TAX PLANNING | 03/03/2024
Key insights
Establishing a trust can be a crucial part of estate planning, but understanding how the trust’s income will be taxed is equally important. Changes such as those introduced by the American Taxpayer Relief Act of 2012 (ATRA), which increased income tax rates and introduced the Net Investment Income Tax (NIIT), can significantly impact trust taxation. Knowing the differences between grantor and non-grantor trusts is essential to managing these complexities.
What is a Grantor Trust?
A grantor trust allows the person who created it (the grantor) to retain certain powers, making the trust’s income taxable on the grantor’s individual income tax return. Common types of grantor trusts include:
- Revocable Living Trusts: Flexible tools for managing assets during life and after death, often an alternative to wills.
- Irrevocable Trusts: Frequently used to transfer assets outside the taxable estate while retaining certain grantor powers. Examples include:
- Spousal Access Trusts
- Grantor Retained Annuity Trusts (GRATs)
- Intentionally Defective Grantor Trusts (IDGTs)
- Irrevocable Life Insurance Trusts (ILITs)
- Dynasty Trusts
Grantor trusts offer significant tax advantages. For example, selling assets to the trust doesn’t trigger capital gains tax, and the grantor’s payment of trust income tax is not treated as an additional gift to the trust. However, grantor trust status can be waived, converting it to a non-grantor trust with different tax implications.
What is a Non-Grantor Trust?
A non-grantor trust is taxed as a separate entity, paying taxes on income retained within the trust. Distributions to beneficiaries shift the income tax burden to the beneficiary, who reports it on their personal tax return. Key considerations include:
- Trusts file Form 1041 and issue Schedule K-1 to beneficiaries for distributed income.
- Trusts face compressed tax brackets; for example, in 2024, the 37% tax rate applies to trust income over $15,200, compared to $609,351 for individuals.
Impact of ATRA on Trust Taxation
ATRA compressed tax brackets for trusts, meaning even modest retained income is subject to high rates. Additionally, the Net Investment Income Tax (NIIT) applies a 3.8% tax on certain trust income exceeding $14,450 in 2024. Proper planning can mitigate these effects, such as by making discretionary distributions to beneficiaries in lower tax brackets, while balancing estate planning and asset protection goals.
State Income Tax Considerations
Trusts are subject to state income tax depending on factors such as the residency of the trustee, grantor, and beneficiaries, as well as the location of administration and assets. These rules vary widely among states, and a trust may face taxation in multiple states or none at all. Selecting the appropriate trustee and structuring the trust strategically can reduce state tax burdens.
Special Considerations for Irrevocable Trusts
- S Corporation Stock: Only specific trusts, such as grantor trusts, Qualified Subchapter S Trusts (QSSTs), or Electing Small Business Trusts (ESBTs), can hold S corporation stock. Timely elections are required to avoid disqualification.
- Discretionary Distributions: Trusts can manage taxable income by making distributions within 65 days after year-end and treating them as prior-year distributions, offering flexibility in tax planning.
The Bigger Picture
With the federal estate tax exclusion currently at $13.61 million for 2024, fewer taxpayers are subject to estate tax. This shift emphasizes income tax planning over estate tax considerations for many individuals. Understanding trust taxation is key to maximizing benefits while aligning with your estate planning goals.
Our tax consultants are here to guide you through these complex issues, offering tailored strategies to optimize your trust’s tax efficiency. Contact us today to ensure your trust aligns with your financial and estate planning objectives.