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How Can Trusts Affect Federal Taxes?

A trust is a legal and fiduciary relationship between the person responsible for managing the trust (the trustee) and the beneficiary of the trust. The person who transfers the property into the trust is known as the grantor or settlor. On its website, the IRS gives this definition: “In general, a trust is a relationship in which one person holds title to property, subject to an obligation to keep or use the property for the benefit of another.”

A trust is a flexible estate planning tool. A multitude of types exist for a variety of purposes. Some individuals create revocable trusts both as a mechanism for managing their assets during life and also to determine how their property will be distributed upon their death.

Most revocable living trusts are treated by the IRS as grantor trusts, which means that trust income is taxed to the grantor and not to the trust. This is because the grantor retains certain powers, including the right to revoke or amend the trust. Alternatively, a trust considered by the IRS to be a non-grantor trust has its own tax identification number and income generated by the trust and left in the trust is taxed to the trust.

This is important because tax brackets for trusts are compressed as compared to tax brackets for individuals. In 2024, for a single individual, the top marginal tax rate of 37% is reached when taxable income exceeds $609,350. For a trust, this rate is reached when taxable income reaches only $15,200. A grantor trust is taxed to the grantor at their individual income tax rate.

An irrevocable trust that, for example, is established for someone else on the death of the grantor, may require the annual income to be distributed to the beneficiary every year or it may give the trustee discretion as to whether or not they distribute the income. If income distributions are required but not made, both the trust and the beneficiaries have to pay tax. If the trustee distributes the income to the beneficiary, IRS Schedule K-1 is generated and the trust income is taxed to the beneficiary and not to the trust. Even when the trustee is not required to distribute the income to the beneficiary, if they don’t, then the trust has to pay the tax, which will almost always lead to higher overall taxes.

Trusts can also be created for the purpose of reducing federal estate tax. Taxpayers who die in 2024 have a lifetime estate and gift tax exemption of $13,610,000, meaning that during life or upon death, they are able to give away, as lifetime taxable gifts and by their estates at death, a total of $13,610,000 with no tax liability. A married person’s Will (or revocable trust) may include two separate trusts to be created at their death: a survivor’s trust and a bypass trust.

The surviving spouse’s trust is revocable and includes property that will be in the survivor’s estate on death. The bypass trust is funded with the deceased spouse’s share of the estate with an amount up to the exemption amount. The bypass trust generally distributes income to the surviving spouse during life, with the property remaining in the trust distributed to other beneficiaries upon the surviving spouse’s death. This type of trust is advantageous for estate tax purposes because assets that are still in the trust on the surviving spouse’s death are not considered part of their estate, thus avoiding estate taxes upon their death. A disadvantage is that the tax basis of assets that fund the trust do not receive a new basis on the surviving spouse’s death, causing potentially large capital gains tax for beneficiaries who later sell the assets.

Nothing contained in this publication should be considered as the rendering of legal advice to any person’s specific case but should be considered general information.