There is no blog that can teach you everything you need to know to understand taxes and trust distribution. Whether you are in the process of setting up a trust, or you are a recent beneficiary of a trust or trust fund, we recommend scheduling an appointment with a licensed estate attorney in your area to learn more about your personal tax responsibilities.
While trusts are inherently designed to minimize the amount of taxes owed by heirs and beneficiaries, there are still taxes to be paid. And, it is the beneficiaries’ responsibility to file the right forms with state and federal tax authorities.
Trust Basics: Principal vs Interest
There is a range of ways trusts are set up, from revocable trusts that can be altered by the grantor at any point in his/her life to irrevocable trusts, which cannot be altered once they are in the paper. All trusts become irrevocable when the grantor dies unless stated otherwise in the trust documentation. There are also blind trusts, charitable trusts, testamentary trusts, marital trusts, and the list goes on.
Despite their differences, most of these different trusts have some things in common. First, the principal is not touched by taxes, although interest or earnings related to the principal are taxable unless the grantor specified otherwise (more on that below). When interests are earned, and distributions – or portions of distributions – are the result of the principals’ interest/earnings, the trust – which is overseen by a trustee – deducts distributions from the taxes owed that year to minimize tax responsibility.
When taxable distributions are paid to beneficiaries, it is the beneficiaries’ responsibility to pay associated taxes with respect to their state and federal estate tax laws. Typically, this requires you or your tax professional to file a K-1 form. This is because estate taxes are handled differently than traditional income-based taxes.
Exceptions: The exception to this rule is a trust that was specifically set up to pay the beneficiaries’ taxes. In fact, one of the most desirable reasons to set up a trust account, rather than a traditional last will and testament, is that grantors can create trusts that absorb the tax fees associated with the trust’s earnings, rather than passing the responsibility on to the beneficiaries. If you are the beneficiary of a trust fund or other trust, the trustee should clarify whether you will be paying taxes on your distributions or not.
Make Sure You’ve Received & Filed a K-1
If you are a beneficiary, any distributions sent your way should come with an accompanying beneficiary tax form, called a K-1. It allows for something called pass-through taxation. This means that the entity earning the income (the trust, in this case), is passing on its tax responsibility to the entity benefitting from the income (the beneficiaries).
The K-1 form(s) will be filed with your taxes, just as W-2s or I099s, and the amounts reported on your K-1 forms will be mirrored by the trusts’ filing of 1041s, preventing the trust funds from being taxed twice. The form will reflect which portion, if any, of your distribution was paid from the trust principal (not taxable) and which portion was paid from the trust’s interest or earnings that year (taxable).
If the trust earned interest or gained other earnings that were not distributed to beneficiaries, the trust will pay those taxes via a 1041 form.
If you do not receive a K-1 form along with your distributions or before the end of January of a given tax form, contact the trustee immediately to find out why. Failure to receive the K-1 does not absolve you from tax responsibility.
Trusts Ultimately Minimize Taxes Owed
Regardless of whether you have to pay taxes on your trust distributions, keep in mind that a trust may protect you from greater tax responsibility. In fact, protecting heirs and beneficiaries from paying steep taxes is one of the main reasons most of our clients set up trusts or trust funds in the first place.
Instead of receiving a large, on-time distribution from an estate – and paying a significant sum in taxes, the grantor has divided up the distributions to minimize the financial losses to the state and feds.
Are you the recent beneficiary of a trust and want to understand more about your taxes and trust distribution? Are you looking for ways to design an estate plan and trust that minimizes the potential taxes and fees for your beneficiaries?