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.
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.
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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.