Question: I am the trustee and beneficiary of my deceased mother’s trust and failed to take distributions from the trust during calendar year 2015. Will all of the trust’s income be taxed to the trust?
Answer: The tax characterization of your mother’s trust must be determined before your question can be answered which necessitates a review of the trust agreement. Certain trusts, known as grantor trusts, are disregarded as separate entities and income is taxed directly to the trust creator or grantor or another person treated as the trust grantor. Other trusts are treated as separate entities and trust income is taxed directly to the trusts or to the trusts’ beneficiaries.
Various provisions of the Internal Revenue Code determine whether or not a trust is a grantor trust. Distributions from grantor trusts have no impact on the determination of trust income. Rather, all trust income of a grantor trust is taxed directly to the grantor or another person treated as the grantor.
A trust which is not treated as a grantor trust is taxed as a separate taxpayer. In such case, the trust will be taxed on income received by the trust except to the extent trust income is distributed to the trust beneficiaries. If no income is distributed by the trust, the income is taxed to the trust; if all trust income is distributed by the trust, then income is taxed to the beneficiaries who receive the income and if some of the income is retained by the trust and some income is distributed to the trust beneficiaries, the trust is taxed on the retained income and the beneficiaries are taxed on the distributed income.
What makes income tax planning for trusts critical is the compression of the tax rate schedule applicable to trusts treated as separate taxpayers. Trusts reach the maximum tax bracket of 39.6% when 2015 trust income reaches $12,300. By contrast, a single taxpayer reaches the maximum tax bracket when taxable income reaches $413,200 and a taxpayer who is married and files a joint income tax return with a spouse reaches the maximum tax bracket when taxable income reaches $464,850. A trustee is incentivized to distribute trust income If the trust’s beneficiaries are not in the top tax bracket.
In the absence of complete information, the assumption is that your mother’s trust is not a grantor trust and the trust will be treated as a separate taxpayer. If you are the sole beneficiary of the trust and you are not in the top income tax bracket, you may realize an income tax benefit if the trust distributes its income to you as a lower income tax rate will apply. While you may have failed to distribute income during calendar year 2015, there is still an opportunity to make a favorable tax planning election. The Internal Revenue Code allows trustees to elect to treat trust distributions made within the first 65 days of a calendar year as a distribution of the trust’s income for the prior year. The election is made on the trust income tax return filed for the applicable trust tax year. In your case, you can make a distribution from the trust to yourself on or before March 5, 2016 and elect to treat the distribution as if it were made in calendar year 2015.
Many factors must be considered in determining whether or not trust income should be distributed. Income taxes are one of these factors and careful planning is required to achieve the optimal tax result.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.