Having a little working knowledge about how trusts are taxed can help you plan for your person with special needs. It will also help you work more effectively with your accountant, attorney, and trustees.
First, it’s important to realize that most trusts are separate entities and may be subject to state and federal income taxes. This applies to trusts established by family members and trusts that hold the personal assets of a disabled person. The rules can be very different for everyone.
TRUSTS HAVE RETURNS AND DEDUCTIONS
The IRS gives taxable trusts a $600 deduction. If a trust fund is small enough, I often advise clients to keep interest income below $600 per year to avoid having to file a trust tax return. The beneficiary may still have to file their own return. The IRS calls the trust tax return a “pass-through” return since most of the income, taxes, and deductions are “passed through” to the beneficiary. The return is filed with the IRS on Form 1041. Trusts are taxed in a calendar year ending December 31.
TRUST PAYMENTS AVOID THE TRUST TAX
Trusts generally get an income tax deduction for all money they distribute to a beneficiary or pay for the beneficiary’s treatment, support, or needs. Frankly, this is how good trustees should use a special needs person’s money. The trust deducts the part of your income that you pay. Principal that is spent or paid is generally not taxable to the trust or beneficiary.
Looking at a simple example is often helpful. If a trust has $100,000 of principal and simply deposits the money in a bank account and earns no interest or income, the trust does not have to pay any income tax or file a return. If the trustees distribute a portion of that account, say $30,000 for the beneficiary’s medical needs, the principal distribution is not taxable income to the beneficiary.
TRY TAX FREE TRUST ASSETS
Income received by a trust from investing in a tax-free source maintains its “character” and is tax-free to the beneficiary when spent for needs. Knowing this, we often advise clients to put some or all of the beneficiary’s funds into tax-free municipal bonds.
WATCH THE END OF THE YEAR AND PLAN AHEAD
The second great rule of thumb is that many but not all of the deductions that are available to individuals may also be available to trusts. However, the trust tax rate on income a Trust does not pay to obtain a beneficiary is much higher than the individual tax rate your special someone will pay. To avoid this, it often makes sense to plan ahead and spend all trust income by December 31 of each year. Currently, trusts pay a 38% federal tax on income that the trust accumulates and does not spend on behalf of a beneficiary. Your state income tax may increase this burden.
HELP PREPAY TAXES
It is important to know that trust income spent for a beneficiary is likely to be subject to tax on the beneficiary’s personal return. The trust can make estimated income tax deposits on Form ES1040 and pass the benefit of those advance income tax payments to your beneficiary. This can cover any tax liability your beneficiary may owe due to trust income. It can help alleviate worries, properly prepaying the tax liability and paying taxes caused by trust income is almost always a legitimate expense of the trust.
DOUBLE DEDUCTION
Congress added a special provision to the tax code for qualified disability trusts. It is found in section 642 and can be useful for a D4a trust as long as the trust is not a “grantor” trust. It effectively doubles the $3,300 personal deduction by giving the trust the benefit of a personal deduction and allowing the beneficiary to maintain a similar personal deduction. In practice, this is difficult for most larger trusts to achieve, but it is worth exploring. You should ask your accountant if it can work for your family.
HAVE THE CONFIDENCE HIRE AN ASSISTANT
A trust can pay employees on behalf of your special needs beneficiary. Don’t forget that workers’ compensation insurance is required. FUTA withholding is required if an employee is paid more than $1,000 in a quarter. Social Security must be withheld and paid if an employee is paid more than $1,500 in a calendar year. Filing a 1099 is generally required when a trust makes payments to vendors that exceed $600.00.
This article just shares a little bit of information about some of the general rules of the trust tax. There are places you can start looking for tax breaks by working with your accountant, trustees, and attorneys. Please note that trusts are subject to the alternative minimum contribution, estimated withholding, capital gains taxes, depreciation, and carry-over and carry-loss regulations. It is important that your professionals always check the current code sections as they apply to your family’s specific situation. Of course, you should also check your state’s specific tax regulations.
