Having a little knowledge of how Trusts are taxed can help you plan for your special needs person. It will also help you to work more effectively with your accountants, attorneys, and trustees.
First, it’s important to realize that most trusts are separate entities and are subject to State and Federal income taxes. This applies to trusts established by family members and trusts that hold assets belonging to persons with disabilities themselves. The rules can be very different for each.
TRUST HAVE RETURNS AND DISCOUNTS
The IRS grants a $600 deductible taxable trust. If the trust fund is small enough, I often advise clients to keep interest income at less than $600 per year to avoid having to file a trust tax return. The recipient may still have to file the return himself. Trust tax returns are called “pass through” returns by the IRS because most income, taxes, and deductions are “passed” to the beneficiaries. Returns are filed with the IRS on Form 1041. Trusts are taxed in the calendar year ending December 31.
PAYING TRUST AVOID TAX TRUST
Trusts generally get an income tax deduction for all money they distribute to beneficiaries or pay for the care, support, or needs of the beneficiary. Frankly, this is how a good guardian should use the money of a person with special needs. The trust reduces the share of its paid income. Principal spent or paid is usually not taxed to the trust or beneficiary.
Looking at simple examples often helps. If the trust has $100,000 in principal and only keeps money in a bank account and earns no interest or income, the trust doesn’t have to pay income taxes or file returns. If the trustee distributes part of the account, say $30,000 for the beneficiary’s medical needs, the principal distribution is not taxable income to the beneficiary.
TRY ASSET TRUST FREE TAX
The income received by the trust from investing in tax-free sources retains its “character” and is tax-free for the beneficiaries when it is spent on their needs. Knowing this, we often advise clients to place some or all of the recipient’s funds in tax-free municipal bonds.
WATCH THE END OF THE YEAR AND PLAN FOR THE FUTURE
The second big general rule is that many but not all pieces available to individuals may also be available to Trusts. However, the trust tax rate on the income that the Trust earns but does not pay to the beneficiaries is much higher than the individual tax rate your special person will pay. To avoid this, it often makes sense to plan ahead and spend all trust income before December 31 each year. Currently, Trusts pay approximately 38% federal tax on income that is accumulated by the trust and not spent on behalf of the beneficiaries. Your state income tax can increase this burden.
IT HELPS TO PAY TAX IN ADVANCE
It is important to know that the trust income spent on the beneficiary is likely to be taxed on the beneficiary’s personal return. The trust may make an estimated income tax deposit on Form ES1040 and transfer the benefits of that income tax prepayment to your beneficiary. This can cover any tax liability your beneficiaries may have to pay due to trustee income. This can help eliminate worries, properly pay tax obligations in advance, and tax payments caused by trustee income are almost always legitimate trust expenses.
DOUBLE REDUCTION
Congress did add special provisions to the tax code for eligible disability guardians. It’s found in section 642 and can help with a D4a trust provided it’s not a “grant” trust. This effectively doubles the $3,300 personal deduction by trusting the benefits of the private deduction and allowing recipients to keep a similar personal deduction. In practice, this is difficult to achieve for most larger trusts but is worth exploring. You should ask your accountant if it can work for your family.
HAVE TRUST, LEARN A HELPER
Trusts can pay employees on behalf of your special needs recipients. Don’t forget workers compensation insurance is required. FUTA deductions are required if an employee is paid more than $1,000 in a quarter. Social Security must be withheld and paid if an employee is paid more than $1,500 in a calendar year. A 1099 filing is generally required when the trust makes payments to vendors more than $600.00.
This article just shares a little insight into some common trust tax rules. There are places where you can start looking for tax breaks if you work with your accountant, trustee, and attorney. Keep in mind that trusts are subject to alternative minimum taxes, withholding estimates, capital gains tax, depreciation, and carry-forward and carry-back loss regulations. It is important that your professionals always check the actual parts of the code as they apply to your particular family situation. Of course, you should also double-check your state’s specific tax regulations.
