How Are Capital Gains Taxed in an Irrevocable Trust?

An irrevocable trust is a legal arrangement where a person, the grantor, transfers assets to a trustee to manage for beneficiaries. Once created, the grantor cannot change or terminate the trust. When assets in this trust, such as stocks or real estate, are sold for a profit, a capital gain occurs. The tax implications depend on whether the trust is a grantor or non-grantor trust, which determines who pays the tax. The trustee’s decision to retain or distribute the profits also affects the tax outcome.

Determining Who Pays the Tax

The responsibility for paying capital gains tax on assets sold in an irrevocable trust falls to either the grantor or the trust itself. This distinction is based on whether the trust is a “grantor” or “non-grantor” for tax purposes. This status dictates who reports the activity to the IRS and remits the tax.

A grantor trust is one where the grantor retains certain powers over the assets or administration. Because of this control, the IRS treats the grantor as the owner of the trust’s assets for income tax purposes. All income, deductions, and credits, including capital gains, are reported on the grantor’s personal income tax return, Form 1040. The trust itself does not pay income tax.

Several powers retained by the grantor can trigger this tax treatment. For example, if the grantor can revoke the trust, control the enjoyment of the trust’s principal or income, or use trust income for life insurance premiums on their own life, it is a grantor trust. Another trigger is the power to substitute assets of equivalent value.

A popular application is the Intentionally Defective Grantor Trust (IDGT). An IDGT is a grantor trust for income tax purposes, so the grantor pays taxes on its earnings, but the assets are excluded from the grantor’s taxable estate. This allows the trust’s assets to grow without being reduced by income taxes, like an additional tax-free gift to the beneficiaries.

A non-grantor trust is a separate taxable entity from its creator, created when the grantor relinquishes the powers that trigger grantor trust status. The trust obtains its own Employer Identification Number (EIN) and files its own tax return. If the trust sells an asset and retains the gains, the trust itself pays the capital gains tax.

Calculating the Tax for Non-Grantor Trusts

When a non-grantor trust is liable for capital gains tax, it uses compressed tax brackets. Trusts reach the highest federal tax rates at much lower income levels than individuals. This can lead to a higher tax bill if gains are retained within the trust.

Trusts are subject to the same 0%, 15%, and 20% long-term capital gains tax rates as individuals, but the income thresholds are lower. For example, a trust reaches the top 20% capital gains rate with taxable income over $15,900. A single individual needs over $533,400 of taxable income to reach the same bracket.

A concept in trust taxation is Distributable Net Income (DNI). DNI is a calculation that determines the maximum income the trust can deduct for distributions to beneficiaries, and it sets the amount and character of income beneficiaries must report. If the trust distributes capital gains to beneficiaries, the tax liability shifts to them.

For capital gains to be included in DNI, the trust document must permit their distribution, or the trustee must have a consistent practice of doing so. Gains realized in the trust’s final year are also automatically included in DNI. When beneficiaries receive these distributions, they pay capital gains tax at their individual tax rates.

A trustee can assess the tax situations of the trust and its beneficiaries to decide if it is better to retain or distribute the gains. If a beneficiary is in a low tax bracket, distributing the gain can result in tax savings compared to having the trust pay the tax at its higher, compressed rates.

The Role of Asset Basis

The calculation of a capital gain or loss begins with the asset’s basis, which is its cost for tax purposes. For assets in an irrevocable trust, the method for determining basis depends on how and when the asset was transferred. The two methods are carryover basis for lifetime gifts and step-up in basis for assets transferred at death.

When a grantor gifts an asset to an irrevocable trust during their lifetime, the trust assumes the grantor’s original basis, known as a carryover basis. For example, if a grantor purchased stock for $20,000 and gifted it when it was worth $100,000, the trust’s basis is still $20,000. If the trustee sells that stock for $120,000, the taxable capital gain is $100,000.

The alternative is a step-up in basis, which occurs when assets are transferred through a trust after the grantor’s death. For this to apply, the trust assets must be included in the grantor’s gross estate for federal estate tax purposes. The basis of the assets is then adjusted to their fair market value on the date of the grantor’s death.

Using the same example, assume the stock purchased for $20,000 was worth $120,000 on the date of the grantor’s death. With a step-up in basis, the basis for the trust is reset to $120,000. If the stock is sold immediately for that price, there is no capital gain and no tax. This provision eliminates the tax on appreciation that occurred during the grantor’s lifetime.

Tax Reporting Requirements

The primary document for reporting trust income is Form 1041, the U.S. Income Tax Return for Estates and Trusts. This form is used to report all income, deductions, and credits for the trust as a separate tax entity. It serves a similar function to the Form 1040 used by individuals.

When a trust has capital gains or losses, the trustee must also complete and attach Schedule D (Form 1041). This schedule is used to report the details of asset sales, including acquisition and sale dates, sale price, and the asset’s basis. The net gain or loss from Schedule D is then transferred to Form 1041. The trustee will need the trust’s Employer Identification Number (EIN).

If the trust distributes income to its beneficiaries, the trustee must prepare a Schedule K-1 (Form 1041) for each one. This form details the amounts and character of the income passed from the trust to the individual. It will separately state the amount of long-term capital gains, interest, and dividends the beneficiary received.

The beneficiary uses the information from their Schedule K-1 to report their share of the trust’s income on their personal tax return. This process ensures the income is taxed at the beneficiary’s individual rate. The trustee is responsible for filing Form 1041 with the IRS and providing each beneficiary with their Schedule K-1.