My father set up a gifting trust for me. The corpus is about $2.5 million right now, and I receive a 4 percent distribution each year broken up into monthly distributions. I've been filing my own taxes on Turbo Tax, and reporting it on Line 13 of the 1040 and on Schedule D. It gets taxed at capital gains rates. Is this correct, or should it be taxed at my marginal tax rate?
The taxation of trusts and trust beneficiaries can be complex. There are two major elements to be considered – corpus (or principal) and income. Corpus is the assets that are deposited into the trust along with any income earned by the trust and not distributed to beneficiaries. Income is the income earned by the trust, such as dividends, interest, rents, etc.
Generally speaking, income earned by the trust and retained by it is taxed at the trust level. Income earned by the trust and distributed to beneficiaries is taxed to the beneficiaries. Principal distributed to beneficiaries -- including income previously earned, retained, and taxed at the trust level -- can be distributed tax-free. Capital gains or losses realized by the trust are typically retained and included in the tax calculation of the trust.
Income distributed to beneficiaries by a trust retains its character. For instance, qualified dividends earned inside the trust and then distributed to the beneficiaries are treated as qualified dividends on the beneficiaries’ tax returns. Interest earned by the trust and distributed to beneficiaries will be treated as interest in their hands.
Normally beneficiaries receive a Form 1041 K-1 each year that reports each beneficiary’s share of income and expenses of the trust and where to report these items on the beneficiary’s tax return.
Your question does not provide enough information to determine exactly what tax treatment to apply to the 4 percent distribution. It could be a combination of interest, dividends, tax-exempt interest, rents, corpus, or any number of things. Reporting the entire distribution on Schedule D as a capital gain is probably incorrect. As stated above, capital gains typically are retained and taxed at the trust level, unless the trust makes different provisions. It also is more than likely that the distribution is not all taxable at the taxpayer’s marginal tax rate.
In this situation, a CPA with experience in trust taxation should be consulted to determine the appropriate tax treatment.
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Answered by: James D. Adelsperger, CPA, is senior wealth adviser with Domani Wealth in Lancaster, Pa.