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Irrevocable trusts are often used as a tool to help a client with long term care (LTC) planning. This is the case, especially in proactive situations. The income taxation of trusts is odd because a trust can be disregarded for income tax purposes as a grantor trust. The trust can pay taxes. A trust can also be a hybrid between these two categories. The tax laws, as they are applied to trusts, are generally put together after the tax system that is applied to individuals, with the exception that is provided in the Internal Revenue Code ( IRC ). The tax rates for trusts are compressed enough so that when compared to those of an individual (39.6 percent rate on income over $12,300).
A wide-ranging view of the income taxation rules as they are applied to trusts is beyond the scope of this subject. There are some attorneys who are progressing into the practice of Elder Law who may not have a background in tax law. There may also be others who may be looking for a brief review of the rules that apply to trusts. This essay will try to balance the two needs as well as raise some income tax considerations surrounding a recent trend away from income-only trusts in Medicaid planning.
The advantages of grantor trust status include the grantor’s taxable estate may be reduced by making the grantor liable for the trust’s income tax liability. Also, transactions between the grantor and the grantor trust are ignored for Federal income tax purposes. It may be possible to deduct the trust’s losses against the grantor’s other income. The trust may be an eligible shareholder of an S Corporation. Finally, the compressed tax rates associated with a non-grantor trust are avoided.
The basic differences between an individual’s income tax return and that of a trust are that a trust is entitled to a deduction for amounts of income distributed or distributable to the beneficiaries. A trust may also deduct from its taxable income an unlimited amount of its gross income for amounts paid to charity, except amounts paid to charity from unrelated business income. The trust receives a personal exemption of either $100 or $300, depending on whether or not it is required to distribute its income currently.
The IRC has separated trusts into two categories, simple trusts and complex trusts for purposes of determining the income taxation of a trust.
A simple trust is a trust that makes no distributions other than distributions of current income. It also requires distribution of all of its current income. Finally, the trust does not provide in its governing instrument for deductible charitable contributions.
A complex trust is any trust that is not a simple trust. Also, a concept central to the taxation of trusts is distributable net income (DNI). DNI is a mechanism that assists in determining the amount of income taxable to the beneficiaries and the allocation of that income among the beneficiaries. It is what makes a “hybrid” tax entity in that at times the trust itself is taxable and at times it is a conduit.