A trust fund is set up like a traditional trust, but how it operates can be a little different. However, some trust funds look and operate like a living trust (or irrevocable trust). What does that mean when it comes to trust funds and taxes? Are they taxed like a living trust or an irrevocable trust?
How is a trust fund any different from an estate trust? Don’t they accomplish the same things?
An estate trust distributes assets to beneficiaries after paying off all debts owed by the estate. Upon the trust owner's death, the beneficiaries will receive the assets as outlined in the trust documents.
One of the benefits of an estate trust is that it avoids costly probate court. Allowing an estate to go into probate is very time-consuming. Probate court can also greatly reduce the value of an estate due to the high cost involved.
So far, we haven’t really said anything that differentiates an estate trust from a trust fund. However, the two are different. The main differences lie in how a trust fund distributes its assets.
A trust fund is generally more restrictive in how its assets are distributed. Assets can be distributed in a lump sum (like an estate trust), on a specific date, or as payments that go out monthly, biannually, or annually. Trust funds may distribute all assets as money or investments instead of physical assets (i.e., house, car, jewelry, etc.).
A trust fund can be set up as a living revocable trust. Many estate trusts use this same framework. A revocable trust allows the owner to move assets into and out of the trust while living. Upon death, some trusts change to irrevocable and follow the owner's wishes regarding asset distribution. Trust funds can do the same.
Some types of trust funds include spendthrift and testamentary trusts. A spendthrift trust distributes money over time to a beneficiary. This might be a younger beneficiary or someone who doesn’t have good spending habits.
A testamentary trust or "after-death trust" is created after the person willing the assets die. The testamentary trust is based on a will, which the trust owner can change while alive. Once the owner dies, the trust becomes irrevocable. One major drawback of a testamentary trust is that it goes through probate.
Now that we understand what a trust fund is and how it differs from an estate trust, how exactly are these trusts taxed?
How a trust fund is taxed will depend on how it is set up. Is it a revocable or irrevocable trust? Does the trust have any income?
A revocable trust is often taxed at the grantor's income tax rate. In that scenario, it is a flow-through entity taxed against the individual (i.e., the grantor).
An irrevocable trust may be taxed as a stand-alone entity. Trust has four different income tax brackets at the federal level:
10%: $0 – $2,750
24%: $2,751 – $9,850
35%: $9,851 – $13,450
37%: $13,451 and higher
Of course, whether the trust pays any taxes depends if the trust produces any income. If a trust produces income, it may pay that income to beneficiaries. The income produced and distributed by a trust is called distributable net income (DNI).
A trust receives a tax deduction for its DNI. The beneficiary is taxed at their income tax rate on any DNI received.
Some trusts do not produce any income. When any assets are distributed from a non-income-producing trust, it is from the principal. Neither the trust nor the beneficiary pays taxes on principal distributions.
What about a trust that distributes everything upon the grantor's death? The beneficiaries receive a lump sum payment or assets that aren't settled in cash. The value of any assets in the trust has a stepped up basis at the time of the grantor's death. This means the assets are valued at the market rate. Beneficiaries then receive those assets at the market rate, owing no taxes at the time of transfer (from the trust to the beneficiaries).
If a beneficiary later sells an inherited asset at a gain, the beneficiary will owe taxes at their regular income tax rate (although long-term capital gains rates may apply).
When an irrevocable trust makes distributions to a beneficiary, the beneficiary will receive a K-1 from the trust showing the amount distributed to them.
Many factors can determine how a trust and its beneficiaries are taxed. The above is a general outline and does not apply in all cases. This is why working with a tax specialist and trust attorney are best when figuring out how taxes may be owed on trusts and any inherited assets.