Wholly Discretionary Trust tax confusion..

[nathstaxes]

Hi,

my mother recently passed away.

Her will set up a Wholly Discretionary Trust (WDT) for me.

My brother is the trustee.

We live in Ohio.

My question is about how taxes are handled for the WDT.

According to a Morgan Stanley pdf on this, INCOME tax rates for trusts in 2024 are:  

• $0 – $3,100:                 10%
• $3,100 – $11,150:       24%
• $11,150 – $15,200:     35%
• $15,200+:                     37%

And then separately it lists Tax Rates on Long-Term CAPITAL GAINS and Qualified Dividends for Trusts as:

• $0 – $3,100:                    0%
• $3,100 – $15,450:        15%
• $15,451+                       20%

In addition, it mentions Net Investment Income Tax of 3.8%. It seems this might only apply to individuals?

I'm struggling to understand a few things.

1. What is considered INCOME vs. CAPITAL GAINS for my WDT?

It's obvious for an individual, but how does a trust earn income? It can clearly earn capital gains by investing in a stock index and then realizing those gains by selling some of the stock. But income? It's not as if the trust is working and earning money, etc.

2. We anticipate that the WDT will earn about 8% in stock index each year, which would be about $20,000 per year of unrealized capital gains.

-If my brother leaves the whole $20,000 unrealized gains alone and neither sells it to realize the capital gains nor distributes it to me, as I understand it the $20,000 won't be taxed for that year. Is that right?

-Let's say he begins at a certain point to DISTRIBUTE say $12,000 per year to me. As I understand it, if he distributes $12,000 to me, in 2024 that will be taxed at the CAPITAL GAINS brackets listed above, so a $12,000 distribution to me would result in $1,335 of tax, is that right?

This seems very high for such a low income. As this will be my only source of income, is there any way to avoid paying such high taxes on a distribution of just $1,000 per month?

THANK YOU!

[M-MTax · Accepted solution]

1. You're not taxed on unrealized gains......only when something is sold for more than what was paid for it do you have a taxable gain.

2. The trust tax rates don't apply to your trust if all of the income and capital gains get distributed to you. Then, you pay tax on your 1040 from your part of the income and gain.

3. Income is a general term. Capital gains are taxed differently......at a lower rate.......than ordinary income like interest from a savings account. Capital gain happens when you sell a capital asset for more you paid for it.

4. The Net Investment Income Tax applies to trusts the same as individuals.

5. Trusts don't have "earned income" if they only invest in assets like stocks and bonds and mutual funds and deposit money in savings accounts or CDs.

6. In your example, if your brother leaves the $20,000 unrealized gains alone and neither sells it to realize the capital gains or otherwise then neither the trust nor you pay tax on it.

7. If the trust has capital gains and distributes it to you, that's still capital gain. The character of the income doesn't change when distributed from the trust to you.

[nathstaxes]

THANK YOU so much for your detailed reply!

I had a few clarifying questions if I may.

1. So, if my WDT is invested all in stock index and earns $20,000 in unrealized gain one year. If my brother leaves $8,000 alone and sells $12,000 of the stock (realizing the gain) and distributes that $12,000 to me - then based on your answers the trust would declare no income that year and I personally would declare $12,000 of 1040 income on my personal return?

If that is correct, then do I declare it as capital gains or income?

And do I use the tax brackets for individuals rather than for trusts?

In other words, let's say I'm supposed to claim it as capital gains and with single filers, the 0% rate now applies to incomes up to $47,025 in 2024. So, would I pay $0 tax on the $12,000 distribution?

2. I totally understand capital gains from stocks and owing no tax if those gains aren't yet realized. However, let's say my brother invests some of the WDT into bonds, CDs or a savings account.

Is interest from bonds, CDs, high yield savings account considered capital gains or income?

Thanks!

[M-MTax]

1. Yes, you would report that as capital gain from the sale of the stock the trust sold. You use the tax bracket for individuals because you're reporting the gain on your return, your 1040. Now you have to be aware that the entire distribution is not taxable, just the gain that is distributed to you.

2. Interest from bonds, CDs, high yield savings accounts is all ordinary income, not capital gain. You don't get the favorable tax rates on interest income like you do with capital gains.

[nathstaxes]

Again, thank you for your knowledgeable reply!

So, just to make sure I understand correctly, let's use an example

that is likely to be roughly what we will actually do with my WDT:

ASSUMPTIONS IN BOTH SCENARIOS:

Let's say my brother invests my WDT half in stock index and half in corporate bonds.

The stocks earn 8% return one year which is $10,000 unrealized capital gains.

