How Trust Income Tax Impacts Your Family Legacy Planning
Trusts play a vital role in family legacy planning by allowing one generation to establish clear guidelines for the next. They help carry out the wealth creator’s intentions and vision for long-term family success. In addition to supporting these goals, trusts offer legal and tax structures that can help preserve, grow, and distribute assets in alignment with that vision. Understanding the technical aspects of a trust is essential to ensure it effectively supports your family’s legacy.
Just like individuals, trusts are subject to income taxes, which are generally taxed either to the entity itself or a beneficiary—although the trust can also be set up to have its income taxed to the person who contributed the assets. Trusts also have their own expenses and deductions, which are separately computed.
If you do not properly structure your trust with these considerations in mind, the assets you are trying to pass down and preserve could be unnecessarily eaten away by taxes.
Trust Income Tax Basics
At the outset of creating a trust, you will need to determine if it will be a “grantor” or “non-grantor” trust.
- A grantor trust (i.e. revocable trusts, grantor retained annuity trusts (GRAT), certain dynasty trusts) is a trust whose income is reported directly on the tax returns of the the person who gifted or transferred the assets to the trust.
- A non-grantor trust reports taxes at the trust entity level and pays income tax for any income that is retained by the trust. If there is a distribution to a beneficiary, generally ordinary income will carry out to be taxed on the beneficiary’s personal tax returns. There are also strategies that can be used to distribute capital gains to the beneficiary as well.
Additionally, charitable and other types of trusts have their own taxation regimes.
Grantor trusts are usually considered more income tax-friendly than non-grantor trusts because individuals have much wider tax brackets than the entity level brackets that apply to non-grantor trusts. For example, an individual taxpayer would pay the top federal marginal tax rate on income over $626,350, while a trust entity would reach the top bracket at income over $15,650. The compressed non-grantor tax brackets also cause these trusts to be subject to additional taxes more quickly than individuals, including the net investment income tax and higher capital gains taxes.
Trust Income Taxes and Family Legacy Planning
The income tax consequences of your choice of trust should be a factor in the decision of how you implement a trust within your legacy planning goals. It may not necessarily be the deciding factor, but it is important to be mindful that your asset distribution, estate tax planning, or creditor protection goals could conflict with the most efficient income tax structure of your trust.
Structuring Dynasty Trusts for Tax Efficiency
A typical dynasty trust facilitates the transfer of wealth across several generations. These trusts, if properly structured, can last in perpetuity. Each time wealth is transferred to the next generation, the trust should allow for avoidance of estate and generation-skipping transfer taxes. The assets should also remain in irrevocable trust structures with ascertainable distribution standards that prevent beneficiary creditors from being able to access these assets.
This dynasty trust is being structured to achieve all three of the non-tax factors that are described above. If the trust is formed during the original grantor’s life, it could even be structured as a grantor trust so as to remain taxable on the grantor’s personal tax returns. However, once the grantor passes away, the trust will become non-grantor and the trust income and expenses will now be reported separately.
This non-grantor trust would not necessarily be the most optimal income tax structure for passing assets. Compared to the beneficiaries’ personal tax returns, non-grantor trusts have steeper tax brackets that cause trust income to reach the highest marginal tax rates at less income than an individual. Assets that remain in the non-grantor trust shares would remain shielded from estate taxes and creditors, but the income they generate would almost always be subject to higher income tax rates and exposed to higher tax burn.
Knowing this, a grantor could include provisions in the trust agreement that create flexibility for income tax planning, including allowing capital gain income to potentially be distributable. Trustees and beneficiaries should also consider how to minimize exposure to this income tax bite within the confines of the terms of the trust through annual distribution planning. The “negatives” associated with non-grantor trusts, such as the trapping of income at the entity level, can be turned into “positives” by the trustee and beneficiary analyzing the tax results of different distribution methods allowable under the trust agreement.
Distribution planning for income tax purposes must be done carefully, as any distribution of assets takes them out of the trust and away from its protections. However, this powerful tool can drastically reduce the income tax bite on these assets, and these benefits can continue to be amplified if applied by each new generation.
Strengthen Your Family’s Legacy
While trusts are powerful tools for supporting your family’s legacy across generations, the way they’re structured—particularly from an income tax perspective—can have a significant impact on their long-term effectiveness. By thoughtfully considering the tax implications alongside your broader legacy goals, you can help ensure that more of your wealth is preserved for future generations, rather than lost to unnecessary taxation. With proper planning and ongoing evaluation, trusts can continue to fulfill the vision and intentions of the wealth creator—safeguarding assets, guiding beneficiaries, and strengthening your family’s legacy over time.
If you or your family would like to learn more about how trust income taxes may apply in your planning, you can reach out to our team today.
