How and When Beneficiaries are Taxed from a Trust or an Estate

When a trust or an estate produces taxable income such as interest, dividends, rental income, royalties, etc., beneficiaries may be concerned with how the resulting income tax will affect their personal financial situation. Whether the trust/estate or individual beneficiaries (or both) are liable for the income tax burden depends on the governing document (trust agreement/will), state law, and the Internal Revenue Code. Understanding how trust and estate income taxes are levied can be integral for a beneficiary so that they are not left with a large, unexpected tax bill.

Trusts and estates function as a sort of hybrid pass-through entity. Often-times, there is no income tax attributed to the beneficiary unless distributions are made from the trust or estate. If distributions are made from a trust or estate to beneficiaries, it will often shift the burden of income tax to the individuals receiving the distributions. Income will be reported on a K-1 from the trust or estate issued in the name of the beneficiary in proportion to their share of the distribution made. The beneficiary will then, in turn, report the income on their individual income tax return. One exception to this general rule is related to capital gains. Typically, capital gains will remain taxable at the trust or estate level regardless of distributions made to beneficiaries.

Because of the capital gains treatment within a trust or estate, there are circumstances in which the trust or estate and the beneficiary could both pay taxes in a single year (i.e. the beneficiary owes taxes on things like interest and dividends and the trust or estate owes capital gains tax). This split tax liability could also result when the distributions made to beneficiaries within a certain year are less than the overall taxable income; some income will push out to beneficiaries on K-1s, and some will remain taxable at the trust or estate level.

If no distributions were made during the year, the income generally remains taxable at the trust or estate level and the trust or estate is responsible for paying the tax due. However, there are instances in which a trust will make no distributions and still not be liable for the income tax. One such example is when the governing instrument includes certain provisions requiring the inclusion of the trust’s income on the grantor’s tax return. This is known as a grantor trust, and income will be included on the grantor’s individual income tax return regardless of any distributions made or capital gains earned during the year.

The above rules can be complex and nuanced. If you are a beneficiary of a trust and/or an estate, it is important to work with your professional advisors to ensure you are taking advantage of any tax-savings strategies available, and that you have the appropriate funds needed to meet your individual tax burden in any given year. Contact us today to learn more about our estate and trust planning services.