In the midst of tax filing season, it’s common to start worrying and thinking about taxes on a trust fund.
You’re right to worry, but we’re here to curb that anxiety and guide you through:
- what the taxes on trust funds are for 2023
- how are trusts taxed
- what the trust tax brackets are
- who is responsible for trust income tax
- and more!
Do trusts pay tax and how are trusts taxed for income tax purposes in California?
Trusts are taxed similarly to how individuals are, but the key differences lie in whether the trust is a simple trust, complex trust or grantor trust. The similarities lie in that if an item is non-deductible for an individual, it’s also non-deductible for the trust.
But we need to explore these different types of trust funds to understand how they operate so you can get a better understanding of how the nuances apply to your trust.
Applicable taxes on trust funds & the different trust funds
The first, and most common, question trust owners ask is:
“What type of taxes apply to trusts?”
The simple answer to this is income tax.
But, whether the trust pays its own taxes will depend upon the type of trust we’re talking about:
- Simple
- Complex
- Grantor
Simple Trust
A simple trust has three elements:
- All trust income be distributed annually, at least
- No charitable beneficiaries
- The trust does not make distributions of trust principal
If any one of these three elements does not apply to the trust, then it is not a simple trust and most likely falls under one of the other two categories below.
Complex Trust
For a trust to be classified as complex, at least one of these activities must be performed each year:
- The trust must retain some income rather than distribute it to the beneficiaries
- Beneficiaries must receive part or all of the trust’s principal
- There must be a distribution of some trust assets to charities
Grantor Trust
A grantor trust is a trust in which the grantor maintains some control or power over the trust.
As a result, the trust’s income is deemed taxable to the grantor.
Some of the retained powers may include:
- The grantor (or spouse) retains the ability to revoke or amend the trust as a revocable trust
- The grantor keeps the power to substitute trust assets with assets of equivalent value
- The grantor is allowed to borrow the trust assets without adequate security
- The grantor receives distributions from the trust
- The trust income is used to pay premiums on life insurance policies on the grantor or the grantor’s spouse’s life.
Responsible person and taxes on a trust fund
Of these three, only two pay their own income taxes:
- Simple trusts
- Complex trusts
By contrast, grantor trusts do not pay their own taxes. Instead, it’s the grantor of the trust’s responsibility to pay taxes on the trust’s income.
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Trust tax rates for 2023
Trusts owe taxes and are subject to tax rates established at the federal, state, and local levels.
The federal government 2023 trust tax rates are at four different levels:
- 10%: $0–$2,900
- 24%: $2,901–$10,550
- 35%: $10,551–$14,450
- 37%: $14,451+
While the income tax rates for trusts above are quite clear, it’s helpful to go through a working example:
CA trust tax brackets: an example
Remember that the calculation that applies to trust taxes is based on the trust’s income.
For example, if a trust earns an annual income of $20,000, it would pay $5,543.54 in tax, which is an average 27.72% trust tax rate.
This broken down as follows:
- $290: 10% on all earnings up to $2,900,
- $1,835.76: 24% on all earnings from 2,901 to $10,550,
- $1,364.65: 35% from $10,551 to $14,450, and
- $2,053.13: 37% from $14,451 to $20,000.
Still, as a current or potential resident of California, it’s imperative that you review the California tax code.
In particular, any trustee or beneficiary who moves to California opens them up to becoming subject to California taxes.
A trust is subject to tax in California “if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor.” See Cal. Rev. & Tax 1774(a).
If you need information on previous years, check these rates below:
Trust tax rates 2021
The trust tax rates for 2021 were:
- 10% of between $0–$2,650
- $265 plus 24% of between $2,651–$9,550
- $1,921 plus 35% of between $9,551–$13,050
- $3,146 plus 37% of between $13,051+
Trust tax rates 2020
The 2020 trust tax rates were:
- 10% of between $0–$2,600
- $260 plus 24% of between $2,601–$9,450
- $1,904 plus 35% of between $9,451–$12,951
- $3,129 plus 37% of between $12,951+
Are distributions from a trust taxable to the recipient in California?
Generally speaking, distributions from trusts are considered income and, therefore, may be subject to taxation depending on the type of trust and its purpose. The trust beneficiaries are those liable for the distributions from a trust.
The two types that determine taxes on trust distributions are:
- Revocable living trust: distributions are typically not taxable as they are considered gifts and not income
- Irrevocable trust: may be subject to taxation depending on who receives them and how much they receive.
More on trust distribution tax in CA: The 65-day window
When thinking about tax on trust distributions, a key deadline to keep in mind is the 65 day window, as established under Section 663(b) of the Internal Revenue Code.
