By Atty. Sam Collins
It is tax season and invariably alarm bells go off among tax preparers when they see trusts that are required to file IRS Form 1041. It is true that non-grantor trusts (sometimes called irrevocable trusts) hit the top income tax bracket much more quickly than an individual. In 2023, a trust hits the 37% tax bracket for all income earned above $14,450. A single individual does not hit the top bracket until $578,126; for married taxpayers filing jointly the top rate kicks in a $693,751.
This glaring disparity in the brackets is the source of a much unnecessary alarm. The sky is not falling. A trust gets a deduction for income that is distributed to a beneficiary within the first 65 days after the close of a tax year. When this happens, the trust does not pay the tax on the income—the beneficiary who received the money pays the tax, at the individual’s own tax rate. The simple act of distributing income to the beneficiary shifts the tax liability. The principal within the trust that generates the income for the beneficiary remains protected from perils like lawsuits, divorce, and catastrophic illnesses. A trust need not pay more taxes than an individual does. All is well.
Of course, when a trust distributes the income to the beneficiary, that income no longer has the advantages of the trust. This is just fine if the beneficiary needed the income for some reason—after all, it was likely spent. But if the beneficiary does not need the income, then all would be better served by leaving the income within the trust protections. Surely, that would cost higher taxes, right?
Not necessarily. For years now, we’ve drafted trusts with a grantor trust component—what we term a power to vest. For those with responsible beneficiaries—those whom you want to have maximum control over the inheritance—this power is incredible: it allows the beneficiary to leave most of the income in the trust, and still pay taxes at the beneficiaries’ own individual tax rate. Trust income below where it would hit the top income tax rate ($14,450 in 2023) still belongs to the trust—meaning that the trust can pay the taxes, or the individual if the income is distributed, or some combination thereof. This is the same general rule described above.
When the income hits the top rate, a beneficiary of a trust with a power to vest becomes the taxpayer and reports the income on his or her own 1040 even if the income was not distributed. By choosing to have the trust pay some of the taxes on the first $14,450, most beneficiaries can save some income taxes. For example, the first $2,900 of trust income is in the 10% bracket. If a beneficiary is in a tax bracket higher than 10%, there would be some tax savings by allowing the trust to pay 10% on that first $2,900. From $2,901 to $10,550, trust income is in the 24% bracket. If a beneficiary is in a higher personal bracket than 24%, there will be some tax savings leaving the first $10,550 in the trust. From $10,551 to $14,450 the trust is in the 35% bracket. If a beneficiary is not in the 35% bracket (and most are not, married filers do not hit the 35% bracket until $462,501 of income) then the trustee can distribute all the income between the 35% and the 37% bracket to the beneficiary and that income would be taxed at the beneficiary’s lower rate. All income over and above $12,950 is taxed to the beneficiary with no need to distribute it. Irrevocable trusts need not increase tax liability. If drafted accordingly, an irrevocable trust need not distribute its income to take advantage of the tax bracket of the beneficiary.
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