Welcome to the latest edition of Fiduciary Focus, Towerpoint Wealth’s newsletter created specifically for professional fiduciaries.
This edition focuses on an area that can have a significant impact on the assets fiduciaries are responsible for managing: trust taxation.
Trusts are taxed differently from individuals, and decisions around income, distributions, investments, and expenses can all affect the tax outcome for both the trust and its beneficiaries.
Because we work under the same fiduciary standard as the professionals we serve, we understand how closely investment decisions and fiduciary responsibilities can overlap. In this edition, we’re taking a closer look at some of the trust taxation basics fiduciaries should have on their radar.
We hope you find this edition useful as you manage the tax and investment considerations that come with administering trust assets on behalf of your clients.
How Trust Taxes Affect Fiduciary Decisions
There are several considerations when it comes to trust taxation that fiduciaries may not encounter when managing assets for an individual. The tax brackets are much more compressed, and the decisions surrounding income, gains, distributions, and expenses can influence taxes paid by the trust, the beneficiaries, or both.
Having a working understanding of these rules can make it easier to see where a routine decision could have a tax consequence, and when the client’s CPA or attorney should become part of the conversation.
Start With How the Trust Is Taxed
A big factor in how a trust’s income is taxed is its structure. A simple trust generally must distribute its income to beneficiaries each year, while a complex trust may retain income or make other types of distributions.
Because trust tax brackets are highly compressed, even a relatively small amount of retained income can be taxed at much higher rates than it would be for an individual. How much income stays inside the trust versus passes out to beneficiaries can therefore make a meaningful difference in the overall tax result.
Distributions can also affect who ultimately reports the income. Depending on the trust and the type of income involved, taxable income may pass through to beneficiaries on a Schedule K-1 and be reported on their individual tax returns. So the beneficiary’s tax situation, along with the terms and purpose of the trust, is an important part of that decision.
Look at the Tax Impact Before Moving Assets
The way assets are held, sold, or distributed can change the tax consequences for the trust and its beneficiaries. Before making any changes, fiduciaries should consider a few areas in particular:
Beneficiary designations
Tax-deferred accounts like traditional IRAs need extra attention because distributions are generally taxable. Naming an individual instead of a trust can lead to different tax and distribution outcomes, so it’s worth reviewing those designations as part of the estate plan.
Liquidating investments vs. distributing in kind:
Selling appreciated investments inside a trust can trigger capital gains. If assets need to be distributed, transferring the investment itself may sometimes be more tax-efficient than selling it first and distributing cash.
Income and capital gains:
Who pays the tax depends on the trust, the type of income, and how distributions are handled. Some taxable income may pass through to beneficiaries on a Schedule K-1, while capital gains can be treated differently.
Deductions and expenses:
Some trust administration expenses may be deductible. Good recordkeeping and coordination with the trust’s tax professional can help make sure eligible expenses are included when the return is prepared.
These decisions can affect one another, so it helps to look at the tax impact before assets are sold, transferred, or distributed.
Coordinate Before the Decision Is Made
Because tax consequences can be tied directly to investment and distribution decisions, coordination is especially important before assets are sold or moved. Towerpoint’s Fiduciary Group works alongside fiduciaries, CPAs, and estate attorneys to help evaluate the investment side of those decisions and keep the rest of the plan in view.
Every trust is different, and the right approach will depend on its terms, beneficiaries, and tax situation. If you have questions about a specific trust or are weighing a distribution or investment decision and want another set of eyes on the investment side, reach out to our team.
This information is intended for general educational purposes and is not specific tax or legal advice.
The 65-Day Election
The first few weeks of a new year can still leave room for prior-year trust tax planning. Under IRC Section 663(b), a fiduciary of a complex trust may elect to treat certain distributions made within the first 65 days of the new tax year as though they were made on the last day of the prior year.
For fiduciaries, this can provide a little more time to review how much income the trust retained, what was distributed to beneficiaries, and whether an additional distribution may make sense for the prior tax year.
A few things to keep in mind:
- The election applies only to qualifying distributions made within that 65-day window.
- This election is made on Form 1041 and must be filed by the return due date, including extensions.
- Once made, the election is irrevocable for that tax year.
Because the right approach depends on the trust and its beneficiaries, this is a good item to review with the trust’s CPA early in the year rather than after the filing deadline is approaching.
“Know what you own, and know why you own it.” — Peter Lynch
Good stewardship means understanding the purpose behind the assets you manage and how each decision can affect the people relying on them.
With trusts, the way assets are held or distributed can also create tax and investment consequences that deserve careful attention. From beneficiary designations to distributions and investment sales, understanding the full picture can help professional fiduciaries make more informed decisions on behalf of the clients they serve.
