This post covers end of year tax planning for ongoing trusts. For a more in-depth treatment of trust accountings, please see our previous post, Trust Accountings for Ongoing Trusts, available here.
Trusts are considered a kind of business for tax purposes. They have their own tax ID and will receive their own 1099s from whatever assets they own.
In most businesses, the owners choose how the business’s income will be taxed when the business is set up. Most small businesses are set up as “flow-through” entities, meaning that if the business earns income, the owners pay the taxes in proportion to their ownership. The business files a tax return, but does not pay any taxes. Most large corporations are taxed at the corporate level, meaning the company pays all taxes on its income. The shareholders only pay tax to the extent they receive a dividend from the company.
In trusts, the trustee essentially chooses each year (within limits) how the trust income will be taxed. The trustee can choose to have the income taxed at the trust level. In that case, the trust will pay the taxes, and the beneficiary will not pay any taxes. Or, the trustee can choose to have the beneficiary pay the taxes. In that case, the trust will file a tax return, but the income is reported by the beneficiary, and the beneficiary will pay the taxes. However, the taxes can be paid by the beneficiary only to the extent that the beneficiary has received distributions for the trust.
A simple example shows how this works. Suppose our trust has $10K in taxable income in 2021. The trustee has distributed a total of $5K to the beneficiary in 2021. The trustee can choose to have the trust pay income taxes on $10K, or can choose to have the trust pay income taxes on $5K and the beneficiary pay income taxes on $5K. However, the trustee cannot have the beneficiary pay taxes on the full $10K, since only $5K was distributed to her.
Why this choice matters
Where the taxes are paid matters because trusts pay taxes at a higher rate than individuals. In 2022, the 37% bracket for an individual started at **; for a trust, it started at $13,451. So, all things being equal, there will be a tax savings by having the beneficiary—not the trust—pay the taxes.
However, saving taxes is not the only thing the trustee must consider. There can be good reasons (typically, that the beneficiary would use the distribution inappropriately) that the trustee would be reluctant to make distributions to the beneficiary. In that case, the trustee must choose between the tax savings and retaining assets in the trust.
Our standard advice
The more income the trust has, the more this matters. Trustees should review their records or talk with their financial advisors in early December to see how much taxable income the trust will have. From there, we recommend the following based on the amount of trust income:
If the trust will have no taxable income, the trustee does not need to do any tax planning with us or their accountant. The trust will not have a filing requirement.
If the trust will have less than $600 of income, it should distribute $600 to the beneficiary if it has not already. This will avoid having a filing requirement.
If the trust will have between $600 and $10,000 of income, the trustee should consider making distributions equal to or greater than the expected income amount. However if there are good reasons not to make the distribution, this is fine and the tax consequences will not be that significant. We are happy to discuss this but don’t feel it’s absolutely necessary.
IF the trust will have more than $10,000 in income and the distributions are significantly less than the income, we will want to discuss with the trustee.
Advice for trustees
We have worked with most of our trustees for years, often because we worked on the estate or trust settlement that created the trust. However, we are happy to meet with trustees managing trusts who are looking for advice on these issues. We do charge for these consults.
Ready to get started? Call our office to set a time for a consultation.