Trusts 101 for physicians: How trusts are taxed

Learn how to the IRS taxes trusts in part two of our in-depth look at this aspect of estate planning.

Trusts are often an integral part of physicians’ asset protection and estate plans. In part two of our discussion of the trust basics every physician must understand we take a look at the what the I.R.S says about taxation of income to trusts and their beneficiaries.

In part one of our look at trusts we covered some of the basic working vocabulary of trusts that is required when considering various trust strategies and their effectiveness and legality. This week, we look at the tax rules that apply to trusts, quoting directly from the best source, the I.R.S. itself.While some trusts do have established legal use for various tax planning purposes including estate tax reduction and tax deferral, many are sold on false promises of tax savings and income tax savings in particular. I’ve previously covered some of the abusive tax plans that are aggressively marketed to doctors in detail, but it’s important we start with some basics rules. This is not tax advice.

  • Someone will always pay the tax, almost no trust can just make taxes “disappear”. Taxes will either be paid by the person who set the trust up, the person who receives the proceeds or the trust itself.

    All income a trust receives, whether from foreign or domestic sources, is taxable to the trust, to the beneficiary, or to the grantor of the trust unless specifically exempted by the Internal Revenue Code (IRC).
  • Trusts that don’t report their income on your tax return as the grantor will generally have to file their own return.

    A domestic trust must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year. If the trust is classified as a Domestic Grantor Trust, it is not generally required to file a Form 1041, provided that the individual taxpayer reports all items of income on his own individual income tax return. Thus, the individual pays the total tax liability upon the filing of his return for that taxable year.
  • Offshore trusts are not tax exempt, and income earned by the trust may be attributable to you here in the U.S. for tax purposes.

    Foreign trusts to which a U.S. taxpayer has transferred property are treated as grantor trusts as long as the trust has at least one U.S. beneficiary. The income the trust earns is taxable to the grantor under the grantor trust rules. Grantor trusts are not recognized as separate taxable entities, because under the terms of the trust, the grantor retains one or more powers and remains the owner of the trust income. In such a case, the trust income is taxed to the grantor.
  • Offshore trusts have special tax reporting requirements, they are not tax free.

    Foreign trusts are subject to special filing requirements. If a trust has income that is effectively connected with a U.S. trade or business, it must file Form 1040NR, U.S. Nonresident Alien Income Tax Return. Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Foreign Gifts, must be filed on the creation of or transfer of property to certain foreign trusts. Form 3520-A, Annual Information Return of Foreign Trusts With U.S. Owner, must also be filed annually.
  • If your offshore trust has an offshore bank account (or if you have one in your own name, through an offshore LLC etc.) you have a legal duty to report the account to the I.R.S. if it is over ten thousand dollars in value.

    In addition to filing trust returns as just described, a taxpayer may be required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts, if the taxpayer has an interest of over $10,000 in foreign bank accounts, securities accounts, or other financial accounts. Also, a taxpayer may be required to acknowledge an interest in a foreign bank account, security account or foreign trust on Schedule B, Interest and Dividend Income, that is attached to the taxpayer’s individual income tax return.
  • Transfers to trusts may be subject to estate and gift tax limits and reporting requirements.

    Transfers to a trust may be recognized as completed gifts for federal gift tax purposes. Further, whether or not the gift tax applies, if the transferor retains until death the use of, enjoyment of, or income from the property placed in a trust, the property will be subject to federal estate tax when the transferor dies. (IRC § 2036(a)).