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USA TAXATION OF TRUSTS

Published: 27 January 2022

I.   INTRODUCTION TO TRUST TAXATION  

The purpose of this alert is to provide a basic overview of the federal taxation of trusts. A trust is a legal arrangement in the United States where a grantor (the person creating the trust) gives legal title to property of the grantor to a trustee for the benefit of someone (the beneficiary).  Usually, this means that a parent will provide the property they have accumulated over the course of their life to a trustee for the benefit of their children and grandchildren.


II.   TYPES OF TRUSTS FOR TAX PURPOSES

A trust has two general formats.  First, a trust may be revocable, which essentially means that the trust provisions or the trust itself may be altered or canceled.  A trust formed in Texas is presumed revocable unless it is explicitly stated in the trust agreement that it is irrevocable.  As a contrast to a revocable trust, the second type of trust is an irrevocable trust. A revocable trust is disregarded  for tax purposes and all income is taxed to the grantor, whereas an irrevocable is a taxable entity as explained below.  Another ‘type’ of trust is a ‘grantor’ trust, in which the grantor of the trust is taxed on the income of the trust himself due to retained control over the trust instrument.

 

III.   SEPARATE TAX ENTITY   

An irrevocable trust is treated as a separate taxable entity for the purposes of tax law and its entire income is taxable to either the trust itself, the beneficiaries or both.  Beneficiaries of the trust are generally taxed on the part of the income that is currently distributed in the same year and the trust is taxed on the portions of income that remain with the trust (the portion that is not distributed to the beneficiaries).  For example, a trust with $200 of taxable income that distributed $100 to the beneficiary of the trust and accumulated $100 would have $100 of that income taxed to both parties.  Generally, a trust is taxed in the same manner as an individual, as trusts are eligible for deductions and exemptions.  However, trusts as entities have high tax rates as for year 2021 the highest tax bracket for trusts is $3,129 plus 37 percent over the amount of taxable income over $12,950.  Small amounts of money which is left in the trust to accumulate can cause serious financial harm to the unaware.  Therefore, it is necessary to engage in effective tax planning for our clients with trusts.

 

IV.   TRUST AGREEMENTS

Trusts are in a way much like contracts.  To a large extent, trusts are governed by the terms of the trust agreements and any gaps in those trust agreements are filled by Texas trust law.  This is important because this means that the parties to the trust make the ‘rules of the road’.  If a party wants to have only certain distributions to certain persons, or only have certain types of property in trust while choosing to retaining others, this is all up to the Grantor of the trust. 

 

V.   TAX COMPLIANCE WITH A TRUST

Domestic trusts file their tax returns with a Form 1041, while foreign trusts may file their tax returns on a 1040-NR.  Gifts towards a foreign trust with United States beneficiaries or a foreign grantor trust may require the filing of a Form 3520.

 

VI.   PARTIES TO A TRUST

There are several legal parties to a trust, some of which can be the same people or entities and some of which must be different people or entities.  The three most important and fundamental persons to a trust are the grantor, the beneficiary and the trustee.  Other parties that can be a part of trusts are trust protectors and committees.

A.  Grantor:  The Grantor is the person which is the original holder of the property who transfers legal title over to the property to the trustee.

B.  Trustee:  The Trustee is the party which holds legal title to the property transferred into trust for the benefit of the trustee.  The Trustee has several powers which generally include the ability to manage trust property or businesses, make investment decisions regarding the trusts

C.   Beneficiary:  The Beneficiary is the party which is the most easily recognizable.  It is the party that receives the benefits placed into the trust by the Grantor.

D.  Trust Protector:  The Trust Protector is a backstop against Trustee overreach or underreach in providing for the Beneficiaries as the Grantor sees fit.  The Trust Protector usually has the power to make distributions, remove Beneficiaries, or decant the trust.

E.  Committees:  Another type of party that generally a Grantor can create is the Committee on a trust.  The two main types of Committees on a trust are the Distribution Committee and the Investment Committee.  Distribution Committees can have the Trustees make distributions out of principal or income in the trust property.  Investment Committees can act as oversights as to how the trust property is being invested in order to obtain the biggest gains.  Other types of trust committees can be made as well, including administrative committees. 

 

VII.   CONCLUSION

As always, thank you so much for being a client of the Flores Group, Attorneys & Advisors, PLLC.  If you desire to have more information on the changes to trust law or trusts themselves, or if you desire to make changes to your estate planning situation, feel free to call our office and schedule an appointment.

                                                                       

Should you need additional information it will be our pleasure to assist you.


Sincerely,

Ruben Flores, Attorney & CPA

 

As requirement of the United States Treasury Regulations, you should be conscious of the fact that this notice has not been written to be used and it should not be used by the recipient to prevent penalties that could be imposed by U.S. Federal Law.

 

Ruben Flores
FGA Attorneys & Advisors
Country:
Texas, USA
Practice Area:
Corporate
Phone Number:
(210) 340-3800
Fax:
(210) 340-5200
FGA Attorneys & Advisors is dedicated to providing comprehensive corporate, tax, and immigration services to individuals and companies doing business in the U.S. and Mexico. Our firm is able to meet the diverse legal and tax needs of local, national, and international clients because we have an experienced team of attorneys and advisors with extensive experience in corporate, tax law, and cross border transactions. We are an international oriented firm with multilingual capabilites including English, Spanish, and Italian.

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