Many estate planners use trusts as a tool to help their clients avoid probate and have more control and privacy with regard to their assets after they die. Although this simplifies matters in many cases, it may place heirs in a strange tax situation. Receiving payments from a trust fund, particularly when it’s income earned by the trust, can be a confusing situation, which is only further clouded by the tax strategies the trust fund itself employs.
Trust Fund Tax Filing
Depending upon the type of trust fund and the circumstances it receives income, the Internal Revenue Service (IRS) may require the trust to file income taxes as a corporate entity or as an individual. In some cases, trusts aren’t required to file income taxes. When a trust issues a payment to a beneficiary, it issues a Form 1041, or Schedule K, to the IRS and the beneficiary reporting the payment. If the trust paid income taxes, which is reported on the Schedule K, beneficiaries aren’t exposed to double taxation and may receive the payment free of personal income taxes.
Individual Tax Filing
If the trust fund didn’t pay taxes, individuals inherit the tax burden when they receive a payment from the trust. In most cases, this is reported as regular income if it’s a distribution from a trust fund. Nontaxable trusts that receive income must pass those taxes along to beneficiaries, who pay individual income taxes of the same type the trust would incur. For example, if a trust sells stock and reports $30,000 in long-term capital gains, beneficiaries report their portion of those proceeds as gains on their individual tax returns when they receive the distribution.
Taxes on Payments to Trust Funds
Beneficiaries of nontaxable trust funds also owe personal income taxes on payments made to the trust fund if they’re not distributed to beneficiaries. Similar to the rules that govern taxation on payments from a trust, beneficiaries must pay taxes on payments to a nontaxable trust according to the type of income the trust receives. Thus, beneficiaries pay gains taxes on sales of assets -- and may claim capital losses in some cases -- or report dividend income the trust received as personal investment income. Payments to nontaxable trusts are then taxed at the appropriate rate individuals would pay if they received those earnings.
Trust Fund Payroll Taxes
Sometimes, payroll taxes that fund Medicare and Social Security are known as trust fund taxes. In the case that a business goes out of business without paying payroll taxes, the IRS pursues outstanding trust fund taxes from the business’ owners. Although corporate tax liabilities don’t shift to owners if their corporation fails, the IRS considers trust fund taxes to be employees’ money held in trust by their employer, and actively seek out former employers to return those taxes to Social Security and Medicare coffers.
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