Whenever someone writes you a check, there's a question as to who is going pay taxes on the money. If you earned the money, the answer is relatively simple – you do. If the money is an inheritance, however, and particularly if it's an inheritance from a trust, the issue becomes more complicated. The answer depends on the type of trust and what portion of its assets it paid out to you.
While the creator or grantor of a revocable trust is alive, he can typically elect to take distributions from his trust if he chooses to. That's the nature of a revocable trust – the grantor reserves the right to change his mind about it and about the assets it holds. Therefore, tax law typically treats the grantor and his trust as one legal entity during his lifetime. Any income that trust assets earn is reported on the grantor's personal return and he pays taxes on it. When the grantor dies, however, this has the effect of changing his revocable trust to an irrevocable trust because he can no longer make changes to it. What happens next for tax purposes depends on how he designed the trust at its inception.
Complex Vs. Simple Trusts
When a revocable trust becomes irrevocable at the grantor's death, one of two things happens according to the terms included in the trust's creating documents. Its assets are either distributed to beneficiaries immediately and the trust closes, or it becomes a new trust – either simple or complex. Simple trusts must distribute all income earned by their assets in the same year the income is received. Complex trusts can hold on to some income, distributing only a portion of it to beneficiaries. More important, simple trusts cannot disburse from the principal of their assets – those that initially funded the trust, plus capital gains. Complex trusts can distribute from capital gains, and this is where an important tax distinction applies.
If you inherit from a simple trust, you must report and pay taxes on the money. By definition, anything you receive from a simple trust is income earned by it during that tax year. The trustee must issue you a Schedule K-1 for the income distributed to you, which you must submit with your tax return. If you inherit money from a complex trust, however, the funds might represent either income or capital gains. The portion representative of the trust's income is ordinary income and is reportable by you on your tax return. You'll receive a Schedule K-1 for the amount. Any portion of the money that derives from the trust's capital gains is capital income, and this is taxable to the trust. This is typically the case when the trust's distributions for the year exceed the amount of income it took in.
Effect of Distributions
A trust takes deductions on its own income tax return for distributions of ordinary income made to beneficiaries – the Internal Revenue Service does not tax this money twice. Tax liability passes through the trust and lands with you as the beneficiary. In the case of a complex trust, however, the trust would still owe taxes on any ordinary income it retains. This is usually not to a trust's advantage.