A trust is a legal arrangement in which one party manages property for the benefit of another. Federal rules govern how trusts are taxed, while state law governs how trusts are created and administered. A living trust takes effect during the grantor’s lifetime, while a testamentary trust is created at death through a will.
Primary Parties
- Grantor — Creates and funds the trust
- Beneficiary — Receives benefits from trust property
- Trustee — Manages trust assets, holds legal title, and handles tax reporting
Grantor Trusts
A grantor trust exists when the grantor retains control or certain interests. In these situations, the trust’s income is taxed directly to the grantor.
Income is taxed to the grantor when:
- The grantor has a reversionary interest exceeding 5%
- The grantor has beneficial enjoyment of trust property
- The grantor retains administrative powers such as borrowing, substituting assets, or directing investments
- The grantor or a nonadverse party can revoke the trust
- The grantor or a nonadverse party can distribute income to the grantor or spouse
When these conditions apply, the trust is ignored for income tax purposes.
Trust Corpus and Distributions
The trust’s property is the corpus (principal). Distributions may consist of principal, income, or both. Classification depends on the trust document, income type, and state law. This classification determines who receives distributions and how much.
Types of Trusts
Simple Trust
- Must distribute all income currently
- Cannot make charitable contributions
- Cannot distribute principal
- Allowed a $300 exemption
Complex Trust
- Any trust that is not a simple trust
- May accumulate income
- May distribute principal
- May make charitable contributions
- Allowed a $100 exemption
A trust may be simple one year and complex the next.
Allocating Expenses Against Income
To determine the taxable portion of distributions, trustees must allocate expenses to income categories.
Rules:
- Direct expenses reduce the specific income class they relate to
- Indirect expenses (trustee fees, legal fees) may be allocated to any income included in DNI
- If the trust has tax‑exempt income, a reasonable portion of indirect expenses must be allocated to tax‑exempt income
- Allocation is based on the ratio of tax‑exempt income to total income included in DNI
Distributable Net Income (DNI)
DNI determines:
- The maximum distribution deduction for the trust
- The taxable amount of distributions to beneficiaries
DNI is taxable income with adjustments:
- No deduction for distributions
- No personal exemption
- Exclude capital gains allocated to principal
- Exclude extraordinary dividends allocated to principal (simple trusts only)
- Add net tax‑exempt income after expense allocation
Taxable Income of a Trust
A trust computes taxable income similarly to an individual, with key differences:
- Trusts receive a distribution deduction
- Trusts are pass‑through entities for distributed income
- Beneficiaries report their share on Schedule K‑1
- Undistributed income is taxed to the trust
The taxable income formula:
- Gross taxable income
- Minus deductions (excluding those tied to tax‑exempt income)
- Minus distribution deduction (limited to taxable DNI)
- Minus exemption ($300 simple, $100 complex)
Depreciation
Depreciation may pass through to beneficiaries unless the trust document allows a depreciation reserve. Trusts cannot elect to expense property under Section 179.
Trust Tax Return Requirements
A trust must use a calendar year and pay estimated tax like an individual.
A domestic trust must file Form 1041 if it has:
- Any taxable income
- Gross income of $600 or more
- A nonresident alien beneficiary
The due date is April 15. A 5½‑month extension is available by filing Form 7004, but tax must still be paid by the original due date.