The Basic Rules The Conduit Principle
A Word about Estates "Grantor" or "Defective" Trusts

The Basic Rules

At base, a trust is taxed much like an individual. It reports income from dividends, interest, capital gains. It may even conduct a business and report income on schedule C, report partnership income or its share of real estate income (and losses). It does not have salary, and an individual cannot assign his or her salary to the trust as has been contended by purveyors of various schemes (well, you probably can assign it, in the sense of having it paid to the trust -- but you will still be taxable on it as though it were paid to you and you turned around and endorsed your paycheck to the trust).

The trust may also claim various deductions for expenses -- interest, administration, taxes, etc. It cannot deduct personal types of deductions (e.g. medical bills). You run into complications when you get into such items as "passive losses" and items requiring "material participation".

The biggest deduction is the distribution deduction discussed as part of what is called the conduit principle.

After deductions, the trust has a small exemption and, finally, calculates the tax on its taxable income.

Trusts used to be taxed under the same extended tables as married persons filing separately, but recent changes have created a compressed progressive table.

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The Conduit Principle

A trust may deduct distributions to a beneficiary. The beneficiary then reports that distribution as income. The income keeps its "character" -- i.e. it is the same proportion of dividends, interest, tax-free interest in the hands of the beneficiary as it was in the trust. If there are distributions to several beneficiaries, the taxable effect is usually allocated proportionally. Thus, the trust serves as a "conduit" or flow-through of the tax effects.

A "spray trust" may allow the trustee to distribute income among several beneficiaries -- e.g. a child and the child's children. It could be beneficial to pay income to lower-bracket taxpayers.

If the trust distributes more than its income. the distribution is free of income tax (it may be a generation-skipping "taxable distribution".) If a trust has a loss in a particular year, including capital loss, the loss isn't passed through but may be accumulated by the trust to offset later income (at termination, any remaining losses are passed through to the beneficiaries receiving the trust).

One complication often used advantageously is the "sixty-five day" rule. Suppose a trustee is supposed to pay out "all income" to the beneficiary. As a practical matter, they don't know what it is at the end of the year. To allow time for determinations, a trustee may elect to treat distributions made during the first 65 days of the year as having been made the previous year.

The trust income is taxed at a higher rate than an individual. This may make it seem advantageous to distribute income to the beneficiary to be subject to lower income tax rates. However, upper-bracket taxpayers must plan for long-range effects. If income is distributed to a beneficiary who doesn't need it, it will accumulate in their bank account and potentially subject to estate tax. This factor must be considered.

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A Word about Estates

Estates are taxed very similarly to trusts. The main practical difference is that they will usually terminate sooner, and will often generate losses on termination resulting from the sale of residences. Estates may choose to have a fiscal year ending in any month -- trusts fiscal years must end in December. However, a revocable trust and estate may agree to file a joint return for a couple of years, enabling use of the fiscal year for trust income.

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"Grantor" or "Defective" Trusts

Suppose I put $100,000 into a trust to pay income to my lower-bracket parent or child. Perhaps the trust only lasts five years. Perhaps one year. Perhaps I have the power to revoke it and get the principal back. Under these circumstances, I remain the virtual owner of the property -- I'm trying to shift the tax effects to someone else.

The Internal Revenue Code provides a string of rules under which the grantor (creator of the trust) or the beneficiary will be treated as the owner of a trust and taxed on the income. See The Use of 'Defective' Trusts. There are ways those rules can be used for the advantage of taxpayers.

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