax return, form 706 (due 9 months after death); form 1041, covering the estate earning between the moment of death and final distribution; and form 1040, reporting the deceased’s income from January 1st to the date of death. An estate may use a calendar or fiscal calendar year (if fiscal, it would be smart to pick a fiscal year ending the month before the decedent’s death).
Exemptions and Rates
An exemption is the amount an estate can earn without being taxed. For estates, the exemption is $600. Simple trusts (all income and only the income is paid out each year) have an exemption of $300. All other trusts have an exemption of $100.
There are four bracket rates where the top bracket is taxed at 37% when the income exceeds $15,200 (2024 rate). Capital gains and dividends are taxed at 20%.
Trusts and estates also are required to pay Net investment income (NII) tax at 3.8% on the lessor of retained investment income or the adjusted gross income minus $15,200.
Formula
The steps to determine taxable income are:
- Determine the accounting or book income (what can be distributed to the beneficaries).
- Determine taxable income before the distribution deduction (reduced by deductable expenses such as trustee fees).
- Compute the distributable net income (DNI) and the distribtuion deduction. Typically, this is the same number as accounting income.
- Compute the final entity taxable income, calculated by taking step 2 and subtracting the lessor of step 1 or step 3.
- Allocate DNI to the beneficiaries.
Accounting Income
Dividends and interest are considered accounting income while capital gains are considerd corpus. Any expenses are allocated against the income as well. Examples of allocable income include operating income and expenses, dividends, rents, and interest. Fiduciary fees are usually split equally between the income and corpus.
Property distibutions
The entity typically does not recognize any gain or loss on a distribtuion (basis will also carry over to the beneficiary).
Deductions
Deductions are permitted for ordinary and necessary expenses up to $10,000 for SALT and 30% for interest expenses. However, no deduction is allowed for expenses related to the production or collection of tax-exempt income such as municpal debt securities and life insurance.
Distributable Net Income (DNI)
The entity is allowed a deduction for distributions to beneficiaries and DNI is the maximum amount allowed. This is also the maximum amount the beneficiares will be taxed on.
To calculate DNI follow these steps:
- Determine the taxable income before the distribution deduction. This includes all of the entity’s gross income and gains then subtracting allowable deductions, losses and exemptions. The number will be different from teh accounting income.
- Take that number and add in the exemption, net tax-exempt interest (exempt interest minus related expenses), and capital losses. Then subtract capital gains.
Distribution Deduction
Is the lessor of either the DNI or the taxable amount actually distributed.
