Are you totally lost when it comes to handling trust taxes for a deceased parent? Here is a super simple and quick guide to bring you up to speed.
Disclaimer: Trust taxes for deceased parents can be quite complicated. The solutions for preparing and filing these taxes may depend on several factors not discussed here. We strongly recommend that you seek out the help of a tax professional with experience with trust taxes. Do not count on this article for tax advice.
What the heck is a trust, really?
Think of your late parents’ trust as if it were a new corporation. You (and likely your siblings) are the owners of this “corporation”.
Mom and dad pass away (sorry), and their wealth is now held in this corporation.
Typically, this wealth includes investments held in brokerage accounts, investment real estate property, and rental real estate property,
The corporation (the trust) has a CEO (the trustee) – who is also likely a shareholder (the beneficiary).
The trustee, by the way, is the one who mom and dad thought would be the best one for the job of running this family corporation. I don’t envy the trustee as the other family members are usually quite critical of the work being done.
Lucky you if you are the trustee.
Please have thick skin and take the high road when dealing with family criticism as you work hard and spend time in handling this stuff.
Anyway, can you see how a trust is almost identical to simply being a corporation?
Good, let’s move on.
Do I need to file a trust tax return for my parents’ trust?
A corporation needs a tax return to report it’s income activity.
And so does a trust.
Typically a trust tax return is required when income is present. Most trust income includes interest income, dividend income, capital gains income, and rental property income from investments and properties owned by the trust.
If there is investment income from a brokerage account, the trust will receive a form 1099B to help with the tax preparation. Rental property and property sales require that the trustee keep track of and report the activity – just as if it were being reported for a corporation or even a personal tax return.
It’s not that complicated.
But I don’t think my parents have been filing a trust tax return.
Your parents probably did not file or need to file a trust return.
Most “living” trusts are “disregarded” by the IRS when the creator(s) of the trust are still alive. When this is the case, mom and dad can report the activity on their personal tax return as if the trust didn’t exist.
Once they pass, however, most trusts are organized so that the IRS “recognizes” the trust for tax purposes now and they will be expecting a trust tax return to be filed to report the income activity.
As long as the trust has income from investments and other property (such as the sale of property) in its name, a trust tax return will be required each year to report it.
You might consider moving the property out of the trust’s name and into the individual beneficiary names and terminate the trust. This will eliminate the need to file the trust tax return in future years. Realize, however, that trusts are set up for legal and wealth management reasons – and you should talk with a trust attorney before making any such moves. I’m just a tax guy and I can’t tell you if that is a good idea or not.
How to file a trust tax return
It might seem daunting to file that first trust tax return, but really all a tax preparer needs are the trust’s organization documents, the FEIN (federal tax identification number) of the trust, and documents for the trusts income activity.
You can verify that the trust has a tax ID number by locating the FEIN letter form the IRS that was provided when the FEIN was issued.
Note that the trust might not yet have a tax ID. After all – it didn’t need one when the tax items were being reported under your parents’ tax IDs.
One way to check is to look at a brokerage tax statement and see what name and tax ID the investment income is being reported under. If it does not match any family member or parent social security number, it’s likely that the trust already has one.
So go look for it.
Another possible option is to go to the trust lawyer who set up the trust and ask him or her.
if you need one, getting a tax ID for a trust is pretty easy – you can do this here or you can hire a professional to do it for you. We recommend that you have a professional get it for you to make sure it is being done properly.
Will the trust owe tax? Who pays it?
This depends on a few things and is a little but complicated, but there are two main ways that a trust will pay tax on its income.
A “complex” trust that retains it’s income, for the most part, pays it’s own taxes. It’s taxed like a classic corporation. If you are the trustee or are handling the trust’s affairs, you will likely write a check to the IRS (and perhaps a state tax agency or two) each year from the trust’s accounts.
A “simple” trust that distributes its income, for the most part, does not pay any tax by itself. It is taxed as a pass-through entity. The income generated by a simple trust is divided between the beneficiaries and must be reported on each of the beneficiaries individual tax return.
Keep in mind that the above advice may be an oversimplification. You can have complex trusts that distribute income and different types of income are sometimes distributed while others are not. This is where you will need to depend on a tax preparer.
You might wonder, “how would the individuals that are beneficiaries to the trust know just how much income to report?”
This is handled by the trust issuing a form K1 to each beneficiary. This form is kind of like a W2 and it lets the preparer know exactly how much and what type of income to report on an individual tax return.
So, as a simple example, if a simple trust makes $1000 in interest income and there are 4 equal beneficiaries, each beneficiary would report $250 of interest income on their individual tax returns and pay the tax on it themselves. They would each get a form K1 form the trust’s tax preparer pointing that out to them.
Which is better, simple or complex? And do you get to choose?
Generally, the organizing lawyer will set the way taxes are handled in the trust’s organizational documents – but this can be likely changed, if needed.
I can’t tell you which is better, simple or complex, because it really depends on your situation.
The advantages and disadvantages of simple vs complex taxation for trusts depend on several factors such as the type of income and the tax brackets of the beneficiaries.
Trust rates tend to be on the high side, so much of the time, a pass through trust is the best way to go. But this is a very general statement and this will not be the case in many scenarios.
You really need a tax pro to look at the entire situation to see which is best.