A trust is a separate legal entity for tax purposes. The trustee, who manages and is responsible for the trust's investment results, must file a tax return each year and declare the money earned. The tax return looks similar to your personal Form 1040, with lines for income and deductions. The big difference is that a trust hits the top tax bracket at a very low level of income compared with individual tax returns.
The income tax rates for a trust are most of the same rates used on regular income tax returns. The American Taxpayer Relief Act of 2012 set permanent tax brackets of 15, 25, 38, 33 and 39.6 percent for trusts. The long-term capital gains tax rate for a trust in the top bracket is 20 percent. A 3.8 percent Medicare tax also applies to trust investment income and capital gains for earnings in the top tax bracket.
While a couple filing a joint tax return hits the top 39.6 percent tax bracket at $450,000 of income, a trust is in at the top rate when its taxable income exceeds $11,950, as of 2013. This means any income a trust earns above this amount will be taxed at either the highest income tax or capital gains rate. The tax rules are written so when investments are held in a trust, the earnings will be taxed at the top rate unless the trust makes distributions to its beneficiaries.
Any investment income a trust earns and distributes to the beneficiaries -- such as bond interest and dividends -- is not taxed on the trust's tax return. In effect, the trust "passes through" this income to the beneficiaries. The recipients receive the income and claim it on their personal income taxes. The nature and tax status of the income also passes along to the beneficiaries. For example, if the trust earns qualified dividends that are taxed a lower rate, the trust income is also classified as qualified dividends for the beneficiary.
A trust can generate capital gains if it sells investments such as stocks. Often, a trust is set up to maintain the principal value of its investments, and capital gains are retained in the trust and reinvested. In this case, the trust could end up paying higher taxes on those gains than if they were distributed to the beneficiaries.