The Taxation of Trusts in the U.S.

Creating a trust can reduce or even eliminate costs related to wealth transfer, such as probate fees, and gift and estate taxes. This benefit might be mitigated however by inadvertently shifting tax liabilities onto other aspects of the trust arrangement, such as the income tax liability of the trust’s beneficiaries and the tax liability of the trust itself.

This article summarises the various kinds of trusts and their respective assignment of tax liabilities to members of the trust, before briefly discussing trust tax margins in the US and other important considerations regarding tax liability going into their establishment and management.

Grantor trust

In grantor trusts, the grantor pays tax on any income the trust generates, in addition to retaining complete control over the trust assets. The grantor can, for instance, transfer assets into and out of the trust, and even terminate or change the trust’s terms (in the case of a ‘revocable trust’). In essence, the grantor, for income tax purposes, is the owner of the trust income.

Variations of the grantor trust can allow transfers into a trust to be treated as completed or incomplete gifts for income tax purposes.

Non-grantor Trusts

Simple trust

Simple non-grantor trusts are characterised as having all three of the following features:

1)     All income in the trust must be distributed at least once a year;

2)     Distribution of the trust’s principal (i.e. the assets, such as real estate or bonds, that the trust owns) is prohibited; and

3)     Distribution of trust income to charities is prohibited.

In the case of simple non-grantor trusts, beneficiaries are required to pay tax on the income that the trust assets generate (assets which the trustee is required to distribute directly to beneficiaries and the distribution of which allows the trust to take a deduction). The trust itself meanwhile pays capital gains tax on the trust’s earnings from sold investments.

Complex trust

Complex non-grantor trusts refer to all other non-grantor trusts. These kinds of trusts give the trustee more flexibility in distributing the principal assets and income, although the trust contract may still specify certain enforceable conditions of distribution. Whether the trust itself, the beneficiaries, or a mixture of both pays tax for the trust will also depend on the trust contract, as well as the actions taken and events that occur in relation to a trust during the relevant financial year.

Managing the Taxation of Trusts

The establishment of a US trust can increase the tax liability of a business or family wealth-allocation enterprise as a whole, except where the business earns little income. For example, a business trust that earns in excess of $2,900 a year will be taxed at least 24%, a rate higher than the US federal income tax rate for corporations earning the same amount (without considering the additional impact of State taxes). Furthermore, although the maximum rate of taxation 37%, is the same for both individuals and trusts, this rate begins at a much earlier income threshold for trusts (any income above $14,450) than for individuals (ordinary income starting from $578,125). 

The most effective applications of a trust usually arise with the use of trust instruments to protect assets or lower taxes on particular kinds of transactions. For example, the management of gifts and estates through a trust where the safekeeping of property also enables the gifting of valuable property to a third party or family member without triggering “gift taxes” immediately. Trusts are also particularly effective at safeguarding assets for beneficiaries and family members prior to the death of an owner-grantor.

If you wish to create a trust and lower its taxable liability, you should carefully consider how the specific goals of the trust can be paired with activities that can strategically lower taxation. For example, if one of the aims of your trust is to distribute income to beneficiaries on a regular basis, you will need to consider how a trust will generate sufficient income to make those distributions while managing the cost of taxes on the trust for its excess earnings or capitals gains, as well as the cost of higher taxes on the beneficiaries’ income. 

In addition, even where distributions to beneficiaries can be taken as deductions from the trust for tax purposes, withdrawing amounts from a trust in excess of its income or dividends will render a payment to the beneficiary as partially withdrawn from trust principal or longer-term capital gains income (rather than just income). This will trigger tax liabilities that remain at the trust level rather than giving effect to the initial aim of shifting all taxes for the distribution to the beneficiary who perhaps is in a lower tax bracket.

If you would like to know more about how to create and manage trusts, don’t hesitate to contact Borderless Counsel at info@borderlesscounsel.com.