While income tax rates and rules for individual and married taxpayers are complicated enough, the application of rates and thresholds to trusts adds a layer of complexity to financial planning. The 65-day rule relates to distributions from complex trusts to beneficiaries made after the end of a calendar year. For the first 65 days of the following year, a distribution is considered to have been made in the previous year.
How Is Trust Income Taxed?
Among the various types of trusts, the four prominent examples can be divided into grantor and non-grantor. Grantor trusts are revocable living trusts and intentionally defective grantor trusts. In these instances, the grantor (who created the trust) typically remains as the taxpayer, responsible for reporting and paying applicable taxes on income in the trust.
Non-grantor trusts are either simple or complex. In a simple trust, the beneficiary(s) pays the taxes, and the trust distributes current income but no principal to the beneficiary Since all income is distributed, the trust is not a taxpayer. In a complex trust, both the beneficiary and the trust can be responsible for tax payments since the trustee can determine whether and when to distribute funds. The trust pays the taxes on income it retains, while beneficiaries pay taxes on the income they receive. It’s helpful to note that the grantor of an irrevocable trust, whether complex or simple, benefits from tax obligation relief. The non-grantor trust typically shifts the trust assets away from the grantor, even removing them from their estate planning.
Rates and Thresholds Differ
Income tax rates reach the highest levels much more quickly for trusts than for individual taxpayers. For example, in 2021, a single filer will hit the 37% rate at a level of $523,601 of ordinary income ($628,301 for married couples filing jointly). In contrast, the top 37% income tax rate for a trust begins with an income of $13,051. Similarly, the trust will reach the full assessment of 20% for capital gains and qualifying dividends, whereas the minimum for married couples is $501,600. Trusts also have drastically greater exposure to the net investment income tax ($13,050 versus $200,000 for individual filers).
Does it Make Sense to Distribute Income to the Beneficiary?
The trustee decides when and if to distribute income to a beneficiary (or beneficiaries). Tax rates and thresholds are part of the overall calculation. Distributions made at any time during a calendar year are considered the same and have the same outcome—providing the income to the beneficiary.
However, the 65-day rule may allow a payment decision to be made with information that was not available during the previous calendar year. Therefore, the trustee may want to consider it in combination with other variables when making distribution decisions.
When year-end accounting information is collected and analyzed, the financial situation may warrant a more significant or additional payment to offset retained income. The trustee can do this using a 663(b) selection on the trust's tax return. However, such an election is irrevocable.