The bonds earn 5% return one year which is $6,250 in INCOME (because interest on bonds is income, not capital gains).

SCENARIO 1 - GROWTH PHASE:

My brother distributes nothing to me that year, as we want the WDT to grow.

The $10,000 unrealized gains are not taxed.

The $6,250 interest is considered INCOME earned by the trust. Since it is not distributed, the trust

pays 10% tax on the first $3,100 and 24% on the $3,101 to $6,250 portion, for a total of $1,066 tax.

Is that right?

--->If I understood that right, then what if we invested in tax-free municipal bonds, would the trust still 

pay tax on the interest from those type of bonds?

SCENARIO 2 - DISTRIBUTION PHASE:

My brother distributes $12,000 to me one year.

The distribution is made up of all the $6,250 bond interest income (makes most sense)

and then also $5,750 of the $10,000 unrealized capital gains are sold and realized.

Since 100% of the income of the trust has been distributed this year, the trust pays no tax.

I pay personal tax on the distribution on my 1040 return, declaring $6,250 of bond interest income.

Since corporate bond interest is treated the same as income, I pay $0 tax on the $6,250 interest income as it

is below the standard deduction of $14,600 for 2024.

I also pay $0 tax on the $5,750 capital gains, as it's under the $47,025 limit (below which you pay 0% capital gains tax).

Did I do that right?

THANK YOU so much!!

[M-MTax]

Scenario 1 - you're right except the trust would not pay tax on interest from tax exempt municipal bonds.

Scenario 2 - if that's all of the income you have.....as you said.....then you will have no tax liability.

[nathstaxes]

Thank you for your answers - much appreciated!

[jtax]

There is another complication. The usual rule under I.R.C. 643(a) is that capital gains stay with the trust (i.e. are taxable to the trust and are not part of DNI - distributable [to a beneficiary] net income) unless an exception applies. "

The exceptions are complicated and must be consistently followed, sometimes from the trust's first year. 

You might want to consult with a professional (CPA, tax attorney -- and one who does trusts all day not now and then) for the first year to make sure how to make things work the way you want to. Well worth buying an hour of their time.

In particular see the rules as described in the IRS regulations

https://www.law.cornell.edu/cfr/text/26/1.643(a)-3

or perhaps more readable this article. 

https://www.thetaxadviser.com/issues/2014/aug/tax-clinic-03.html

in particular if the terms of the trust combined with state law do not allocate capital gains to income, which is unlikely in my experience, you are probably better off relying on a consistent, from day one, application of Treas. Reg. 1-643(a)-3(b)(3) and exception 3 (" Allocated to Corpus but Actually Distributed") in the article.

That exception applies if you actually distribute the capital gains to a beneficiary and/or use the amount of gains in a year to determine how much to distribute. 

That is a bit confusing because the whole 643 DNI paradigm otherwise does not trace what money is distributed. I.e. A trust earning only $1000 in interest on 12/01 but distributing $700 cash to a bene on 03/01, is treated as having distributed $700 of interest income to the bene (and having $300 of interest income itself). That is so even though the $700 distributed was not the interest income. Capital gains are confusingly different, though I'm not sure if they really require tracing. That's why I recommend getting a professional opinion at the start and following it.

Also of interest to your brother when planning is the ability to make distributions during the first 65 days of a new trust tax year and elect (on the trusts 1041) to treat them as having been made in the prior year. See https://www.law.cornell.edu/uscode/text/26/663 paragraph (b).

Finally also in the arsenal of a trustee of a irrevocable trust is the ability to distribute assets in-kind (without selling). I.R.C. 643(e). The bene keeps the trust's basis and only pays capital gains when sold. Yet the fair-market value of the distribution is DNI. This only applies to certain distributions. In particular it does not apply to distributions described in I.R.C. 663(a), which include a gift under the terms of the trust that is a specific sum of money (or specific property) and is paid in not more than 3 installments and charitable distributions. https://www.law.cornell.edu/uscode/text/26/663

[M-MTax]

You might want to consult with a professional (CPA, tax attorney -- and one who does trusts all day not now and then) for the first year to make sure how to make things work the way you want to. 

Are you a lawyer or do you just manage a couple of trusts for yourself and/or family members. Also, how in the world are you in any position to know what anyone on this forum does "now and then"? Furthermore, no attorney or CPA does "trusts all day" - there's just not that big of a market for just "doing trusts".

This is simply not a big deal since most states have enacted the Uniform Principal and Income Act, in whole or in part, and standard trust terms give the trustee wide discretion.

You're also a day late and a dollar short having posted a response to a question that was answered over 2 months ago.