Irrevocable trusts include language directing how taxes on income should be paid. This falls into two general kinds of taxes, according to a recent article from Kiplinger, “Should You or the Trust Pay a Trust’s Income Taxes?” The first category includes transfer taxes, typically in the form of gift and estate taxes and generation-skipping transfer taxes, which are less common. The second category includes income taxes, such as earned income taxes and income taxes on investments, as well as capital gains taxes, best described as income taxes on property appreciation following the sale or exchange of property.
Who is responsible for paying these taxes? Rental income from real estate, profits from trust investments, appreciation income from selling property and distributions of assets from the trust are all taxable. Trust income is reported on either the trust’s income tax returns or on the tax return of either the trust maker or the beneficiary. The trust income tax return pays taxes at trust tax rates, while the beneficiary will pay taxes at individual tax rates.
While it seems intuitive to opt for the trust to pay the taxes, trust tax rates are often far higher than individual tax rates.
Trust tax rates are higher because an irrevocable trust has only hundreds of dollars of standard deductions. Irrevocable trusts pay the highest federal taxes after a few thousand dollars of income. Unless the trust maker is already paying taxes in the highest tax brackets, it’s almost always less costly for the taxes to be paid by the trust maker.
When speaking with your estate planning attorney about how to structure an irrevocable trust, the conversation will include how the irrevocable trust’s tax responsibilities will be managed. When the trust is being created, examine your budget to ensure the taxes will be manageable.
The language in the trust is known as “grantor trust status,” permitting the trust maker or another person to pay trust income taxes.
When an irrevocable trust is treated as a grantor trust, the trust maker is treated as the owner of the trust’s income or principal and must include any items about trust income, deductions and credits on their personal tax filing. This is required even though income remains in the trust.
Making matters more complicated, in some cases, having trust income tax grantor powers may mean the trust is included in the trust maker's taxable estate. Estate taxes are different from trust taxes. If the grantor has the power to revoke or amend the trust, it may also be considered part of the grantor’s taxable estate, as opposed to a true irrevocable trust outside of their estate.
Creating and planning trusts should only be done with the help of an experienced estate planning attorney, as there are many nuances to be considered.
Reference: Kiplinger (July 1, 2024) “Should You or the Trust Pay a Trust’s Income Taxes?”