Trustee, Trust Me? -- Part 3
In the last two issues we have been looking at some of the basic duties of a Trustee. This time we will consider one of the less glamorous aspects of being a Trustee, filing tax returns.
We will consider this example. While she was alive Bertha created a Trust. After her death, you were named to be the successor trustee. The Trust provides so long as he is alive, Trust “income” should be paid to Bertha’s second husband Borg, who was much younger than Bertha. After Borg’s death, the remaining Trust assets (sometimes called “principal”) are to be distributed to Bertha’s children from her first marriage, Betty and Boris.
Because this was a revocable trust, Bertha reported all of the income from the Trust assets on her own personal income tax returns, Form 1040. When Bertha died, the Trust became irrevocable and the Trust became a separate taxable entity. That means that the Trust must obtain a new Entity Identification Number (EIN) and all of the income earned by the Trust after Bertha’s death must be reported on a Fiduciary Income Tax return (Form 1041).
When assets are transferred to a Trust, this is treated as making a gift, and the recipients of the a gift (i.e., the Trust beneficiaries) do not have taxable income from the gift itself. After the gift is made, however, the recipient of the gift (in this case Bertha’s Trust) must report all of the income from the Trust’s assets.
In many cases, however, tax is paid on that income by those to whom it is distributed. In our situation, all of the income must be paid to Bertha’s husband Borg, so Borg will end up paying the tax on the Trust income that he receives.
In other words, many Trusts are, at least to a degree, “flow-through” entities, where the tax burden is borne by the recipients of the income.
But what, exactly, is the Trust “income”?
In the previous newsletters, we talked about the Trustee’s duty to treat the beneficiaries impartially. That duty comes into play in determining the Trust’s income.
Suppose Bertha’s Trust contains a large block of stock and that you, as the Trustee and a prudent investor, decide to sell at a large gain, because you suspect that the value of the stock will go down substantially in the future.
If all of the Trust income must be distributed to Boris, does that mean that Boris will get all of the gain from the stock sale? If he does, that will substantially deplete the principal, or the value of the assets remaining for the other beneficiaries. In other words, that would seem to favor Boris over the other beneficiaries.
To avoid that result, laws in most states say that the proceeds from the sale of Trust assets are not really “income” but instead are just the “principal” in another form. As a result, under these laws, Borg’s “income” interest will not include any of the proceeds from the stock sale.
There are a variety of other rules about how a Trustee determines what is the “income” of the Trust. For example, these rules govern the allocation of expenses between the “income” portion and the “principal” portion of the Trust.
For a trustee, such as yourself, these rules are important for two reasons. First, your duty to distribute “income” to Boris means that you must distribute only the “income” as determined under these rules. Second, the classification of Trust revenue as “income” or “principal” affects the taxation of the Trust and the beneficiaries.
Except in simple situations, Trustees may need professional assistance in applying these rules and determining their tax consequences.
For present purposes, it is enough to say that while the beneficiaries who receive distributions of “income” will pay the tax on that income, the Trust will usually pay the tax on any gain that is treated as “principal.”
The good news is that distributions of principal to Trust beneficiaries, as opposed to income, are usually tax free.
In these newsletters we have tried to highlight some of the challenges that a Trustee can face. In many situations, however, being a Trustee can be a fairly straightforward task, so long as the Trustee remembers the basic guidelines that we’ve talked about.
If you have questions about Trusts, please call Newland & Associates.
Copyright 2010
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