The type of trust that you utilize in your estate planning will affect how the trust’s income will be taxed. This is an important consideration when creating a trust as it will determine who will be taxed for the trust income.
Posted on October 29, 2016
A grantor trust occurs when the person who created the trust (i.e. the grantor) retains power over the trust so that he or she still has to pay income taxes on the trust assets. A grantor trust is generally a revocable trust, but there are some exceptions for irrevocable trusts where the grantor retains some control over the trust assets. For income tax purposes, a grantor trust is deemed a “disregarded entity.” This means that all taxable income or deductions will be taxed to the grantor, not the trust beneficiaries. As a result, you generally do not need to file a trust income tax return. Instead, you can use the grantor’s social security number and the trust will be taxed as income to the grantor.
A non-grantor trust pays income taxes at the trust level, rather than by the grantor. If the trust makes a distribution to a beneficiary of the trust, the beneficiary will be taxed on his or her personal income taxes. Essentially, the beneficiary takes on the tax burden rather than the grantor.
An irrevocable trust generally needs its own taxpayer identification number (TIN). A revocable trust can become an irrevocable trust once the grantor dies. If a married couple creates a revocable joint trust and one of the grantors spouses’ dies, the trust can become irrevocable even though one spouse remains. If a revocable trust becomes irrevocable, you must get a TIN for the trust.
Trusts can also be divided into categories based on the assets contained in the trust. The principal is the property that was transferred into the trust by the grantor. The income is the money earned by the trust. Income generally is accumulated from investing the principal of the trust. A simple trust must distribute all of its annual income to its beneficiaries, the beneficiaries cannot be charities, and the trust cannot distribute the principal. The trust income is taxed to the beneficiaries, rather than the trust. A complex trust is any trust that does not qualify as a simple trust. The categorization of a trust as simple or complex governs the amount of personal exemptions allowed when calculating the taxes owed. The personal exemption is $300 for simple trusts and $100 for complex trusts.
One type of trust that has gained recent popularity is the Irrevocable Pure Grantor Trust (“iPug”). iPugs are based on common law, rather than state statutes, so they will remain enforceable in any state in which you reside here in the U.S., even if you move. The iPug is considered a grantor trust for taxation purposes, so the grantor is responsible for paying taxes on the trust. There are three types of iPug trusts: income-only, control-only, and third-party.
The income-only iPug requires the grantor to give up complete control over the assets in the trust. The beneficiaries are the only individuals who can receive the trust assets. The only benefit to the grantor is that they get to keep any income that the iPug trust generates. One downside to the income-only iPug is that creditors can access the income, although they cannot reach the assets of the trust.
The control-only iPug trust allows the grantor to have full control over both the assets and the income of the trust. The grantor has the power to distribute trust assets as they choose, except the ability distribute assets to himself or herself. Additionally, creditors cannot access the assets of the control-only iPug.
The third-party iPug allows grantors to create a trust to benefit some third party. This situation usually occurs when parents have transferred assets to their children but the parents are worried they might need to use those assets at a later time. Adult children can set up a third-party trust with their parents as the beneficiaries. The third-party iPug protects the trust assets from the children’s creditors.
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