In the August 6th blog, we learned about how grantor’s trusts work, but who pays the taxes on a grantor’s trust? The simple answer is it depends. The grantor pays the taxes if the grantor is still living on their personal income tax return. If the grantor has passed away, the trust and the beneficiary(ies) of the trust are responsible for the taxes on the income.
When the grantor of the trust is still living, the grantor receives the income from the trust; therefore, the grantor pays the taxes on the income. The income from the trust is reported to the IRS under the grantor’s social security number and is reported on the grantor’s personal tax return. The income is taxed at their income and capital gains tax rates.
Grantor’s trusts are required to have a Federal Employer Identification Number (EIN) once the grantor dies. The EIN is the social security number for the Trust. An EIN can be applied for by going to IRS.gov. When the grantor of a grantor’s trust passes away, the trust now becomes irrevocable, if it was not already.
Income after the date of death is no longer reported under the grantor’s social security number. It is now reported under the trust’s EIN and taxed in the trust. Trusts are generally calendar year filers. The income and expenses are reported from January 1st through December 31st. For the first year, it is from the date of death until December 31st. Trust returns are due April 15th, just like personal income tax returns.
The trust tax return, Form 1041, is completed every year, reporting all trust income and deductions if income is more than $600. This income can include but is not limited to interest, dividends, capital gains, rental property income, partnership income, and C and S corporation income.
Deductible expenses of the trust usually consist of: legal fees, trust tax return preparer fees, certain investment advisory fees, appraisal fees, selling expenses, trustee commissions and fees. Trust accounting fees can be deductible if required by the trust agreement.
Once the investment that is earning income is distributed to the beneficiary (ies), it is taxable to the beneficiary (ies). It is important to remember investment income is taxable to the beneficiary (ies) in the year it is received. If no investment income is distributed, the beneficiary (ies) will not pay any tax on the income. While the investment remains in the trust the trust pays the tax on the earnings. In the final year when the trust is closed the income passes to the beneficiary (ies). The trust tax return will generate Form K-1 for each beneficiary’s share of the income and deductions and IRS receives a copy. The income and deductions are reported by each beneficiary on their personal income tax return and taxed at the beneficiary’s income tax rate.
Any questions regarding deductible trust expenses should be discussed with a tax return preparer. Any distribution requirements should be directed to an attorney. Much like estate tax returns, discussed in the July 27th and July 30th posts, it is recommended you consult a tax preparer and an attorney. We see many times where trustees do not understand the filing requirement are for the trust and fail to file trust tax returns. Many times this leads to beneficiaries having to amend their personal back tax returns for the K-1 income. Following the trust requirements and the IRS filing requirements can save the trustee and beneficiary(ies) a lot of time and money.