Income Taxation of Trusts and Estates

Much popular attention surrounding estate planning focuses on the estate tax. But more significant for most Californians than the estate tax is the income tax, which applies not only to individuals and their businesses, but also to trusts and estates.

For tax purposes, the Internal Revenue Code (IRC) generally recognizes three types of trusts: grantor trusts, simple trusts, and complex trusts. It taxes each type of trust differently. This post provides a general overview of how trusts and estates are taxed, but keep in mind that the topic is much more complicated than what can be covered here.

Grantor Trusts

The type of trust most Californians are familiar with is the revocable—or “living”—trust. For tax purposes, these are called “grantor” trusts, and they are effectively disregarded. The person who creates the trust (called the “settlor” or “grantor”) is treated as if he or she owns the property in trust, and so is taxed on the trust’s income as though he or she earned it directly.

But income taxes become quite a bit more complicated for irrevocable trusts, which can be either “simple” or “complex”:

Simple Trusts

A simple trust is one in which all of the income earned in a year must be distributed to one or more beneficiaries. In addition, the trust is generally not allowed to distribute corpus—i.e., the trust principal.

Simple trusts do not pay income tax. Rather, the trust beneficiaries pay tax on their share of the income—whether they actually receive it or not. In this way, simple trusts are similar to pass-through business entities like partnerships and S corporations.

The biggest advantage for simple trusts is that they avoid the accelerated tax rates that apply to complex trusts. On the other hand, the requirement that the trust annually distribute its income leaves little room for financial flexibility.

Estates and Complex Trusts

Complex trusts are trusts that aren’t required to distribute all of their income in the year it is earned. The IRC calls these “trusts which may accumulate income.”

How complex trusts are taxed is . . . well, complex! To simplify significantly, income that is distributed to beneficiaries in the year it is earned is taxed to those beneficiaries. Income that is accumulated in the trust from one year to the next is taxed to the trust at accelerated marginal rates.

In general, estates are subject to the same tax rules as complex trusts. Income that is accumulated in the estate is taxed at accelerated rates, and income that is distributed in the year it is earned is taxed to the beneficiaries.

The Bottom Line: Plan for All Taxes

The estate tax may get all of the attention when people think about estate planning, but the income tax can be just as important. Without proper planning, income that would otherwise be earned by your loved ones and taxed at their ordinary rates could be stuck subject to higher taxes. That’s all the more reason you should consult an experienced estate planning attorney to help develop your estate plan.

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