With the tax season fast approaching, you may have questions about how your trust is taxed, who is responsible for tax filings or how trust income taxes get paid. Here are some answers to the most common questions you may have to field about trust taxation.

Do all trusts pay income taxes?

It depends. A trust is a separate legal and taxable entity. Whether the trust pays its own taxes depends on whether the trust is a simple trust, a complex trust or a grantor trust. Simple trusts and complex trusts pay their own income taxes. Grantor trusts do NOT pay their own taxes—the grantor of the trust pays the taxes on a grantor trust’s income.

How do I know if a trust is a simple trust?

A simple trust is a trust that: a) requires all trust income to be distributed at least annually; b) has no charitable beneficiaries; and c) makes no distributions of trust principal.

If the trust does not meet the above definition of simple trust, it is usually either a complex trust or a grantor trust.

What is a grantor trust?

A grantor trust is a trust where the grantor is treated as the owner for income tax purposes only, by retaining certain powers over the trust assets as described in the trust agreement. Grantor trusts can either be revocable or irrevocable. Because of these grantor-retained powers, the grantor trust is ignored for income tax purposes. Some of these powers include:

  • Grantor or the grantor’s spouse retains the power to revoke or amend the trust (revocable trusts);
  • Grantor retains the power to substitute trust assets with assets of equal value;
  • Grantor retains power to borrow trust assets without adequate security;
  • Grantor or grantor’s spouse may receive distributions from the trust (spousal lifetime access trusts); or
  • Trust income may be used to pay premiums on life insurance policies on life of grantor or grantor’s spouse (irrevocable life insurance trusts).

Though there are other grantor-retained powers that make a trust a grantor trust, the above are the most common.

For income tax purposes, the grantor trust is treated as the same taxpayer as the grantor, even though the trust is a separate legal entity and separate legal owner of the trust’s assets. So, the trust’s income items are reported on the grantor’s personal income tax return and the grantor pays the taxes.

If the grantor does not retain any grantor trust powers, such as those listed above, and the trust is not a simple trust, it is a complex trust.

Does a trust file its own income tax return?

Yes, if the trust is a simple trust or complex trust, the trustee must file a tax return for the trust (IRS Form 1041) if the trust has any taxable income (gross income less deductions is greater than $0), or gross income of $600 or more.

For grantor trusts, it depends. A grantor trust may use the grantor’s Social Security number as its taxpayer identification number, or it may obtain its own taxpayer identification number from the IRS. If a grantor trust uses the grantor’s Social Security number as its taxpayer identification number, it does not need to file its own income tax return as all tax documents such as 1099s will be issued to the grantor directly to report on the grantor’s individual income tax return. However, if a grantor trust has its own taxpayer identification number, it may have to file its own tax return for informational purposes only. The pro forma tax return identifies the trust as a grantor trust and includes a grantor trust letter that lists all income items that should be reported on the grantor’s individual income tax return, so that the grantor can pay the taxes.

If the trust is its own taxpayer, does the trust also have to file a state income tax return and pay state income taxes as well?

Yes, if a state has tax jurisdiction over the trust, the trust will have to file a state income tax return and pay state income taxes in that state. Each state has its own rules regarding whether it has tax jurisdiction over a trust. Some states such as New York may tax a trust if the grantor resided in New York when the trust was funded, unless there are no New York trustees, no New York situs trust assets and no New York source income. Other states like California may tax a trust if one of the trustees or beneficiaries is a California resident. Because each state has different rules for imposing income taxes on trusts, it is possible for a trust’s income to be taxable in multiple states. However, if you know these rules, you can reveal opportunities to reduce or eliminate a trust’s state tax liability. For example, if the grantor resided in New York when the simple or complex trust was funded, New York state tax liability may be eliminated by replacing a New York trustee with a trustee who is not a New York resident, as long as the trust has no New York situs assets or New York source income.

For a trust that pays its own income taxes, what deductions can the trust claim?

The usual deductions a simple or complex trust can claim on its tax return are for state tax paid, trustee fees, tax return preparer fees and the income distribution deduction. Because a grantor trust is not considered a separate taxpayer, it cannot claim its own deductions.

Trustee Fees and Tax Return Preparer Fees

For trust expenses such as trustee fees and tax return preparer fees, only the portion attributable to taxable income is deductible. For example, if the trust’s income consists of $10,000 in dividends and $5,000 in tax-exempt interest, only two-thirds of the trustee fees and tax return preparer fees are deductible.

