Inheriting from a trust can sound like a dream come true, but it's not without tax implications. If your dear old uncle dies and leaves you $50,000 in his will, the Internal Revenue Service doesn't consider this income and you don't have to pay taxes on the cash. This basic rule can change if you inherit from a trust instead.
The Trust’s Tax Liability
A trust is a legal entity set up to hold someone's cash and assets and pass them to beneficiaries after his death without the need for probate. There are two basic types of trusts – revocable and irrevocable. Tax-wise, they differ mostly before the grantor's death. After death, when beneficiaries begin to inherit, the IRS treats them largely the same. Income generated by or earned from assets held in the trust is taxable to the trust.
A revocable trust becomes irrevocable when the grantor – the person who created it -- dies. During his lifetime, while the trust is still revocable, the grantor must claim all the trust’s income on his own personal tax return.
Everything changes when a trust makes distributions to its beneficiaries. If the distributions are required -– as when the trust's formation documents say income must be distributed to beneficiaries -- this shifts the tax burden to the beneficiaries. The trust must issue each beneficiary a Form K-1 at the end of the year, showing the total amount they received, and that amount is taxable income on each beneficiary's individual return. The trust pays tax only on income it doesn't distribute to beneficiaries.
Trusts are either simple or complex for tax purposes. A simple trust must pay all its income to beneficiaries in the year the income is earned. A complex trust is allowed to retain some of its earnings from year to year. If you’re the beneficiary of a simple trust, the tax hit might be significant because you’ll have to claim all – or your share if there are multiple beneficiaries – of everything the trust earned during the year.
The IRS has safeguards in place to ensure that trusts and their beneficiaries don't both pay taxes on the same income. Trusts take deductions on their tax returns for all income that's distributed and shifted to beneficiaries and reported on Forms K-1.
Not all trusts set specific terms for distributions to beneficiaries. If the trustee has control over the distributions -- he can decide when and if beneficiaries receive money and how much -- these distributions are considered discretionary. The trust can't shift tax liability for these distributions to the beneficiaries. It can't issue Forms K-1 or take a deduction for the distributed amounts. The trust pays taxes on this income, even though it's distributed to the beneficiaries. If you're the beneficiary of a trust and you're not sure whether the distribution was discretionary or required, consult with a lawyer or tax professional -- it could make a significant difference on your tax return.
Capital gains and losses are treated differently for both beneficiaries and trusts. They might stay with the trust, or might transfer to you as beneficiary under some complex circumstances. If you receive a distribution that’s not clearly trust income, speak with an accountant before you file your tax return.