One questions that clients often ask is whether having a trust will impact the client’s taxes.  Obviously, with the tax law being what it is, this is not necessarily an easy question to address in a short blog post.  Nevertheless, there are certain principals that can help establish the lay of the land and give some basic guidelines on Taxation of Trusts.

In general there are two types of trusts for tax purposes, the “grantor-type” trust and the “non-grantor type” trust.

The term grantor trust describes a trust which is treated as “owned” by the person who made trust, also called the grantor or creator or trustor.  The rules for grantor trusts are contained in the Internal Revenue Cod sections 671 to 679.  The basic idea with grantor trusts is that the grantor will include the taxable income, deductions and credits in his or her own tax calculations.  The grantor will pay the tax on the trust’s income based on his or her own tax rates.  The owner will pay tax on the trust’s income and by the same token, if the trust has losses or deductions, they can be used by the owner as well.   In other words, there is no separate tax treatment of the income and losses in a grantor trust as in the individual who created the trust.

Whether a particular trust is a grantor type trust depends on the application of a number of factors contained in the Code, the subject of which can be addressed in a separate post.  For the time being, however, two of the most common trusts utilized in estate planning are grantor trusts, being the Medicaid Asset Protection Trust and the Revocable Living Trust.

A non-grantor type trust on the other hand is a separate entity for income tax purposes.  It pays taxes on income generated by assets in the trust based on a different tax rate schedule.  This schedule is highly compressed compared to the individual tax rate schedule.  For example, trusts (and estates for that matter) only need taxable income of $12,400 to reach the 39.6% tax bracket compared to an unmarried individual taxable income of $415,050 to reach this rate.  Income can be shifted in certain situations to the beneficiaries from a non-grantor trust thereby shifting the income taxation to the individual and the individual’s tax rates.  Otherwise, accumulated, non-distributed income will be potentially result in much more tax liability.

Which tax treatment will be a product of which type of trust, which in turn will be a product of the needs of a client’s overall plan.  Therefore, the best place to start is discussing the plan with a professional and no doubt the tax treatment will emerge as an important factor to consider in more depth.