Stacey K. from Reading, Pennsylvania asks: I am the beneficiary of a trust and am confused about how to pay taxes on the trust. Can you explain, what taxes am I expected to pay? What tax forms do I need to complete?

Matt's Response:

Hi Stacey, great questions. The roles of a beneficiary can sometimes be difficult to understand.

First, while the below will hopefully provide you with some clarity and guidance, consultation with competent tax and/or legal counsel should be used to determine proper actions for your circumstances.

Determining the party responsible for trust taxes depends on whether the trust is a so called "grantor" trust.

A grantor trust is one where the grantor retains sufficient control or rights over the assets and therefore it is determined that the trust's income is taxable to the grantor. In this case, regardless of distributions from the trust, the grantor is responsible for all tax liability generated by the trust assets. 

If the trust is a non-grantor trust, then either a) the trust will pay the tax on any income generated, b) the beneficiary or beneficiaries with pay the tax or c) a combination of the two. 

For a non-grantor trust, to the extent there is taxable income and no distribution are made to trust beneficiaries, the trust is responsible for any tax liability generated. However, if there is taxable income and distribution are made to trust beneficiaries, the equation becomes more complicated.

A beneficiary would be taxed on any distributions received from a trust to the extent that the distributions do not exceed the income generated. For clarity, let's assume a trust generates $100,000 of taxable income in one year. If the trust distributes $50,000 of that income to the beneficiary and retains $50,000, then both the trust and beneficiary would pay tax on their respective portions. If in this same scenario the beneficiary receives $150,000 in distributions, then he or she would pay tax on the $100,000, but not the additional $50,000 as this is considered trust principle.

While the above is easy to understand, the actual calculations to determine the tax liability due from the income received is much more complicated. Just as with our personal taxes, some income is taxed at different rates, such as interest, dividends and capital gains. This applies to trusts as well. Therefore, calculations are necessary to determine what type of income (interest, dividends, capital gains, etc.) flowed from the trust to the beneficiary and thus the amount of the tax liability passed onto the trust beneficiary. For these reasons and more, we recommend seeking competent tax counsel.

The necessary tax forms to be completed depends on a number of factors, including trust type and whether distributions were made. For a grantor trust, the taxes flow from the trust to the grantors 1040 (personal tax return).

For a non-grantor trust, the trust completes a Form 1041 (return for trusts and estates). To the extent there were distributions, the trust will issue a Form K-1 to each beneficiary who received a distribution. This Form K-1 will be used by the beneficiary in preparing his or her Form 1040. 

If you are a client of Peak Trust Company, we assist in the coordination of all of this for you.