Navigating Family Trusts and Taxes
Family trusts offer a solution for managing assets such as a home or an investment portfolio and there are certain tax implications involved that taxpayers should know about.
Key Takeaways
- A trust is created by a grantor to pass on assets to beneficiaries upon the grantor’s death or at any time before, depending on the terms of the trust document.
- With a grantor trust, the grantor has control over the assets and generally reports all income from the trust on their own individual tax return.
- With a non-grantor trust, the trust itself or its beneficiaries pay tax on taxable income.
- Income distributed to beneficiaries is reported to the beneficiaries on Form K-1. Beneficiaries input information from Form K-1 into their personal tax returns.
Family trusts
While each family trust is different, they all generally come with tax liabilities for either beneficiaries or grantors. The details vary based on the specific trust and how it is set up. Let's gather an understanding of how a trust works.
What is a basic trust?
A trust is a financial planning tool used to manage assets. When you create the trust, you're called the grantor. Common assets that are put into a trust by a grantor may include:
- investments
- bank accounts
- business interests
- real estate
The details of what assets are included in the trust and how the trust will be managed are put into a trust document. The trust document also names a trustee. The trustee is the person responsible for managing the trust and distributing its assets according to the trust document.
The trust document also names beneficiaries. These are the people or entities that will receive the assets held within the trust at some point in the future. This often occurs after you pass away, but trusts can distribute assets at any time.
Many people confuse trusts and wills, but they are very different. A trust can be used to pass on assets at any time while a will only takes effect after you die. Wills are also overseen by the courts through probate while certain trusts may not go through probate if you establish them properly.
Family trusts
A family trust is a trust typically used to pass assets on to family members rather than other people. It isn't a specific type of trust beyond defining who the assets go to. Family trusts can come in different types, such as revocable and irrevocable trusts.
TurboTax Tip:
If a taxable estate value is $13,610,000 or less (tax year 2024), the estate doesn't have to pay the estate tax upon the death of the estate owner.
Revocable vs. irrevocable trusts
A revocable trust allows the grantor to make changes to it after it is put into effect. The assets in a revocable trust are still essentially owned and controlled by the grantor. This means they aren't protected from lawsuits or lenders.
An irrevocable trust generally doesn't allow the grantor to make many changes after it is established. The assets are placed in the trust's name and are no longer owned by the grantor. This can protect the assets from lawsuits and creditors.
How are family trusts taxed?
The taxation of family trusts can be complex. It's always a good idea to consult a tax professional to determine how your specific family trust may be taxed.
Grantor trusts, where the grantor has control over the assets, generally require grantors to report all income from a trust on their own individual tax returns. Non-grantor trusts, on the other hand, work differently. Typically, the trust itself or its beneficiaries pay tax on taxable income.
Income kept in the trust is paid on a trust tax return using Form 1041. Income distributed to beneficiaries is reported to the beneficiaries by the trust using Form K-1. This form specifies how much of the distribution is a principal distribution, which generally isn't taxable, versus an interest, capital gains or other income distribution, which may be taxable.
If a non-grantor trust has more than one beneficiary, the trust will divide the income between each beneficiary based on the terms of the trust. Then, it will issue a Form K-1 to each beneficiary specify each individual's portion of the income. Beneficiaries input information from Form K-1 into their personal tax returns.
Who benefits from family trusts?
An entire family can benefit from establishing a family trust. Family trusts can be beneficial for a few different reasons:
- The grantor has peace of mind knowing their assets will be passed on as the trust specifies, potentially avoiding probate.
- Properly constructed trusts that avoid probate can help beneficiaries squash any fighting over the grantor's assets.
- Once assets get distributed from the trust to a beneficiary, the beneficiary can do whatever they want with the assets. They can transfer them to someone else if they want to. That said, the beneficiary is still responsible for the taxes owed on assets distributed to them, even if they give the assets to someone else.
- A beneficiary may gift or sell their interest in a trust in some cases as well. They may only do so if the trust doesn't have a restriction prohibiting this. Selling your interest in a trust is a complex transaction that could have several tax consequences. It is best to consult a tax professional before making any decisions to determine what potential tax impacts you may face.
- Family trusts can also help manage taxation. In general, wealthier individuals stand to gain the largest tax benefits by creating a family trust. By moving assets into a qualifying trust, you may be able to avoid paying some or all of the estate tax due on your estate when you pass away. This is only a challenge for the wealthiest individuals, though. In 2024, the estate tax exemption is $13,610,000 per person. If your taxable estate value falls under this exemption amount, your estate doesn't have to pay the estate tax.
Creating a family trust and the tax implications you may encounter is highly dependent on your individual situation. Laws concerning trusts may vary from state to state, as well. Consult an estate planning attorney or tax professional in your area to get advice specific to your circumstances.
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