Beneficiaries who receive distributions from a trust often have tax questions about whether they have to pay tax or not. Fundamentally, whether a beneficiary pays taxes on distributions or not depends on whether the money they receive is considered “income” or “principal”.
When an irrevocable trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary’s distribution that’s interest income, as opposed to principal. With that information, the beneficiary knows how much she’s required to claim as taxable income when filing taxes.
Investopedia’s recent article on this subject asks “Do Trust Beneficiaries Pay Taxes?” The article explains that when trust beneficiaries receive distributions from the trust’s principal balance, they don’t have to pay taxes on the distribution. The IRS assumes this money was already taxed before it was put into the trust.
After money is placed into the trust, the interest it accumulates is taxable as income—either to the beneficiary or the trust. The trust is required to pay taxes on any interest income it holds (in other words, the income it doesn’t distribute by the taxable year-end). If the trust distributes the interest income, though, it is considered taxable income to the beneficiary who gets it.
The money given to the beneficiary is considered to be from the current-year income first. That means that a distribution to the beneficiary will first be categorized as “income”, and the beneficiary will have to pay taxes on it. If a trustee gives a beneficiary a distribution that is more than the amount of the current-year income, then it is considered to be a distribution from the accumulated principal. This is usually the original contribution that was placed into the trust account, plus any subsequent deposits.
Capital gains may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary is taxable to her to the extent of the distribution deduction of the trust.
If the income or deduction is part of a change in the principal or part of the estate’s distributable income, then the income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in how much to distribute and how much to keep as retained earnings will pay trust tax based on the rate schedule for trusts and estates, but a beneficiary will pay income tax based on the rate schedule that applies to the beneficiary (single, married, head of household, etc.).
The two critical IRS forms for trusts are the 1041 and the K-1. IRS Form 1041 is like a Form 1040. This is used to show that the trust is deducting any interest it distributes to beneficiaries from its own taxable income.
The trust will also issue a K-1. This IRS form provides details about the distribution. Specifically, it will tell the beneficiary how much of the distributed money came from principal and how much is interest. The K-1 is the form that allows the beneficiary to see their specific tax liability from trust distributions.
The K-1 schedule for taxing distributed amounts is generated by the trust and given to the IRS. The IRS will deliver this schedule to the beneficiary so that they can pay the tax. The trust will fill out a Form 1041 to determine the income distribution deduction that’s conferred to the distributed amount. Your estate planning attorney will be able to help you work through this process.
Reference: Investopedia (July 15, 2019) “Do Trust Beneficiaries Pay Taxes?”