Income Taxation of Grantor Trusts
The income taxation of trusts is governed by Subchapter J of the Internal Revenue Code, §§ 641 through 692. For purposes of certain provisions within Subchapter J, a trust will either be classified as a simple trust or a complex trust.
Simple Trust: A simple trust is (1) required to distribute its entire accounting income every year; (2) has no beneficiaries that are qualifying charitable organizations; and (3) makes no distributions of amounts allocated to the corpus of the trust.
Complex Trust: Is defined as any trust that is not a simple trust.
In general, the taxable income of a trust is taxed to the entity or to its beneficiaries to the extent that each has received the accounting income of the entity. In effect, Subchapter J creates a modified pass-through principle, so that whoever receives the accounting income of the entity, or some portion of it, is liable for the income tax that results.
Special Rules for Grantor Trusts
A Grantor type trust is a legal trust under applicable state law that is not recognized as a separate taxable entity for income tax purposes because the grantor has not relinquished complete control over the trust. Internal Revenue Code Sections 671-678 apply to grantor trusts. Certain conditions which would be viewed as keeping the grantor in control are:
Whether the grantor retains a reversionary interest in the trust;
The grantor’s abilities or powers to control the beneficial enjoyment of the trust principal;
The grantor has certain administrative powers;
The grantor’s abilities or power to revoke the trust; or
Whether the trust income can be distributed to or for the benefit of the grantor.
If any of these controls are retained by the grantor the trust is ignored for tax purposes and all of the associated income and deductions of the trust are treated as belonging directly to the grantor.
Generally, most irrevocable Medicaid or asset protection trusts are simple grantor trusts during the life or lives of the grantor(s).
Filing Requirement of a Grantor Trust
If the entire trust is a grantor trust, fill in only the entity portion of form 1041. Label it a grantor trust, immediately after the name of the trust in the entity portion. Do not show any amounts on the form itself. All dollar amounts will be shown on an attachment to grantor’s form 1041.
On the attachment to form 1041 include the following:
the name, identifying number, and address of the person(s) to whom the income is taxable;
the income that is taxable to the grantor (report the income in the same detail as it would be reported on the grantor’s return had it been received directly by the grantor); and
Any deductions and credits applicable to this income.
The income and deductions applicable to this income must be reported by the grantor on his or her own federal income tax return.
New York State Filing Requirements of a Grantor Trust
New York State follows the same requirements as the federal 1041. The New York Fiduciary Income Tax Return (Form IT-205) is filled out exactly as you would fill out the 1041. You fill in only the entity portion and leave the rest of the return blank. Again all dollar amounts will be shown on the attachment to the IT-205 including the same information required on the attachment to the 1041.
The income would again be reported by the grantor on his or her own New York State personal income tax return.
This Memorandum is based on current law and is for informational purposes only. It is important that you discuss all legal options and consequences with a qualified tax professional (CPA) or elder law attorney prior to any action. Should you wish to discuss your situation with us, please call (631) 424-2800 for a consultation. For additional Memoranda, please call or visit our website at www.elderlaw.pro.