A trust is a lawful entity that holds assets and money for future distribution or administration. For example, you can create trust for your children's college education by setting aside money they can withdraw for education. Or you can place the family home in a trust, creating an entity that will hold the property indefinitely to ensure it always stays in the family. The intersection of taxes and trusts can be difficult, but working with a financial advisor can help clarify relevant issues so you can make the right decisions.
What is a trust?
There are three main types of trusts:
Simple Trust: This is the basic and most common. It holds assets and distributes any income from those assets to the trust's beneficiaries. It does not distribute its principal.
Complex Trust: Broadly defined as "a trust that is not simple," this trust is considered complex if it pays out less than the total income earned in a year; if you distribute one of your administrators; or if you make distributions to charities and designated beneficiaries.
Grantor Trust: This type of trust is managed by the person who created it. They exercise a potentially significant degree of control over the assets of the trust, depending on how the trust was set up.
With a trust, the person establishing the trust pays all the taxes related to the trust. On the other hand, simple and complex trusts must pay taxes directly on all income, assets, and tax events.
Trusts pay federal, state, and (if applicable) local taxes. However, this article will only discuss federal tax rates and exemptions, as tax rates and regulations specific to state trusts are beyond the scope of this article.
Ordinary Trust Tax Rates for 2022
For 2022, the federal government taxes trust income at four levels:
10%: $0 to $2,750
24%: $2,751 - $9,850
35%: $9,851 – $13,450
37%: $13,451 or more
These tax rates also apply to all property income.
Standard rules apply to these four categories of taxes. So, for example, if a trust earned $10,000 in income in 2022, it would pay the following taxes:
10% of $2,750 (all income between $0 and $2,750) = $275
24% of $7,099 (all income between $2,751 and $9,850) = $1,703.76
35% of $149 (all income between $9,851 and $10,000) = $52.15
Total charges = $2,030.91
Long-Term Capital Gains Trust Tax Rates for 2022
Short-term capital gains (on assets held for 12 months or less) and non-qualifying dividends are taxed as ordinary income. Eligible capital gains and dividends on assets held for more than 12 months (over one year) are taxed at a lower rate (long-term capital gains rate). For 2022, three brackets of long-term capital gains are in place:
0%: $0 to $2,800
15%: $2,801 - $13,700
20: $13,701 or more
Again, these tax brackets apply equally to all real estate income.
Most trusts get most of their income from investments, but that's not a hard and fast rule. Many manage assets such as buildings and properties, for example. Any income generated from rents or lease payments related to these assets would be classified as ordinary income, not capital gains.
Primary tax deductions for trust funds
Here are four main categories of fund-related deductions.
Contributions and donations
Contributions made to a trust are generally not subject to income tax. The individual making this contribution has already paid taxes on the money, so the I.R.S. considers this double taxation. Generally, a trust only pays tax on the income it earns from its money and assets.
The beneficiary of a trust may have to pay taxes on the money they receive. Beneficiaries generally have to pay tax on distributions they receive, and the fund has paid out of income earned in the current tax year. A beneficiary is not required to pay tax on distributions made by the fund from its principal balance. This is to avoid double taxation. All trust capital funds have already been encumbered. Any money the trust earns and distributes in the same year is not taxed.
Where both may apply, distributions from a trust are taken first against current year income (and therefore, the beneficiary must pay tax on this money), then against capital. However, in some instances, a beneficiary can still avoid paying tax if they receive less than the lifetime tax exemption from the trust. For 2022, it is set at $12.06 million for individuals and $24.12 million for couples.
Trustee and Tax Preparation Fees
The trust may deduct reasonable administration and tax preparation expenses. However, the trust can only deduct these taxes based on the percentage of income subject to tax. For example, suppose a trust received an income of $20,000 in a given year. However, only $10,000 of this income was taxable. The trust could then deduct half of its administrative and accounting expenses.
Charitable Donations
Generally, a trust can deduct any cash donations made to charities. Since this is a deduction, it is non-refundable, meaning a trust cannot deduct more donations than earned against taxable income.
Income Distribution Deduction
Trusts that distribute to beneficiaries may separate their income into two parts for tax purposes: the income the trust retains and the income it distributes. The portion of the trust's income that it distributes is known as Distributable Net Income, or DNI Trusts are not required to pay tax on the portion of the income they distribute to beneficiaries in the same calendar year in which it was earned. This is because the beneficiaries pay taxes on this income. Any income not distributed by the trust in the year it was earned is taxed and then added to the trust's capital.
The DNI is calculated as the fund's total taxable income minus its capital gains plus any applicable tax relief. Therefore, DNI = total tax base - total capital gain + applicable exemptions.
Remember that total capital gains are the sum total of all capital gains offset by capital losses. A fund may then deduct the amount of any distributions it makes from its income taxes to eligible beneficiaries up to the total DNI.
Bottom Line
Trusts are taxed on ordinary income and long-term capital gains. Although their rates have changed slightly for the 2022 tax year, they remain broadly comparable to previous years.
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