Who pays tax on trust income?

[install4you]

Greetings.

I hope I'm doing this right. @dmertz gave some good answers close to my issue, but I have some differentiations. Anyone who understands the question is welcome to answer. I apologize in advance for my ignorance. Thanks to anyone who takes the time to read this, & especially to anyone who answers

I'm the sole trustee and 50% beneficiary of my parents irrevocable trust. The lawyer who drew it up in 2011 also called it an intentionally defective trust so my parents' tax status would remain in effect. The trust was funded with most of my parents' investments and there was a separate trust for their house.

I was granted broad decision making powers over everything including distribution of the principle & there were no required distributions. I'll skip all the reasons, but after the trust was created, and with my parents full agreement (telling you this so it won't look like I was abusing my authority), it was necessary for me to distribute to myself about $24,000/year. In the first few years I had difficulty and had to amend several tax returns because I didn't understand the idea of "basis." After receiving a huge tax bill from the IRS I consulted a CPA and learned just how ignorant I was on the subject. By having the tax liability for those years shifted to me we ended up paying about $8,000 rather than $20,000+ in taxes.

When the cash investments were depleted, we sold the house & put the proceeds in the other trust as required. The capital gains threshold was not crossed, so there were no taxes due from the sale. Since 2017, the only money in the trust came from the house and the only income has been simple interest. 2018 was the first entire year like this. The money from the sale of the house was all basis, so only the interest earnings are taxable.

When the accountant prepared the 2018 tax return, she assigned all the interest earned to me on my K-1. I questioned that because the tax liability on the interest was about double for me what it would have been if the trust had paid it. Circumstances were such I just didn't force the issue and on about $1,400 earned interest, we paid about $300+400 in tax & accounting vs. about $150 in tax if I could have filed the trust return on my own.

As of December 2018, both parents have died. In 2020 I distributed the 25% each to my kids as instructed. I wanted to file the return for 2019 on my own and let the trust pay its own tax. The more I read the more confused I became. I read an answer from DMERTZ that said distributions always came from income first and principal second. This is echoed in several web searches.

I also found definitions & interpretations that took me the other way. As I understand it, the biggest difference between a simple and complex trust is the requirement or lack thereof to distribute all earnings each year. Since there is no required distribution, it seems like the trust could choose to retain the earnings and distribute only nontaxable principle.

My problem is that I just don't understand all the nuances of how the rules work here. Some articles I've read seem to say a trust can keep the tax liability by choice.

Even if I decide to just report the interest earnings on the K1 to me, when I look at the accountant's 2018 return I get confused.

[install4you]

Oops. I didn't see a way to edit my post, so here are a couple of corrections.

1) I said both parents had died as of December 2018. Should have been 2019.

2) After posting, I realized I in the retirement section. Sorry about that. If there's a way to move this to a better place I welcome instruction.

I'm beginning to feel the slow-down effects of 67 years and mental stress of Covid 19 isolation. Thanks for patience.

[dmertz]

I'm not particularly familiar with trusts, I really only have looked at the requirements for estate income tax returns.  You really need to be dealing with someone who is familiar with the type of trust for which you are trustee and that would require that person to review the trust instrument.

Whether or not distributions of income are required are governed by the trust instrument (the choice was made when the trust instrument was created).  That's where you need to look to see if income is permitted to be retained (with retaining income forcing it to be a complex trust; simple trusts are required to distribute income currently).  As you noted, if any distributions are made, they come first from this taxable income, so distributions can't come from corpus until all of the current-year income has been distributed.  To retain all of the income for taxation in the trust you would not be able to make any distributions for that trust tax year.  You can see how this is dictated by reviewing the calculations on Schedule B (Form 1014).

As trustee you have a fiduciary responsibility to the beneficiaries of the trust.  For a small amount of tax and CPA fees, is it worth the potential increase in liability for any errors in the handling of the trust that might have been avoided by having a CPA prepare the trust's income tax return?  Even when using a CPA, you sign the trust's income tax return, so you have the opportunity to question the CPA about how the return is prepared, including questioning whether or not income can and should be retained in the trust rather than distributed currently.

[install4you]

Thanks for your prompt reply.

The only thing the trust says about distribution is that after the death of the 2 people who created it (my parents), it should go to me & my 2 children in a 50/25/25 split. 

What has confused me is the many articles I've read that talk about a complex trust not distributing the earnings  but distributing from the principle. If the earnings-first rule is as certain as you and many others say, I don't understand why I've seen so many articles discussing the opposite.

The attorney who set up the trust said (& it's very clear to me) that an irrevocable trust with broad decision making authority given to the trustee absolutely must have a trustee whose integrity is unquestionable. I've done everything I could to be transparent in everything. I think my mistakes early on may be pushing toward penny-wise & dollar-foolish in the name of protecting the money. 

The original plan was that the trust would retain all earnings & pay tax on its earnings along the way. When things didn't happen as we expected my parents needed help to live in a senior apartment complex near me. With the distribution authority given to me as the trustee, the lawyer explained I could distribute money to myself (especially since I am 50% beneficiary) and do what I wanted to do with "my" money. Thus, if I chose to use the money to help my parents, the integrity of the irrevocable trust was maintained. It just so happened that my parents had elected to withdraw mostly principle (basis) from their various investments over the years prior to the trust, leaving mostly taxable earnings.

When I withdrew funds in the early years I was unaware it was mostly taxable earnings. My tax-filing errors then are what initiated bringing in a CPA and amending both trust and personal returns for at least 4 years.

I guess now when it only involves a $400-600 difference I should not quibble over the little bit of taxable interest that shows up on my K1.

I've emailed the accountant about my questions & expect to hear before long. If you have any other thoughts, I'd love to hear them.

I've let myself share some details in hope that this story helps someone else.

Thanks for your help. If you (@DMERTZ) need advice about hanging stuff on the wall, tell me how to message you my contact info & I'll be glad to talk you through.

[dmertz]

All I can suggest is to do a sample calculation on Schedule B (Form 1041).