The Motley Fool cautions that the taxation of these trusts can become extremely complicated, and the structure of a family trust is critical in how the trust gets taxed. In the January 18 article "Taxation of Family Trusts," The Fool notes that those who want to avoid complications can generally include provisions that will keep things simple for at least some of the trust's existence.
For tax purposes, the big factor in a family trust is whether it qualifies as a grantor trust. To qualify, a trust has to satisfy at least one condition in a list of requirements. Most commonly, this condition involves the person creating the trust ("the grantor") retaining the right to take assets back out of the trust. That means that revocable trusts will typically qualify as grantor trusts. Also, powers like the ability to capture trust income, the ability to retain a remainder or reversionary interest in the trust, or the ability to have certain administrative powers over trust assets can constitute grantor trust status.
The resulting benefit is that the trust doesn't have to file a separate tax return at the entity level. Instead, the grantor must include any income from trust assets on his or her individual tax return and pay any tax liability. Sometimes, a grantor trust will have to file a return on Form 1041, but it need only state that all income was carried out to the grantor's tax return according to the grantor tax rules.
What if the trust doesn't qualify? Then it will have to file a trust tax return; however, there are more complex rules, such as a result where the trust itself pays the tax and rules which can lead to other trust beneficiaries having taxable income.
If grantor trust rules don't apply, then the big issue is who is entitled to the trust income. The trust generally must pay income tax on any income its assets generate. However, if the terms of the trust require it to pay out its income to a beneficiary, then the trust gets a deduction for any distributable net income. Any remaining income not distributed gets taxed to the trust directly. So if the trust gets a deduction, those receiving the income have to include that income on their own individual tax returns. The trust will need to create an income statement on Schedule K-1.
Got it? Well, as you can see, income taxes on trusts get real complicated real fast. Talk with an experienced estate planning attorney to see if this might be applicable for your family. He or she can do the heavy lifting, allowing you to enjoy the benefits.
Reference: Motley Fool (January 18, 2016) "Taxation of Family Trusts"