In this Elder Law Minute, Wes Coulson discusses how trusts and income taxes operate together.
Back many many many years ago when I was in law school, I and most of the rest of the class sat glazed through the professor’s attempts to explain the tax laws as they relate to trusts. Let me give it a go in about two understandable minutes.
Let’s start with the basics — The IRS is in the business of collecting taxes on income. Well, in order to do that, they need a taxpayer. That’s why whenever you open a bank or a financial account, they ask for your social security number so they can send you a 1099 copy to the IRS so the IRS will know that you’ve made some income. Well, when you have a trust, it first depends on what type of trust it is.
If it’s a living trust, it’s still you; you don’t need a tax ID number, everything is the same as before. If you do an irrevocable trust, legally that’s not you anymore so the IRS raises a hand and says, “wait a minute, we need a taxpayer here.” That’s why those types of trusts have to get their own tax ID number. It’s known as an EIN.
Then the next question comes: the trust generates income, who is going to pay the tax on it? Well, the IRS says, you know we don’t so much care as long as we have a taxpayer. So, the rule on that is if the trust distributes income out to one or more beneficiaries, whoever winds up with the income for that year, you show that to the IRS and that’s who pays the taxes on it. If the trust income stays in the trust, then by default the trust has to pay the taxes on it.
You don’t want the trust to be the taxpayer because trusts get a very very measly exemption and they rocket through the tax brackets to get up to the top one after a very small amount of income. So, that sort of explains the strategy when we have trusts. We want them to distribute out income.
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