A trust can be an excellent tool for safely stowing assets that can mature in value for the future benefit of the trust's beneficiary. Trusts are commonly used as a platform for growing and nurturing an inheritance, allowing older generations to pass on their wealth and assets to the children and young adults in their lineage. When it comes time to remove assets from a trust and deliver them to the beneficiary, this is commonly defined as a trust disbursement.
Depending upon the specific type of trust used and the nature of the disbursement, the beneficiary may be exposed to some form of trust tax. Understanding the law with respect to these disbursements will ensure that all parties involved have a keen awareness of the process taking place.
When assets are disbursed from a trust, a variety of factors will influence who is responsible for paying tax. Generally speaking, beneficiaries from a trust will only be responsible for paying tax on income generated by the assets rather than their principal value.
Basics of Trusts and Trust Tax
Generally speaking, there are two forms of trusts that are commonly used today. They are commonly labeled revocable and irrevocable trusts. The primary thing that distinguishes one form of trust form another is how assets within the trust are managed and who specifically owns them once they enter the trust itself. With each type of trust comes a unique set of implications and processes with respect to tax law.
Irrespective of which type of trust is created, there are certain fundamental aspects of each that are identical. One of the most important elements of both living trusts and irrevocable trusts is the relationship between the grantor of the trust, the trustee and the beneficiary.
A revocable trust is by far the most common form of trust created today. With it, an individual can effectively store, monitor and control assets that they own and keep them safely stored in a trust until the time of their death, at which point they will be distributed to the named beneficiary. In this circumstance, the individual placing the assets in the trust is the grantor. With a revocable trust, the grantor can also act as the trustee, managing the assets and ensuring that they are prepared for a streamlined disbursement to the beneficiary at a point in the future.
Control of Assets in a Revocable Trust
With a revocable trust, the grantor can move assets into and out of the trust at any point as needed. For example, if the grantor places a diverse portfolio of stocks and bonds in the trust, they can remove them if they would prefer to actively trade them, perhaps growing the value of the portfolio. Or, if a grantor has placed a highly valuable inheritance in the trust, such as a family heirloom, they can remove it as needed if they think the trust's interests are best served by this decision.
Ultimately, a revocable trust acts as a highly flexible platform which provides the grantor ultimate control over the assets in question. Only at the point of the grantor's death will the assets in the trust become the property of the beneficiary. It is also at this point that the trust itself transfers from a revocable to an irrevocable trust. This change in status carries with it serious implications.
Exploring Irrevocable Trusts
Fundamentally, an irrevocable trust fulfills the same objectives as revocable trusts, that being to safeguard assets until their ownership is transferred to a beneficiary. Where an irrevocable trust differs, however, is in the specific type of control offered to the grantor. Unlike a revocable trust, the grantor of an irrevocable trust forsakes ownership in their assets when they transfer them into an irrevocable trust.
Whereas a revocable trust simply acts as an extension of the grantor's asset holdings, an irrevocable trust is its own unique taxable entity. From a legal perspective, the assets placed inside of an irrevocable trust are the property of the trust itself.
As an example, consider the following scenario. The grantor of an irrevocable trust decides to place a portfolio of stocks and bonds inside the trust. Once the assets have been transferred, the grantor is no longer able to access the portfolio at any point. From this point forward, it is the responsibility of the trustee to effectively manage the assets in the trust and ensure that they are protected and nurtured until a point comes when they can be distributed to the beneficiary.
Grantors, Trustees and Irrevocable Trusts
Although it is possible that the grantor of an irrevocable trust also assumes the role of trustee, this arrangement is much less common in these trusts than it is with revocable trusts. This is due to a variety of tax statutes regarding the role of the grantor in a trust and their tax liability.
Far more common is a scenario where the trustee is a separate individual. Although the grantor and trustee can have a close relationship and discuss at length the goals and objectives of the trust, it is ultimately the trustee who has the vested authority to make important decisions regarding the daily management of trust assets.
As mentioned previously, a revocable trust transforms into an irrevocable trust upon the death of the grantor. It is at this point where it is essential that the grantor took the time to name a trustee who will manage the assets.
Disbursements to Beneficiaries in Trusts
The tax situation surrounding a revocable trust will change depending on the specific point in time an asset is taken out of the trust and the intended recipient of the asset. It is important to remember that the items placed inside of a revocable trust are still the effective property of the grantor until their passing. Because of this, certain situations may occur in which the grantor of the trust is actually required to pay tax on income earned by the trust itself. Keep in mind that this scenario does not involve any disbursements to beneficiaries.
Upon the death of the grantor, the trust will be transformed into an irrevocable trust, at which point the trustee will apply for a Taxpayer Identification Number, or TIN, for the trust. For however long assets remain in the trust, the trustee will be required to file IRS Form 1041. When the trustee initiates a disbursement to a beneficiary, however, the situation changes entirely. According to IRS guidelines, the beneficiary of the trust will be required to pay tax on any income generated by the assets in the trust, not their principal value.
Therefore, if a beneficiary requests a disbursement from the principal balance of the trust, they will not be required to pay income tax. However, as soon as the beneficiary begins to withdraw funds that formed part of the income generated by the trust, the situation changed entirely. Upon the death of the grantor, the current value of items in the trust is established as the new basis. This is due to the fact that the IRS will have required the grantor and/or trustee to pay tax on the funds in either a revocable or irrevocable trust up to the point of the grantor's death and potentially beyond. With that in mind, any disbursements made that do not exceed the basis value of these assets can be accomplished tax-free.
Taxation on Continued Trust Holdings
In the event that a trust does not immediately disburse all of its assets to the named beneficiary or beneficiaries, the trustee will be required to complete IRS Form 1041 on an annual basis until all assets have been properly dispersed. This means that any interest income generated by the trust will be subject to taxation on an annual basis.
When a trust does make a disbursement to a beneficiary, each of these transactions must be logged for the IRS using Form K-1. This particular document allows the trustee to itemize any and all disbursements made to beneficiaries throughout the tax year, documenting the total sum of the disbursement and the specific percentage of the disbursement that was composed of principal/interest. After receiving the income, the beneficiary will then be required to document the receipt of the disbursement on their own tax return, regardless of whether or not the funds in question represented principal or interest. Failure to do so could result in a variety of logistical hurdles after filing the tax return.
Closing a Trust
Once the trust has completed all disbursements to beneficiaries, its role has essentially been fulfilled. With that in mind, the trustee can then begin the process of closing the trust. In order to do so, they will need to file a final tax return, as well as provide comprehensive accounting statements which definitely show that all assets held in the trust have been fully disbursed to beneficiaries.
Closing the trust will allow the trustee to walk away from it entirely without being held liable for any legal elements of trust oversight. Given the complexities associated with running a trust, this will likely be highly beneficial for the trustee.
Moving Forward With Trust Tax
As a beneficiary of a trust, you have one significant advantage working on your behalf, the trustee. The trustee is required by law to manage the assets in the trust to the best of their ability, ensuring that the beneficiary has all of the information and resources they need to maximize their benefit from them. With that in mind, the named beneficiary of a trust can consult with the trustee at any time in order to learn more about their specific privileges and obligations with respect to trust assets.
The beneficiary can also speak directly with a financial adviser or tax expert if they require additional assistance with any of the documentation associated with their disbursement. As always, it is in the best interest of the beneficiary to seek out all available assistance before tax season approaches in order to ensure that they are not caught unaware by various elements of the tax code.
This advice also applies directly to the grantors of revocable trusts, individuals who may not be aware that they are still required to pay income tax on funds in the trust. Failure to report income earned by these assets could result in stiff financial penalties during tax season.