Irrevocable trusts are very different from revocable trusts in the way they are taxed. An irrevocable trust needs to get a tax ID (EIN) number and pay taxes each year by filing a 1041 tax return. Trust tax rates are very high as you can see here.
Table of Current Income Tax Rates for Estates and Trusts 2021
|$0 – $ 2,650||10%|
|$2,651 – $ 9,550||24%|
|$9,551 – $13,050||35%|
Irrevocable trusts have a major tax issue. At basically $13,000 in income, they hit the highest tax rate. Although irrevocable trusts are complex trusts, which means they can accumulate income they make on trust assets, the trustees normally reduce taxes by distributing all the trust income each year to the beneficiaries in the year the income is earned. The trust generally gets a tax deduction for the income it pays out to the beneficiaries. Thus, the trust doesn’t pay income tax and the income tax is paid by the beneficiary at his or her tax rate. More or less, it is just income to the beneficiary.
Trusts are generally limited to making distributions of “distributable net income” (DNI). DNI includes dividends, interest, rents, etc., but DOES NOT include capital gains. Capital gains ordinarily are held by the trust and taxed at the trust level (BIG tax).
Depending on how the trust is written and which state the trust is located (state laws apply), it may be possible to include capital gains in DNI. It may be possible to amend the trust to permit the inclusion of capital gains in DNI or the trustee may simply be able to exercise his or her discretion. How the trust handles the capital gains makes a big difference in the family’s tax outcome.
For example, if the trust provides that the beneficiaries are to receive all the trust’s income (the trustee shall pay out all of the trust’s income out at least annually), and the trust also allows the trustee to use the principal of the trust in the trustee’s discretion for the beneficiaries’ benefit, then the trustee may be able to achieve the best tax result.
Say the trust earned $12,300 in dividends and also earned $75,000 of long-term capital gains. The $12,300 is DNI and will be distributed. The trustee could distribute the $75,000 as principal. Assume there is one beneficiary who files as a single individual and the trust is his or her only income. Under these circumstances the beneficiary wouldn’t pay anything in income taxes, but the trust will pay about $16,000 in taxes on the capital gains income before it is given to the beneficiary as principal.
Handled another way, the trust, in the trustee’s discretion, may be able to distribute the capital gains income as income to the beneficiary and the beneficiary would pay the tax. If that is possible, the beneficiary would pay about $6,000 instead of the $16,000 the trust would pay. That’s a big difference.
It is important that the trust document gives the trustee the ability to make distributions of capital gain income and pass that through to the beneficiary(ies).