Trust Distribution Taxes 101: What Trustees and Beneficiaries Must Understand

Trusts are an essential part of estate planning, offering a range of benefits for managing and distributing assets. However, understanding how trust distributions are taxed can be complex. Whether you are a trustee or a beneficiary, knowing the tax implications of receiving or distributing trust income is crucial.

What Are Trust Distributions?

Trust distributions are payments made from a trust’s assets or income to its beneficiaries, according to the terms of the trust document. These distributions can take various forms, including cash, securities, property, or income generated by the trust, such as dividends or interest.

For beneficiaries, it’s important to understand that not all distributions are treated equally for tax purposes. Distributions of trust income, for example, are typically taxable to the recipient, while distributions of principal (the original assets placed into the trust) are generally not.

However, the tax rules governing trust distributions can become complex, particularly when multiple types of assets or income are involved. Trustees must carefully account for every kind of distribution to ensure proper tax reporting.

Tax Treatment of Trust Income vs. Principal

Income generated by the trust, such as dividends, interest, or rental income, is generally taxable to the beneficiary when distributed. The trustee issues a Schedule K-1 to beneficiaries, detailing the amount of income they must report on their individual tax returns.

Distributions of principal, or the original assets placed in the trust, are typically not taxable. This is because the principal was already subject to tax when contributed to the trust.

However, there are exceptions, particularly in cases where the principal includes assets that have appreciated in value. For example, if a trust distributes real estate or stocks that have gained value since their inclusion in the trust, beneficiaries may face capital gains taxes when those assets are sold. However, if the distribution occurs shortly after the death of the person which established the trust (the “Settlor”) then the assets get a “step up in basis” and no taxes will be due except for the appreciation which occurs after the death, but before the distribution.

In addition, some trusts may have “throwback” rules that affect the taxation of accumulated income. If the trust accumulates income and distributes it in later years, beneficiaries may be subject to additional taxes based on prior year tax rates.

Settlor Trusts vs. Non-Settlor Trusts

In a settlor trust, the individual who established the trust retains control over the trust’s assets and is considered the owner for tax purposes. Any income generated by the trust is reported on the settlor’s personal income tax return, regardless of whether the income is distributed to beneficiaries. Upon the settlor’s death the trust becomes irrevocable and distributions are made in accordance with the trust.

By contrast, a non-settlor trust is treated as a separate tax entity. The trust must file its own tax return and pay taxes on any income it retains. When a non-settlor trust distributes income to beneficiaries, the beneficiaries are responsible for paying taxes on those distributions. The trustee provides beneficiaries with a Schedule K-1, which outlines the portion of trust income they must include on their tax returns.

It’s important to note that trusts are subject to higher income tax rates than individuals. For example, trusts reach the highest federal income tax bracket (37%) at much lower income levels than individuals. Therefore, trustees and beneficiaries should carefully consider the timing and size of distributions to minimize the overall tax burden.

Maximizing the Benefits of Trusts

By knowing how different types of trust income and principal are taxed and staying informed about the rules that apply to settlor and non-settlor trusts, you can make more informed decisions that protect your financial interests. Trustees, in particular, must take a strategic approach to managing trust distributions to minimize tax liabilities while fulfilling their fiduciary duties.

At Kreis Enderle, our attorneys have extensive experience advising clients on all aspects of trust administration and tax compliance. If you have questions about trust distributions or need assistance navigating your trust’s tax implications, contact our team today.