Trust Taxation Basics
Trusts earn income in the same way that individuals do, and it’s for this reason that the IRS treats most trusts as separate taxpayers—distinct from their trustees, beneficiaries and grantors. This means that regardless of whether the trust earns income from investments, rental real estate or from interest on the funds in a bank account, either the trust or the beneficiary must pay the income tax on it. However, making this determination depends on whether the terms of the trust require all income to be distributed or allocated to beneficiaries or to accumulate within the trust. As the trustee, you always have an obligation to file an income tax return for the trust on Form 1041 if it earns more than a few hundred dollars of income.
When to Issue K-1s
In addition to preparing the trust tax return, you must report the amount of “distributable net income”—which is the amount of trust income taxable to the beneficiaries—on a separate K-1 for each beneficiary. If K-1s are necessary, you must attach all of them to the 1041 and also provide each beneficiary with a copy by the due date of the trust tax return. The K-1 reports each beneficiary’s share of trust income, deductions and credits that he must report on a personal tax return. Moreover, these K-1s also provide the beneficiary with information on the tax treatment of the amounts you report on it, such as when part of the trust’s earnings constitute capital gains rather than ordinary income.
K-1 Reporting Penalties
When you fail to issue a K-1 to a beneficiary, not only does it prevent the beneficiaries from filing a complete and accurate tax return, but the IRS will also impose a $50 penalty on you for each one you fail to issue by the 1041 filing deadline. However, if you’re the trustee of a trust with a substantial number of beneficiaries, the maximum penalty can be as high as $100,000 for all K-1s you fail to issue in a calendar year. But if your failure to issue the K-1s is intentional rather than an oversight, the penalty increases to the greater of $100 for each K-1 or 10 percent of the aggregate amount of net income that you fail to report on them.
Issuing K-1s Late
The IRS will waive the penalty if you can show there is reasonable cause for failing to issue the K-1s. However, if you attempt to avoid the penalty under the reasonable cause exception, you should issue the K-1s as soon as possible. Moreover, it’s important to remember that the trust’s beneficiaries need this information before their personal tax returns are due; otherwise, they may incur unnecessary penalties and interest if they underreport their income.