As you've no doubt figured out by now, putting money into a trust doesn't mean that you don't pay any tax on the income. Quite the contrary — all taxable income earned by a trust, in whatever form, is subject to applicable federal, state, and local income taxes. What you have to figure out is who pays the tax, how much has to be paid, and what you can do to make the taxes as minimal as possible.
Figuring Out Who Foots The Bill
What makes trust taxation interesting is figuring out who gets to pay the tax. If the trust is a revocable trust, or otherwise falls within the grantor rules (where the grantor retains at least some of the benefit of the assets inside the trust), the grantor includes the income on his income tax return and pays the tax. In certain situations, the trust may need to file its own income tax return, but in such cases, it shows only that the income will be reported on the grantor's return.
For all other trusts, the rules are more complex. Irrevocable trusts, such as Crummey trusts, Section 2053 (c) or (b) trusts for minors, and testamentary trusts, must file their own income tax returns. For trusts that make no distributions to beneficiaries, the tax return preparation is roughly the same as it is for an individual.
If a trust makes distributions to a beneficiary during the year, though, things change. A trust is an entity that the IRS refers to as flow-through or pass-through. Just as the income comes into the trust (in the form of interest, dividends, rents, business earnings) and then flows out of the trust to the beneficiary in the same form, the income tax liability that travels with the income flows into the trust and out to the beneficiary, who then has the responsibility to pay the tax. In every year in which a distribution is made, the trustee must provide to the trust beneficiary a copy of Schedule K-1 from the trust's income tax return, which provides the beneficiary with the breakdown into the various types of income he received during the year.
Kiddie Tax: Making The Children pay
If you fund a trust for a minor child and you determine that he should receive a distribution from the trust, if he is under age 18, the trust distribution may trigger the kiddie tax.
The kiddie tax was inaugurated in 1986 as a way to prevent high-income taxpayers from shifting their income to their children, who were presumably in a lower tax bracket. The rules and forms are somewhat complicated, but the net result is this: Effective 2008, a child under age 18 who has investment income in excess of a base amount, which is looked at annually and adjusted periodically ($6,400 in 2008) will pay tax on the excess amount at his parents' highest bracket. In other words, if in 2008 you paid in a 35 percent tax bracket, your child also paid at that rate for all investment income over $6,400.
Unless you're making trust distributions to a young child, the "kiddie tax" shouldn't be a cause for concern for you. Because you've probably created the trust to deal with future college expenses, you probably don't need to fret over this particular provision unless you're living with Einstein reincarnated, who'll be starting college when he's twelve.
Running Through The Trust Tax Brackets
Although most trust tax laws do follow the individual tax rules very closely, there is one place with a huge discrepancy: where the tax bracket changes occur. Trusts aren't a very popular area with the IRS, and Congress generally considers trusts fair game when trying to balance its checkbook — after all, trusts don't vote.
Accordingly, the amount of income you need to go from the lowest income tax rate to the highest (the bracket ride) for non-grantor trusts is short, not-so-sweet, and very much to the point. For example, in 2003, a trust begins to pay income tax at the highest rate with only $9,350 of income (as compared to $311,950 for single individuals and married couples filing jointly). There is some relief, though — the new 15 percent top dividend and long-term capital gains rates created by the Jobs and Growth Tax Relief Reconciliation Act of 2003 apply to trusts as well as to individuals.
Obviously, when investing the assets in a trust, you want to make the most of the dividends and long-term capital gains tax rates, and rely less on other investments that produce income taxed at a higher rate. Municipal bonds are also very popular trust investments due to the tax-exempt nature of the interest. A great trust investment strategy is to buy investments that you expect will appreciate in value but that don't produce much income. When you finally sell, you'll pay the tax at the lower long-term capital gain tax rate rather than the rate on ordinary investment income.
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