What Is Trust Income and How Is It Taxed?

Defining Trust Income

A trust is a legal arrangement where one party, known as the grantor, transfers assets to another party, the trustee, who holds and manages those assets for the benefit of a third party, the beneficiary. This arrangement establishes a fiduciary relationship, meaning the trustee has a legal and ethical duty to act in the beneficiaries’ best interests. Money generated by the assets held within this legal structure is known as “trust income.”

Trust income represents the earnings produced by the trust’s principal assets over a period. This income is distinct from the trust’s principal, also called the corpus or trust property, which refers to the original assets placed into the trust. For example, if a trust holds a rental property, the rent collected would be income, while the property itself is part of the principal. Similarly, dividends from stocks held in the trust are income, while the stocks themselves are principal.

This distinction between income and principal is important for how a trust is managed and how its beneficiaries receive benefits. The trust document specifies how income and principal can be used or distributed. Trustees must adhere to these instructions, ensuring that income beneficiaries receive their due while preserving the principal for future beneficiaries or a later distribution event. Proper classification also impacts taxation.

Sources of Trust Income

Trusts can generate income from various sources, reflecting the diverse types of assets they may hold. One common source is interest income, which arises from assets like savings accounts, money market accounts, certificates of deposit (CDs), and bonds. When a trust holds these types of investments, the interest payments they yield are considered trust income.

Dividends are another source of trust income. Trusts that hold shares of stock receive dividend payments, which are distributions of a company’s profits to its shareholders. Dividends can be a regular source of income, often occurring quarterly.

Rental income also contributes to trust earnings, particularly when real estate is part of the trust’s assets. If a trust owns residential or commercial properties that are leased to tenants, the rent collected from these properties constitutes trust income. This type of income often comes with associated expenses, such as property taxes, maintenance, and insurance, which must be managed by the trustee.

Beyond traditional investments, a trust might also generate income from business operations if it holds an interest in a partnership, a limited liability company (LLC), or a closely held corporation. Profits distributed from these entities to the trust would be classified as trust income. This can involve more complex accounting and management responsibilities for the trustee, as it requires understanding the underlying business’s financial performance.

Taxation of Trust Income

The taxation of trust income depends primarily on whether the income is distributed to beneficiaries or retained within the trust. Generally, income distributed to beneficiaries is taxed at the beneficiary’s individual income tax rate. Conversely, income retained by the trust is taxed at the trust’s income tax rates, which are compressed and can reach the highest marginal rates at much lower income thresholds compared to individual tax rates. For the 2024 tax year, the highest trust tax rate of 37% applies to taxable income over $15,200.

A key concept in trust taxation is “distributable net income” (DNI), which limits the amount of income a trust can deduct for distributions to beneficiaries. DNI is the maximum income that can be passed through to beneficiaries and taxed to them, rather than to the trust. It prevents the trust from distributing principal and claiming it as income for tax purposes. Internal Revenue Code Sections 641 through 679 govern the taxation of trusts and their beneficiaries.

If a trust distributes income to its beneficiaries, the trust receives a deduction for the amount distributed, reducing its own taxable income. The beneficiary then reports this income on their personal income tax return, receiving a Form K-1 from the trust detailing their share of the income. This mechanism avoids double taxation, where both the trust and the beneficiary would pay taxes on the same income.

Income that is not distributed and remains within the trust’s principal is subject to taxation at the trust level. Trusts are required to file Form 1041, U.S. Income Tax Return for Estates and Trusts, annually to report their income, deductions, gains, and losses. The tax rates for trusts can be quite high, making it financially advantageous for trusts to distribute income when possible, depending on the beneficiaries’ individual tax situations.

The grantor of the trust may be responsible for paying taxes on the trust’s income, known as “grantor trusts.” This occurs when the grantor retains certain powers or interests over the trust assets or income. For example, if the grantor has the power to revoke the trust or direct its income for their own benefit, the income is taxed to the grantor directly, even if it is not distributed to them.

Distributing Trust Income

The method by which trust income is paid out or managed is dictated by the trust document. One common method involves mandatory distributions, where the trust instrument specifies that a certain amount or percentage of income must be paid to beneficiaries at predetermined intervals, such as annually or quarterly. In such cases, the trustee has little discretion regarding the timing or amount of these payments.

In contrast to mandatory distributions, many trusts incorporate discretionary distributions, granting the trustee the authority to decide when and how much income to distribute to beneficiaries. This discretion is guided by standards set forth in the trust document, such as distributions for a beneficiary’s “health, education, maintenance, and support” (HEMS). The trustee must exercise this discretion prudently and in accordance with their fiduciary duties.

Retained income is another approach, where the income generated by the trust’s assets is kept within the trust rather than being distributed to beneficiaries. This retained income can be reinvested to grow the trust’s principal, or it may be accumulated for future distributions. The decision to retain income is often influenced by the trust’s overall purpose, the needs of the beneficiaries, and tax considerations.

Trusts are categorized as “simple trusts” or “complex trusts,” which impacts their income distribution rules. A simple trust is required to distribute all of its income currently and does not distribute principal. A complex trust, on the other hand, can accumulate income, distribute principal, and make charitable contributions. These distinctions affect how the trust’s income is reported and taxed, both at the trust level and for the beneficiaries.