Income Tax
Accounting for Trusts
Allocating Income
Between Beneficiaries and the Trust Greatly Affects Taxes
Estates
and nongrantor trusts must file income tax returns.
There are many similarities between 1041 trust returns and 1040
Individual Tax Returns. Nevertheless, there are some
important differences.
FIrst, Trust
Income taxed at either the Trust
or Beneficiary
level. This is determined by whether trust reciepts are allocated to principal or
to distributable
income, and whether it is distributed
to the
beneficiaries.
Secondly, because
the exemption amounts, tax brackets and related thresholdsfor Trusts
are not indexed for inflation like the rates for individuals have,
Trust Income pays a higher tax rate at lower levels of
incomeFurther, the Obama Medicare tax on investment income on the
highest tax brackets, estates and trusts pay still more taxes on
incomes over $11,200, as opposed to $200,000 or $250,000 for
individuals.
FIDUCIARY
ACCOUNTING AND INCOME TAXES
Income of estates
and nongrantor
trusts is taxed at either the entity
or the beneficiary
level, depending on the
answer to the following two questions:
- Is each income,
loss or deduction item part of the trust’s or
estate’s distributable income, or is it part of a change in
the principal?
- Is the income,
loss or deduction item distributed to the beneficiaries, or does the
entity retain it?
Fiduciary
accountingt deals with a fund (the trust principal) and income derived
from the fund.
Practical Result
of Trust Income
Trusts
will reach the top marginal tax rate faster than individuals because of
the tax schedule (in 2010, the top marginal tax rate for trusts starts
at $11,200). Therefore it is
beneficial
to allocate as much depreciation as possible to the trust..
It is also
beneficial to distribute the income to the beneficiaries.
This can be done by your Estate Tax Attorney specifying the allocation
in the trust instrument
Distribution to
Beneficiaries.
To prevent double
taxation on their income, estates and trusts are allowed to deduct the
lesser of distributable net income (DNI) or the sum of the trust income
required to be distributed and other amounts “properly paid
or credited or required to be distributed” to the
beneficiaries (IRC § 661(a)). This includes distributions that
can be made out of either income or trust principal to the extent they
are made from trust income. Therefore,
the income
distibuted to the beneficiaries is usually taxed at a lower rate than
the Trust.
Tax Free Income
Because
the tax rates of estates and trusts are likely higher than the tax
rates of the individual beneficiaries, it is best to retain the tax-exempt
income in the Trust and distribute taxable income to the
Beneficiaries..
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