When you set up a trust as part of your comprehensive estate plan, it is important to know how this will figure into your income tax filings. All trusts become separate legal entities upon creation. Therefore, depending on the type of trust you create, you may need to file a separate tax return for the trust itself.
Revocable trusts have the advantage of being a simpler solution as far as income tax filing goes. Any income generated by the revocable trust is taxable to the grantor (i.e. creator of the trust) during that grantor’s lifetime. Since the grantor retains full control over the terms of the trust and the assets within the trust, taxing authorities simply require all items of income, deductions and credits to be reported on the grantor’s personal income tax return. No tax return needs to be filed separately for the trust itself.
This is not the case for all irrevocable trusts. Since the grantor does not have authority over the terms of the trust or the assets, it is viewed differently. First, it must be determined for taxing purposes whether the irrevocable trust is considered a grantor trust or a non-grantor trust.
If the trust is considered a grantor trust for income tax purposes, the income and any deductions or credits will not be taxed at the trust level but rather reported on the personal income tax return of the grantor like a revocable trust. The grantor is the individual who contributed the funds to the trust not necessarily the person who signs the trust as the creator. This distinction matters because there may be a first-party grantor trust or a third-party grantor trust. Generally, all first-party trusts are considered grantor trusts for income tax purposes.
Third-party trusts may also be created as grantor trusts if the creator of the third-party trust wants to continue making income tax payments during his or her lifetime. The grantor may retain those rights and be treated as a grantor trust for income tax purposes. At the time the grantor passes away the trust income will no longer be taxable to the grantor and the trust will no longer be considered a grantor trust.
When a trust does not qualify as a grantor trust for income tax purposes it falls into the other category which is the non-grantor trust. Taxation of non-grantor trusts becomes more complicated. An irrevocable, non-grantor trust requires its own separate tax identification number so that the IRS and the state of Maryland have a record that the trust exists. Income from the trust is reported using IRS Form 1041.
The following trusts are required to file IRS Form 1041 for the 2020 tax year:
The Tax Cuts and Jobs Act (TCJA) changed income tax brackets across the board when it went into effect in January 2018, including those assigned to estate and trust income.
The latest 2020 federal trust tax rates and brackets are:
In addition to federal taxes, a trust created and earning income in the state of Maryland may be subject to state income taxes. The Maryland Comptroller looks at whether the grantor was domiciled in Maryland at the time the trust was created, whether the trust is governed by the law of Maryland according to its terms, and whether the trustee and/or beneficiaries are Maryland residents.
Understanding the taxation implications of trusts helps clients make the right choices upon creating these trust documents. We help to minimize the taxes paid and the administration hassles involved with filing. For more information on trust taxation and trust creation, contact the experienced estate and trust planning attorneys at Stouffer Legal in the Greater Baltimore area. You can schedule an appointment by calling us at (443) 470-3599 or emailing us at office@stoufflerlegal.com.
