Trusts are legal entities that contain assets designed to benefit a set group of people or institutions. Some assets are distributed to the trust's beneficiaries on an occasional or routine basis, and the beneficiaries are required to pay income taxes each year on the distributions of funds that they receive from a trust.
Beneficiaries of a trust have to pay income taxes on their distributions.
How Trusts Work
When someone sets up a trust, she selects a trustee to serve as the administrator of the trust. That trustee manages the trust and its contents, which could include cash, property, securities or other assets, and tends to tasks such as distributing income from the trust to beneficiaries, who are named at the outset of the trust's formation. Income is distributed to beneficiaries according to stipulations made at the trust's inception. A trust's beneficiary can be one person, a group of people, or an organization.
Beneficiaries and Distributions
Beneficiaries who receive distributions must include the money they make from the distributions in their income calculations on their annual tax return. Beneficiaries receive a Schedule K-1, which is tax Form 1041, at the conclusion of each tax year with the details of the relevant trust that they need to include on their federal income tax return. That information includes the total amount of distribution funds that the beneficiaries received during the course of the year. Beneficiaries are taxed on the income at the same rate as other income.
Trusts and Distributions
Trusts serve as a sort of conduit for funds. Because the tax obligations of the income that the trust generates falls to the beneficiaries, the trust itself, in its role as a separate financial entity, does not have to pay taxes on the distributions. In fact, distribution payments benefit trusts on a tax basis. That is because executors of the trust can claim a deduction for the trust that is equal to the amount of those distributions.
A second way that federal tax code encourages trusts to distribute income to beneficiaries is that it triggers higher tax rates at much lower income levels for trusts than for individuals and families.
Foreign Trust Distributions
Offshore trusts have acquired a reputation as serving as tax shelter tool, enabling American citizens to move assets out of the United States in order to avoid paying U.S. tax rates. However, the Internal Revenue Service emphasizes that all income that Americans earn worldwide is subject to federal taxation. That includes distributions from trusts that are located outside of the U.S. in one of the noted tax havens such as the Cayman Islands or the Bahamas. If you receive distributions from a foreign trust, then you are required to report the distributions in your federal income tax return using Form 3520.