Income Distribution Deduction

To determine the trust’s income distribution deduction, you must first calculate the trust’s distributable net income (DNI). DNI is defined by the Internal Revenue Code—generally, it is equal to total trust income (including tax-exempt interest but excluding capital gains or losses), less deductions such as state tax paid, trustee fees and tax return preparer fees.

If the trust’s total distributions to beneficiaries is greater than DNI, the income distribution deduction = DNI – tax-exempt interest.

If the trust’s total distributions to beneficiaries is less than DNI, the income distribution deduction = total distributions – (Total distributions × tax-exempt interest/DNI).

If the trust claims an income distribution deduction on its tax return, the amount deducted gets passed to the trust beneficiary on a Schedule K-1, and the trust beneficiary must report the Schedule K-1 income items on his or her own personal income tax return.

How do a trust’s income tax rates compare with an individual’s income tax rates?

For the 2020 tax year, a simple or complex trust’s income is taxed at bracket rates of 10%, 24%, 35% and 37%, with income exceeding $12,950 taxed at that 37% rate. By comparison, a single person’s income is taxed at bracket rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%, with income exceeding $518,401 taxed at that 37% rate. Because the trust’s tax brackets are much more compressed, trusts pay more taxes than individual taxpayers. Below are the 2020 tax brackets for trusts that pay their own taxes:

  • $0 to $2,600 in income: 10% of taxable income
  • $2,601 to $9,450 in income: $260 plus 24% of the amount over $2,600
  • $9,451 to $12,950 in income: $1,904 plus 35% of the amount over $9,450
  • Over $12,950 in income: $3,129 plus 37% of the amount over $12,950

What is the 65-day rule?

Under the 65-day rule, a trustee can make distributions to trust beneficiaries within 65 days after year-end and treat those distributions as if they were made in the previous tax year. The deadline for the distribution is March 6 (March 5 in a leap year). An irrevocable election must be made on the trust’s income tax return to treat the distributions made within the 65-day window as made in the prior tax year. For tax year 2020, if trustees make distributions to trust beneficiaries before March 6, 2021, they can elect to treat those distributions as 2020 tax year distributions. The trustee would claim an income distribution deduction for these “65-day rule” distributions on the trust’s 2020 tax return and shift some of the trust’s 2020 income tax burden to the trust beneficiaries, who would be taxed at lower rates than the trust. Trustees may take advantage of the “65-day rule” when the trust’s distributions to beneficiaries during the calendar year are less than the trust’s DNI for that year. If that is the case, the trustee may make “65-day rule” distributions up to the trust’s DNI to maximize the trust’s income distribution deduction and shift the tax liability on those distributions to the beneficiaries.

 

US Economy

 

  • The Dallas Fed manufacturing report (the last of the regional surveys for the month) further validated continued strength in the nation’s factory activity.
  • The index of capacity utilization hit a record high.
  • And workers’ weekly hours climbed sharply.
  • Supplier delivery times spiked (a global trend).
  • But manufacturers expect these supply-chain bottlenecks to ease over the next few months.
  • Prices increases are accelerating.
  • The spread between indices of prices paid and prices charged keeps widening. Without further boosting output prices, some manufacturers could face margin pressures.
  • Based on historical data, the yield curve slope suggests that US manufacturing activity will peak this summer.
  • The “effective” unemployment rate is substantially higher than the headline figures.
  • BofA expects US labor force participation to return to pre-COVID levels by the end of next year.
  • Airport travel hit the highest level in a year.
  • Hotel occupancy is returning to normalcy.
  • There should be a similar rebound in restaurant hiring.
  • Job postings on Indeed point to rising demand for workers.
  • US bank deposits hit another record high.
  • The Conference Board’s consumer confidence index surged in March, topping forecasts.
  • The Dallas Fed’s regional nonmanufacturing reports showed accelerating growth.
  • Only four FOMC members expect a rate hike (liftoff) next year. However, the market continues to assign close to an 80% probability of liftoff in 2022. It’s important to note that the Fed will not raise rates while conducting QE. It means that the central bank will need to announce tapering as soon as late this year to gradually reduce securities purchases. Given the Fed officials’ statements, that seems unlikely. There is a clear disconnect between the markets and the Fed’s communications.
  • Refi mortgage applications are down as rates climb.
  • Combined with the vaccine progress, the nation’s economic outperformance is boosting the US dollar.
  • The ADP private payrolls report was roughly in line with expectations.
  • The Chicago PMI index surprised to the upside, suggesting that manufacturing activity at the national level (ISM) will show further gains.
  • The US economy is heating up as the job market strengthens. The March headline payrolls report topped economists’ forecast.
  • While hiring was robust last month, it should be noted that the upside surprise was mostly due to seasonal adjustments – see the comment from Mizuho Securities below.

