Our office routinely assists trustees in preparing accountings for ongoing trusts. This post explains what those accountings are and why they are important. It also gives some advice for trustees on making financial reporting as easy as possible.
Trust Accounting Basics
An ongoing trust is an arrangement under which one person is managing money for another according to a governing document. The person managing the trust is the trustee, and the person they are managing for is the beneficiary. The governing document explains how the funds are to be used.
For example, a grandparent may create a trust for a grandchild in their will. The will (the governing document in this example) might name the grandchild’s parent as trustee, and state that the funds can be used for health, education, maintenance, and support of the child until age 25, after which the remaining funds are distributed to the child.
Once funds are placed in a trust, the trustee’s job is to (1) invest the funds properly; (2) make distributions to or for the beneficiary according to the document; and (3) keep accurate records. This post explains this record keeping requirement.
A Trust is a Business
For record keeping purposes, a trust is a business. It has its own tax ID, its own financial accounts, and its own earnings and losses. The trustee is the manager of the business, directing what the trust does. The beneficiary is the owner of the business, where gains, losses, and distributions ultimately accrue.
And like a business, the trust will have its own financial and reporting requirements. Just as the company’s CEO must report to the shareholders, the trustee must report to the beneficiaries. And just as a company must report to the IRS and (potentially) pay taxes, the trust must do the same.
Business Financials 101
In the business world, two key financial reports are the company’s income statement and the company’s balance sheet. A balance sheet is a snapshot of the company’s assets at any given time. So, for example, the company’s balance sheet might list real estate, cash on hand, equipment, inventory, and so on, each with a value, as of a specific date.
The income statement is shows the company’s financial performance over time. So, for example, an operating business will (hopefully) earn money from sales (perhaps broken out into different products or lines of business) and from appreciation in its assets. It will spend money on materials, marketing, purchases of equipment, insurance, maintenance, and so on. An income statement shows all funds paid or received, broken out by time period, over the course of a given time period. This time period might be monthly, quarterly, or annually.
Trust Financials
In the trust administration world, the trustee must prepare each of these financial reports, typically for each calendar year. Fortunately, trust finances are generally much simpler than those of an operating business. Generally, an ongoing trust will have gains or losses from investments, amounts paid for professional fees (attorney, CPA, and investment advisor) and distributions to the beneficiary.
An example of this would be a simple trust for a young person. The trustee receives $400K when the trust is created in mid-2021. She keeps $10K in the trust checking account, and invests the remaining $390K in an investment account with her financial advisor. At the end of 2021, she has made $5K in distributions to the beneficiary, and paid $1K in fees to her financial advisor. Her investments have gained $20K in value from capital gains and dividends.
Her end of year balance sheet will show:
$5K checking
$409K investment account
$414K total
Her 2021 income statement will show:
$400K property received
$15K capital gains
$5K dividends
-$5K distribution to beneficiary
-$1K professional fees
These amounts must be reported to the beneficiary.
Tax Reporting
In addition to reporting to the beneficiary, the trustee will need to file an income tax return for the trust. This return will report gains and losses by the trust. However, like a business return, the amount of taxable income may vary somewhat from the income shown in the business financials. This variation is most commonly because gains and losses on stocks are realized when the stock is sold, so taxable capital gains and losses will not match the actual gains or losses shown on a trust accounting.
Taxes are paid by the beneficiary to the extent the beneficiary has received distributions from the trust. Tax on any additional income received by the trust must be paid by the trust. So, in the example above, the trust has $20K in income (assuming taxable gains equal actual gains). The $1K in fees are deductible, leaving $19K in income. The beneficiary pays taxes on his $5K distribution and the trust pays taxes on the remaining $14K.
Our Process
Typically, our trustees are comfortable working with financial advisors and making distribution decisions on their own, but need some help with these reporting requirements. Our process for this is:
In late November, we reach out to trustees with substantial funds under management and offer to discuss end of year tax planning with the trustee and their advisor. Trusts pay higher rates than individuals, so it can sometimes be a good idea to make additional distributions before the end of the year for tax reasons.
In January, we reach out to our trustees and ask them to gather financial documents (check ledgers and bank/brokerage statements) for the trust. We also ask them to advise the beneficiary to wait to file their individual return until the trust tax return is finalized.
We create the trust accountings for the trust based on the records provided, and review those with the trustee.
Once the accountings are reviewed and signed by the trustee, we make arrangements with a CPA for preparation of the trust’s tax return. As part of this process, the beneficiary receives a tax form showing the income they must report on their individual return.
Tips and Tricks
Our general advice to new trustees is to make the process as simple as possible from the beginning. That means having a single checking account and brokerage account, and working with a single financial advisor who can recommend a solid investment approach.
Keeping things simple also means managing the checkbook effectively, automating distributions to the extent possible, and keeping contemporaneous records of amounts paid. For example, the trustee might set up monthly autopays for the beneficiary’s phone, rent, or regular support payment. The trustee should make all payments directly from trust checking, rather than paying themselves back for purchases.
Starting off on the right foot with a solid process will go a long way in making the reporting process as painless as possible.
Have questions about managing an ongoing trust? Contact our office for a consultation.