This deadline applies to any distribution by trust within the first 65 days of the tax year and allows the distribution to be treated as having been made on the last day of the preceding tax year.
This rule may come in handy as it provides an opportunity for tax savings.
Since trusts pay income taxes at graduated rates, splitting up the income earned between years may allow for taxation at a lower rate.
For example, if you earned a total of $4,000 in 2023 and find it possible to split this amount in half so that $2,000 is recorded in 2022 and the next $2,000 in 2023, then you would only pay 10% on the total $4,000.
By contrast, recall the tiered rates mentioned above:
- 10%: $0–$2,900
- 24%: $2,901–$10,550
If all $4,000 were to be recorded in 2023, then you would pay 10% on the first $2,900 and 24% on everything between $2,901 and $4,000. Calculating this out, this would be the difference between $553 and $400 in taxes.
While this difference may seem slim, applying this to much larger amounts, such as in the hundreds of thousands or millions, could result in vastly different tax payments.
Fortunately, the California Franchise Tax Board follows the Internal Revenue Code guidance on the 65-day window.
The board states that when it comes time to allocate estimated tax payments to beneficiaries, the trust (or decedent’s estate) must file the Form 541-T by the 65th day after the close of the current taxable year.
As applied to trusts filed by calendar year, the date of filing for the Form 541-T is March 6, 2023.
Failure to do this, and anything else relating to trust funds, falls under a payroll tax audit.
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Allocation of taxes on a trust fund in California
Expanding on the above California tax code, note that the taxation of trust income is not a one-size fits all model.
The key factor in determining how much of the trust’s income is taxable under California law depends on how much of it is actually “California-source” income.
Below are just a few examples where how much of a trust’s income may be taxed under California law may fluctuate based on the source of the income and residency of the parties involved:
Scenario 1: All trustees are California residents
If all trustees are California residents, then the entirety of the trust’s income is taxable in California.
This is because the trustees’ residency determines how much of the income is California-sourced.
Scenario 2: Mix of California and non-California trustees and beneficiaries
If the parties involved (i.e. trustees and beneficiaries) are of mixed residencies, the amount of income taxable by the state of California is calculated based on the ratio of California trustees to total trustees.
Example: $100,000 trust income of a trust with two non-California trustees and one California trustee.
In this case, the ratio of California trustees to total trustees is 1:3, meaning that the amount of income allocated to taxable California-source income is $100,000 * (⅓) = $33,333.33.
Therefore, one way to reduce the possible amount of income tax owed to the state of California would be to carefully decide the number of trustees, if any, may reside in the state.
Depending on the total number of trustees and the ratio of in-state and out-of-state residents involved, the amount owed under California tax law can fluctuate dramatically.
Responsibility for California trust taxes: the trustees
Ultimately, the responsibility for trust taxes lies with the trustees.
As such, this also means the trust fund recovery penalty lies with them, too.
The trustees, and their fees, vary depending on the type of trustee involved. The primary, and most common, types of trustees you may see include:
- Private
- Professional
- Corporate
California private trustee
A private trustee is typically a close friend, relative, or family member of the maker of the trust.
They’re usually appointed as the trust’s administrator, meaning that they have the responsibility of making financial decisions on the trust’s behalf to ensure that they are in accordance with the trust maker’s intent for said trust.
Private trustees usually work at an hourly rate, ranging from $25 to $35 per hour.
Still, considering the intimate connection between the trust administrator and the maker of the trust, many private trustees opt to carry out these services pro bono, as the trust is highly connected to the family.
California professional trustee
Professional trustees, also known as private professional fiduciaries, are trustees who carry out fiduciary tasks and related duties as part of their occupation.
In other words, these are career trustees who are skilled and experienced in the field.
As a result, they are often held to a higher ethical standard, since they have deep knowledge of what does and does not constitute self-dealing when handling financial matters related to trusts.
California corporate trustee
Lastly, the corporate trustee is entirely different from the above two types of trustees, as it is not an individual at all.
Rather, a corporate trustee is typically a bank or investment firm that the beneficiary hires to perform services and administer their trust.
Unlike the private trustee, the corporate trustee is compensated through a percentage of the trust’s assets, typically ranging between 1 and 2% annually.
In order to properly file a return, you must file and pay by either:
- Calendar Year: April 18, 2023, or
- Fiscal Year: 15th day of the 4th month after the taxable year concludes.
Final words on trust fund taxes in California
Ultimately, income taxes as applied to trusts are complicated.
Understanding the nuances and the interplay between federal, state, and local tax codes can mean the difference between making or breaking the bank.
Fundamentally, make sure you’re aware of the nuances around the following:
- Trust type
- Trust brackets
- Distributions
- Trustees
Knowing these and how they influence your trust taxation could be the difference in a tax saving.
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