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.
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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.
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:
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.
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.
If a taxable estate value is $12,920,000 or less (tax year 2023), the estate doesn't have to pay the estate tax upon the death of the estate owner.
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.
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.
An entire family can benefit from establishing a family trust. Family trusts can be beneficial for a few different reasons:
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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