Taxation of Family Trusts
Original post by Constitution Guru of Demand Media
A family trust is a specific type of estate planning document that creates a formal legal relationship for holding and sharing property among various family members. The various beneficiaries of the trust are family members that each have a right to the money, property and distribution from the trust. Each of those beneficiaries will also share in the tax burdens, or benefits, imposed on the family trust and the trust property.
The federal government collects income tax on trusts or, more appropriately, on income-producing property held by the trust. A trust can be set up as an independent tax entity, which means the trust itself pays all income taxes before making any distributions to the beneficiaries. Alternatively, the family trust can be set up as a pass-through entity for taxing purposes, which means each beneficiary pays a proportionate share of the trust income taxes. By far, the large majority of family trusts are set up as pass-through entities where each beneficiary accounts for her portion of the trust income. In a pass-through entity, the tax benefits and burdens of the trust are shown on a Schedule K-1, which is a specific tax form prepared by the trustee.
State Income Tax
State income taxes work similar to federal income taxes, in those states that actually impose and collect income tax. State income tax liability can occur at the trust level or can be distributed proportionately to the interest of each beneficiary. Again, the large majority of family trusts follow the taxation of beneficiary model, rather than the trust-as-a-separate-entity model.
A family trust can be either revocable or irrevocable, depending on the intent of the grantor at the time of creating the family trust. When a grantor creates an irrevocable family trust, the grantor may have to pay real estate transfer taxes on property conveyed into the trust. Not all states impose a real estate transfer tax, but some do. However, when a grantor creates a revocable trust, the grantor does not have to pay a state transfer tax. Property held in a revocable family trust is considered property of the grantor until the grantor's death, which means a transfer of property to a revocable family trust is not a full legal transfer of the property from the grantor.
Federal Estate Tax
As of publication, the federal government collects an estate tax on family trusts with a total property value of more than $5 million at the time of the grantor's death. The trustee of the family trust will pay the estate tax before making any property distributions to the various beneficiaries. The individual beneficiaries do not pay any federal estate tax, but some states impose an inheritance tax on the recipient beneficiary. This means the trustee may pay the federal estate tax, then distribute the trust property to the family beneficiaries, and then the beneficiaries may have to pay an additional state inheritance tax. This can result in double taxation on distributions from a family trust after a grantor's death.
- "Estate Planning Basics"; Denis Clifford; 2011
About the Author
The Constitution Guru has worked as a writer and editor for "BYU Law Review" and "BYU Journal of Public Law." He is an experienced attorney with a law degree and a B.A. degree in history with an emphasis on U.S. Constitutional history, both earned at Brigham Young University.
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