What Are the Trust Tax Rates on Capital Gains?
Understand the tax implications when a trust realizes capital gains. Explore how compressed tax rates and distribution strategies affect the total tax paid.
A trust is a distinct legal arrangement that holds assets for beneficiaries, and for tax purposes, it is often treated as a separate entity. When a trust sells an asset like stocks or real estate for a profit, it realizes a capital gain. This gain is subject to its own set of tax rules, which differ significantly from those that apply to individuals. The tax treatment of a trust’s capital gains hinges on the type of trust and how its income is handled, which dictates whether the trust itself or another party is responsible for paying the taxes.
Identifying the Taxpayer: Grantor vs. Non-Grantor Trusts
The initial step in determining tax responsibility for trust capital gains is to identify whether the trust is a grantor or non-grantor trust. A grantor trust is a structure where the creator, or grantor, retains certain powers, such as the ability to revoke it or control its assets. For federal income tax purposes, a grantor trust is disregarded as a separate entity. Consequently, all income, deductions, and credits, including any capital gains, are reported directly on the grantor’s personal income tax return, Form 1040, and the grantor pays tax on those gains at their individual tax rates.
In contrast, a non-grantor trust is treated as a separate taxable entity by the IRS. In this arrangement, the grantor has relinquished control over the trust assets, making the trust itself responsible for its tax obligations. The trust must file its own income tax return and pay taxes on any income or capital gains it earns and does not distribute to its beneficiaries.
Federal Tax on Trust Capital Gains
The federal taxation of a non-grantor trust’s capital gains depends on the holding period of the asset. Gains from assets held for one year or less are classified as short-term capital gains and are taxed at the trust’s ordinary income tax rates. Gains from assets held for more than one year are long-term capital gains and are subject to preferential tax rates.
A feature of trust taxation is its highly compressed ordinary income tax brackets. For the 2024 tax year, these brackets cause a trust’s income to be taxed at the highest marginal rate very quickly, a structure markedly different from individual income tax brackets.
2024 Ordinary Income Tax Brackets for Trusts
- 10% on income up to $3,100
- 24% on income over $3,100 up to $11,150
- 35% on income over $11,150 up to $15,200
- 37% on income over $15,200
Similarly, the long-term capital gains tax rates for trusts also have very low income thresholds. The rates are 0%, 15%, and 20%, but they apply at much lower income levels compared to individual taxpayers.
2024 Long-Term Capital Gains Tax Brackets for Trusts
- 0% on income up to $3,150
- 15% on income over $3,150 up to $15,450
- 20% on income over $15,450
In addition to the regular capital gains tax, trusts may also be subject to the 3.8% Net Investment Income Tax (NIIT). This tax applies to the lesser of the trust’s undistributed net investment income or the excess of its adjusted gross income over the threshold where the highest tax bracket begins. For 2024, this threshold is $15,200. Net investment income includes capital gains, interest, and dividends, making the NIIT a frequent addition to a trust’s total tax bill.
Consider a trust that realizes and retains a $25,000 long-term capital gain in 2024. The regular capital gains tax would be calculated using the compressed brackets, resulting in a significant portion being taxed at the 20% rate. The NIIT would also apply, as the trust’s income exceeds the $15,200 threshold, adding to the overall tax liability.
Impact of Distributions on Tax Liability
A primary method for managing the tax burden of a non-grantor trust is through the distribution of income to its beneficiaries. The mechanism governing this process is known as Distributable Net Income (DNI). DNI is a calculation that determines the maximum amount of a distribution that will be taxable to the beneficiaries. It acts as a ceiling for the income distribution deduction the trust can claim and the amount of income a beneficiary must report.
When a non-grantor trust distributes income to a beneficiary, the trust is entitled to an income distribution deduction on its tax return. This deduction reduces the trust’s taxable income, meaning the trust itself does not pay tax on the amount distributed. The tax liability for that income is effectively passed from the trust to the beneficiary who receives it.
The beneficiary who receives the distribution must then report that income on their personal tax return. The income retains its character, meaning if the trust distributes long-term capital gains, the beneficiary reports it as such. The beneficiary pays tax on this income at their individual capital gains tax rates, which are often more favorable than the compressed rates applied to trusts. This strategy can result in significant tax savings.
For example, imagine a trust with $20,000 in long-term capital gains. If the trust retains the gain, it would quickly be subject to the 20% capital gains rate plus the 3.8% NIIT. However, if the trust distributes the $20,000 gain to a beneficiary in a lower tax bracket, that beneficiary might pay tax at a 0% or 15% rate and potentially avoid the NIIT altogether.
Reporting Requirements for Trusts and Beneficiaries
The compliance for trust taxation centers on a few key IRS forms. The primary document for a non-grantor trust is Form 1041, U.S. Income Tax Return for Estates and Trusts. This form is used to report the trust’s income, deductions, gains, and losses for the year. It is the return where the trust’s tax liability is calculated and reported to the IRS.
To specifically calculate and report the trust’s capital gains and losses, the fiduciary must complete and attach Schedule D (Form 1041). This schedule separates short-term and long-term transactions, allowing for the proper application of the different tax rates. The net gain or loss calculated on Schedule D is then carried over to the main Form 1041.
When a trust makes distributions to its beneficiaries, it must issue a Schedule K-1 (Form 1041) to each recipient. This informational form details the amount and character of the income that was distributed to that specific beneficiary. The beneficiary then uses the information provided on their Schedule K-1 to report their share of the trust’s income on their personal Form 1040. The Schedule K-1 serves as the link that connects the trust’s tax return with the beneficiary’s, facilitating the pass-through of tax liability.