What does it mean to be a beneficiary of a trust?
A trust is a legal arrangement where the creator of the trust (called either a grantor or settlor) transfers legal title to property to a trustee to manage for the benefit of individual(s) or entities (such as a charity). The person(s) or entities for whom the property is managed are called “beneficiaries”.
The trust may provide that a beneficiary receives a specific amount every year, or as is often the case, leaves the amount and timing of a distribution to the discretion of the trustee.
The trust may outline specific considerations that the trustee should give as to when and how much is to be distributed. For example, the trust may provide that the trustee distributes cash amounts to pay for the health and welfare of the beneficiary; or to cover the costs of schooling or medical bills of a beneficiary that has “special needs”. There is no right or wrong here, it is up to the grantor/settlor to decide how the distribution provisions apply.
Trusts can be set up during the grantor/settlor’s life (technically called an “inter vivos” –during life—trust) or may be provided for in the Will of the grantor/settlor (technically a “testamentary trust—by “testament i.e. Will).
The legal rights of the beneficiaries and the legal obligations of the trustee are provided under the law of the jurisdiction that governs the trust. These rules will also determine who pays tax on the income and gains realized by the trust. It may be that the settlor/grantor or trustees are taxed on the trust income, or the beneficiaries are taxed on the distributions received. These rules are often very complex and differ from jurisdiction to jurisdiction.
Taxation of US domestic trusts
For US income tax purposes there are three basic types of trust:
- Grantor Trust – A trust where the grantor controls the management of the trust or where the grantor is the beneficiary of the trust. The Grantor is treated as owning all the assets of the trust and thus is taxable on all realized income and capital gains of the trust.
- Simple Trust – All the income is required to be paid to the beneficiary. Generally, the trust beneficiary is subject to tax on the income required to be distributed to them. The Trustee pays tax on realized capital gains.
- Complex Trust – Any trust that is not a Simple or Grantor Trust.
Generally, the beneficiaries pay tax on all income or capital gains required or actually paid to them. (Tax is based on the beneficiaries’ individual tax brackets and rates.)
All income and gains retained by the trust are taxable to the trustee at rates and brackets applicable to trusts (see below).
Note: Trusts and beneficiaries may also have to pay State and Local Taxes.
In 2023 the federal government taxes trust income at four levels:
– 10%: $0 – $2,900
– 24%: $2,901 – $10,550
– 35%: $10,551 – $14,450
– 37%: $14,451 and higher
For trusts in 2023 there are three long-term capital gains brackets:
– 0%: $0 – $3,000
– 15%: $3,001 – $14,649
– 20: $14,650 and higher
Taxation of US beneficiaries of Foreign Non-Grantor Trusts (FNGT)
Generally, US beneficiaries are taxed on distributions (and sometimes deemed distributions). In this context, non-qualified loans from the trust, and the use of trust property for less than adequate compensation are also considered trust distributions.
Distributions are subject to a different US tax treatment depending on the nature of the distribution received. All distributions consist of either:
- Distributable Net Income (“DNI”) which is current year income (e.g., interest, dividends, or capital gains),
- Undistributed Net Income (“UNI”) which is income and gains accumulated in prior years, and
- Trust corpus/principal (tax-free).
Distributions are taxed as occurring in the order above.
For a US beneficiary, a distribution of DNI is taxed at marginal income tax rates, (top rate for 2023 is 37%) while DNI which consists of long-term capital gains and qualified dividends is taxed at a maximum rate of 20%. (Special rates may apply to real estate gains.) Net Income Investment Tax (NIIT) at 3.8% will also apply.
DNI not distributed during the year it is earned becomes UNI – also called accumulated income. Accumulated income is subject to taxation under what are commonly called the “throwback rules” and once a trust holds accumulated income it remains in the trust until distributed. Under the throwback rules:
(i) the amount of the accumulation distribution is “thrown back” to the prior tax years in which the income accumulated, beginning with the earliest of such taxable years,
(ii) the US beneficiary is treated as receiving the UNI as if distributed in such prior tax years until all UNI is deemed distributed,
(iii) the applicable tax rate is that of the prior year from which the income is deemed to arise (so a higher applicable tax rate could apply),
(iv) the beneficiary is subject to an interest charge on the UNI which compounds over the length of time the accumulated income remained in the trust, and
(v) any UNI which was constituted of capital gains in prior years is treated as ordinary income when distributed, and therefore subject to a higher tax rate.
The throwback rules ensure that the US government recovers any tax which would arise to a US beneficiary from the deferral of income held through a FNGT. These rules can make a distribution of accumulated income very “tax expensive” to a US beneficiary.
Where DNI is distributed to multiple beneficiaries, the amount of DNI includible in a beneficiary’s gross income is allocated proportionately between the amount of the trust’s DNI for such taxable year multiplied by a ratio, where the numerator equals the amounts properly paid or credited to such beneficiary and the denominator equals the amounts properly paid or credited to all beneficiaries. This rule also applies to apportion distributions of UNI and applies equally to US and non-US beneficiaries.
Finally, distributions from a FNGT to a US beneficiary which are categorized as distributions of trust corpus are treated as tax-free distributions to the US beneficiary. These are still subject to reporting on the US tax forms.
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