 

 

  • There is still plenty of room for job gains ahead before we reach the pre-COVID trend.

 

 

  • Long-term unemployment keeps climbing.

 

 

  • The market is now pricing a 50%+ chance of two rate hikes next year. This is entirely inconsistent with the FOMC’s forecasts and Powell’s statements.

 

 

COVID Update

 

COVID-19 vaccinations are now an economic indicator. We showed you an earlier version of this chart three weeks ago. It tracks when a given percentage of the US population will have received at least one vaccine dose, assuming progress continues at the current 7-day average. Back then, US vaccine uptake was projected to reach 50% on May 29, 70% on July 19, and 90% on September 8. But the pace has quickened considerably, moving the target dates forward several weeks.

 

 

Of course, there is no assurance the pace will continue and some reason to think it will slow. States have moved through the easily reached population segments. But increasing supplies should also reduce waiting time and make the process more convenient. Note: The chart percentages are of the entire US population, including children. The numbers as a percentage of the adult population would be higher.

Vaccinations clearly help but the relief looks neither perfect nor immediate. This chart shows daily per capita new cases in some of the fast-vaccinating larger countries. New cases are actually rising in Bahrain, Chile, the United Arab Emirates, and the US. The UK improved considerably but is flattening. Only Israel, where almost the whole population has at least one dose, shows steady improvement.

 

 

At the same time, these cases may be less alarming than the numbers imply. Between vaccinations and better treatments, the risk of hospital overload is falling. This should reduce pressure to impose economically problematic mitigation measures. But it still won’t be good and may affect consumer confidence until others reach Israel’s level.

We know the pandemic was a dagger in the travel industry’s heart. This FRED graph is interesting for a couple of reasons. First, we see air and rail travel fell a lot more than vehicle miles. But second, all three modes seem to have slowed their improvement in early 2021.

 

 

We should know in the next few weeks whether confidence is returning enough to make a difference. Anecdotally, we know many people are planning summer vacations on the assumption they will be safe and enjoyable. Let’s hope they are right on both.

 

 

 

Debt

 

People disagree on whether the latest pandemic relief/stimulus act was needed, but everyone admits it will add to the national debt. How much? This chart shows the effect, comparing debt with the new legislation to the prior baseline. Visually, the difference as percentage of GDP doesn’t look so great, just 7 percentage points 10 years out. But in nominal dollars, the 2031 debt will be $2.1 trillion higher, according to CRFB’s estimate. The fact that such a huge number can look insignificant is notable in itself.

 

 

Personal Debt Trap/Cycle

 

(This article was written NOT for any of our DRP clients.  It is to have on hand for any of your children or loved ones who fall victim to the debt cycle.)

To understand the nature of personal debt, it is important to understand the debt cycle.  The debt cycle starts when you begin to spend more than you earn.  You know it’s wrong, but you do it anyway, telling yourself, “It’s just this once,” and “I’ll pay it back next month.”

When you are not living within your means, you must borrow to maintain your standard of living.  At first, this may mean adding a little more debt to your credit card because it is easily accessible.  Although you intend to pay this debt off soon, you may find yourself continuing to spend more than you earn in order to support your lifestyle.  Soon you may find that you have borrowed to the available limit on your credit card, so you get a second credit card, and your spending continues.  You dig yourself deeper and deeper into debt each month.

The situation keeps growing worse.  You obtain more credit cards, and soon you may find that you have as many as five – all of them used to their maximum limit.  You may be able to get another card, but the interest rate is now over 20%.  Interest costs on your cards are high too, and now you are only paying minimum balances on all cards.  With so much of your income going toward interest costs, you find yourself limited financially and unable to maintain your current standard of living.

This debt cycle can only continue for so long.  Eventually you cannot get any more credit, and the interest alone becomes more than you can pay each month.  You have lost your money, your sense of self-worth and your good credit history.

Some people are already so deep in debt that it will take a long time for them to get back out; others are just beginning the cycle.

Knowing how the debt cycle works may help recognize it…hopefully early enough to stop it before it destroys the victim.

 

Thought of the Week

 

“Those are my principles, and if you don’t like them, well, I have others.”
― Groucho Marx

 

Picture of the Week

 

 

 

All content is the opinion of Brian J. Decker