Does a trust beneficiary pay income taxes on Trust earnings?
When trust creator dies and the trust becomes irrevocable trust, it’s a separate taxpayer at that point and needs to file tax returns. You can bet that someone will be paying income taxes on trust earning, rights?
When the trustee makes a distribution, the trust can, and usually should deduct the income distributed on its own tax return and issue the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary’s distribution that’s interest income, as opposed to principal. With that information, the beneficiary knows how much she’s required to claim as taxable income when filing taxes.
Investopedia’s recent article on this subject asks, “Do Trust Beneficiaries Pay Taxes?” The article explains that when trust beneficiaries receive distributions from the trust’s principal balance, they don’t have to pay taxes on the distribution. The IRS assumes this money was already taxed before it was put into the trust. After the money is placed into the trust, the interest it accumulates is taxable as income, either to the beneficiary or to the trust. The trust is required to pay taxes on any interest income it holds and doesn’t distribute past year-end. Interest income the trust distributes is taxable to the beneficiary who gets it.
The money given to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is usually the original contribution with any subsequent deposits. It’s income in excess of the amount distributed. Capital gains from this amount may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary is taxable to her to the extent of the distribution deduction of the trust.
If the income or deduction is part of a change in the principal or part of the estate’s distributable income, then the income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in the distribution of amounts and retains earnings pays trust tax that is $3,011.50 plus 37% of the excess over $12,500.
The two critical IRS forms for trusts are the 1041 and the K-1. IRS Form 1041 is like a Form 1040. This is used to show that the trust is deducting any interest it distributes to beneficiaries from its own taxable income.
The trust will also issue a K-1. This IRS form details the distribution, or how much of the distributed money came from the principal and how much is from interest. The K-1 is the form that allows the beneficiary to see her tax liability from trust distributions.
The K-1 schedule for taxing distributed amounts is generated by the trust and given to the IRS. The IRS will deliver this schedule to the beneficiary so that she can pay the tax. The trust will fill out a Form 1041 to determine the income distribution deduction that’s conferred to the distributed amount.
Your CPA and estate planning attorney will be able to help you through the process of working out if the Trust beneficiary pays income taxes or the trust does.
Reference: Investopedia (July 15, 2019) “Do Trust Beneficiaries Pay Taxes?”