There are two main types of trusts that most people use, and each is taxed differently: revocable trust and irrevocable trust.
Revocable Trust Taxation
When you have a revocable trust, you are the grantor and the primary beneficiary. You have complete control over the assets owned by the trust. Because of it, the IRS treats the revocable trust as a pass-through entity, meaning you are personally responsible for the trust's gains and losses.
Any income earned by the trust will be reported on your personal tax return and taxed at your individual ordinary income or capital gains tax rate. Allowed losses will be deducted on your personal return to lower your tax liability. You will not need to file Form 1041 for the trust.
Irrevocable Trust Taxation
With an irrevocable trust, you are the grantor but not the beneficiary. You give up control of all assets transferred from yourself to the trust. You cannot amend or revoke the trust. If you do name yourself as a beneficiary, the trust will automatically be considered revocable even if you labeled it as irrevocable.
Irrevocable trusts are treated as entities separate from the grantor, subject to their own taxation. Trusts are taxed at a much higher tax rate than most individuals. In 2022, a trust's ordinary income will be taxed as follows:
10%: $0 – $2,750
24%: $2,751 – $9,850
35%: $9,851 – $13,450
37%: $13,451 and higher
A trust's capital gains will be taxed as follows:
0%: $0 – $2,800
15%: $2,801 – $13,700
20%: $13,701 and higher
An irrevocable trust must file Form 1041 and pay tax each year it has $600 or more in income.
When a grantor of a revocable trust dies, the trust becomes irrevocable.
Taxable Income
Both revocable and irrevocable trusts are taxed on the income they generate. The transfer of property from a grantor to the trust or from the trust to beneficiaries is not taxable. This includes the transfer of income.
For example: transferring a home from the grantor to the trust is not taxable; the trust renting that home and generating rental income that is not distributed is taxable.
Irrevocable trusts may reduce their tax liability by distributing income to beneficiaries before the end of the tax year. When income is distributed, the trust can deduct the distribution, lowering its tax liability, making the beneficiary responsible for paying tax on the income at the beneficiary's individual ordinary income or capital gains tax rate.
However, not all irrevocable trusts are allowed to distribute some or all of its yearly income. Read the trust document carefully to know if such distributions are allowed and consider the benefits vs losses of income distribution in any given year.
Have a trust but not sure how to properly report and pay tax on trust income? Need help planning trust transfers and distributions? Reach out! We're happy to help.