Tax Treatment of Living Trust Distributions

By Jeff Franco J.D./M.A./M.B.A.

When a grantor transfers assets to a trust during his lifetime, rather than having the trust take effect at death by operation of a will, the IRS treats it as a living trust. The tax treatment of distributions from any trust to its beneficiaries is the same, regardless of whether the trust is effective before or after the grantor’s death. The factors that determine who is responsible for paying the taxes on trust income depends on the stipulations of the trust document and whether the grantor retains the right to revoke it.

Trust Income Taxation

Once a grantor transfers assets to a living trust, any income accrued to the principal is taxable. The trust must report all trust income on Form 1041 (trust tax return); however, this does not necessarily mean the trust is liable for paying the income tax. When the trust document requires the trustee to distribute trust income to the beneficiaries, the beneficiaries are responsible for all tax payments on those distributions. If the trustee has discretion as to the timing and amount of income distributions, then the trust is responsible for the tax payments, irrespective of how and when the trustee decides to distribute the income.

Capital Gains vs Ordinary Income

The tax treatment of required trust income distributions to beneficiairies depends on whether the distribution includes capital gains or ordinary income. To illustrate, assume the grantor transfers a portfolio of corporate bonds to the trust and requires that beneficiaries receive immediate distributions of all interest payments and gains on the sale of any bonds. In this scenario, distributions of bond interest are subject to the beneficiaries’ ordinary income tax rates. However, if the trustee sells the bonds at a profit, all gain distributions are taxable to the beneficiaries as capital gains.

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Distributions of Principal

At some point, the terms of the living trust may require the trustee to distribute all or some of the trust assets, also known as the principal, to beneficiaries. Since the trust principal and any income remaining in the trust for prior years was already taxed, beneficiaries will receive these distributions tax free. However, if the trustee has the authority to retain trust income, meaning the trust document doesn’t require its distribution to beneficiaries, the trust is responsible for paying the tax on the income in the year it accrued even if the income is earned and distributed in the same year.

Revocable Living Trusts

The IRS imposes special rules on the grantor of a living trust if he retains the authority to revoke the trust. In this case, the IRS still requires the filing of a 1041 on behalf of the trust, but the grantor is personally responsible for reporting the trust income on a personal tax return and paying the appropriate tax. Therefore, regardless of whether the trust distributes all income to beneficiaries, the grantor and not the beneficiaries, is responsible for the tax.

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What Happens When a Beneficiary of an Irrevocable Trust Receives Money?

References

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