INCOME TAXATION OF TRUSTS, ESTATES AND DECEDENTS

INCOME TAXATION OF TRUSTS, ESTATES AND DECEDENTS
Trusts and estates are separate, fiduciary entities for income tax purposes. The trustee or executor, known as the fiduciary, reports the income earned by the trust or estate on a fiduciary income tax return (Form 1041) and pays the tax due. A trust or estate can lower its tax liability by taking applicable deductions, credits, or exemptions. The trust or estate can pay the tax on the income or it can flow through the income to the beneficiaries. Special rules determine the allocation of the tax burden between the trust or estate and its beneficiaries. Distributable net income (DNI) is the rule that determines the amount and character of the income a trust or estate retains or distributes.
How Are Trusts and Estates Taxed for Income Tax Purposes
A trust is created when you (the grantor) transfer property to a trustee for the benefit of a third person (the beneficiary). An estate is the assets and liabilities left by a person at death. Both a trust and an estate are separate, legal, taxpaying entities, just like any individual. Income earned by the trust or estate property (e.g., rents collected from real estate) is income earned by the trust or estate.
Who is liable for taxes on income earned by a trust depends on who receives or retains benefits from the trust (i.e., the trust entity, the beneficiaries, the grantor, or the powerholder). Who is liable for taxes on income received by an estate depends on how the income is classified (i.e., income earned by the decedent, income earned by the estate, income in respect of the decedent, or income distributed to beneficiaries). In general, trusts and estates are taxed like individuals.
General tax principles that apply to individuals also apply to trusts and estates. A trust or estate may earn tax-exempt income and may deduct certain expenses. Each is allowed a small exemption ($300 for a simple trust, $100 for a complex trust, $600 for an estate). However, neither is allowed a standard deduction. The tax brackets for income taxable to a trust or estate are much more compressed and can result in higher taxes than for individuals.
Technical Note: Income tax returns for trusts and estates are known as fiduciary tax returns (Form 1041). That is because the fiduciary (the trustee or estate representative) is generally responsible for filing the return and paying any taxes owed. Trusts and estates may also be required to file a state income tax return. You should consult an attorney or accountant to determine the requirements for your state.
What Are The General Income Tax Rules for Trusts?
Generally, Income Is Taxable to Trust Entity or Trust Beneficiaries
Trust income retained by the trust is taxed to the trust, while distributed income is taxed to the beneficiary who receives it. Thus, trust income is taxable to the trust or to the beneficiary but not to both. This result is obtained though the use of the distributable net income (DNI) concept.
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