Theresa Marx:
Hello and welcome to another episode of Wealth Planning Illuminated. I’m your host, Theresa
Marx, a senior wealth strategist at CIBC Private Wealth in the US. I am joined today by my
colleague Halsey Schreier, also a senior wealth strategist at CIBC Private Wealth. In today’s
episode, Halsey and I will discuss the federal income taxation of trusts. In particular, we will
discuss grantor and non grantor trusts as well as the general rules that apply when determining
how the income of a trust will be taxed. Alright, with that, let’s get started. As strategists, we
spend a lot of time talking about trusts, whether it’s creating trusts or funding trusts or
administering trusts. And a question that comes up often in all of those phases of trust is how is
a trust taxed for income tax purposes? And I know that question can be complex and it is
dependent on a lot of different factors, but Halsey generally, where should we start when trying
to understand the income taxation of trusts?
Halsey Schreier:
So the first place to start with the income taxation of trust, which is obviously a pretty
complicated area, is there are two choices. Initially, it’s either going to be a grantor trust for
income tax purposes or a non grantor trust for income tax purposes.
Theresa Marx:
So what do you mean by grantor trust?
Halsey Schreier:
So grantor trusts are trusts that are taxed back to the individual that created them. So your most
common example of a grantor trust is your revocable trust because you have the authority to
revoke the trust, it is deemed and also receive distributions from the trust you are deemed to be
the owner of the trust for income tax purposes. So that is a grantor trust for income tax purposes
and all the sort income that’s either generated inside the trust capital gains, interest income
dividends, all that is reported on the individual’s income tax return. So it’s really the most
straightforward example of trust taxation and probably the most intuitive because it is really just
reflected on that individual grantor’s return.
Theresa Marx:
So it’s almost like for income tax purposes, it’s the grantor’s kind of like alter ego if you will. Like
whatever is happening in that grantor trust ultimately shows up on the grantor’s income tax
return.
Halsey Schreier:
Exactly. And grantor trust, they aren’t all revocable. That’s one way that becomes a grantor
trust. But there are a few different powers that can be utilized to make an irrevocable trust that is
outside of your estate for estate tax purposes. A grantor trust for income tax purposes, which
can be quite useful because it really does help sort of relieve the income tax burden on the trust
and allow for the grantor to pay that income tax during his or her lifetime, which helps those
assets accumulate more outside of their his or her own estate. So it’s a pretty powerful estate
planning tool. There are a few ways to structure that to sort of make sure that you retain enough
power, retain enough of a string over the trust for income tax purposes, but not to do something
bad for the estate tax planning. And that’s a lot of them is really it’s substituting the trust assets,
the ability to swap the assets for equivalent value, the ability to borrow against the trust without
adequate security. And then one that really comes up a lot nowadays is that if your spouse is
also a potential beneficiary, so think about a spousal lifetime access trust, a slat, which I feel like
we talk about all the time with the elevated exemptions, that is generally going to be a grantor
trust for income tax purposes. Of course you can draft around that and create a non grantor
trust, but it’s a little bit more difficult. So the grantor trust is really, I think though a lot of the trust
we see today are grantor trust.
Theresa Marx:
And it sounds like it’s the easier one when it comes to income tax questions because it all is just
flowing to the grantor. So if it’s not a grantor trust or as we call it a non grantor trust for income
tax purposes, what do we need to know about the income tax rules for a non-grantor trust?
Halsey Schreier:
Yeah, you were definitely right there. A grantor trust is the easier choice. So a non-grantor trust
really it’s if an irrevocable trust, it’s its own separate taxpayer. So that trust is going to have to
determine sort of like a company what its income tax is and everything else. And this brings in
some fun terms including DNI or distributable net income, which we cannot get into here. This is
not the right forum, but we can talk about it a little bit. But basically a non-grantor trust is going
to figure out their total income just like an individual would and sort of total up all the numbers. It
has its own standard deduction, all those things. It can deduct certain expenses, so it can do a
lot. That sort of calculation is very similar to an individual’s, but then you have to sort of branch
off into this DNI world, which is odd and it can be very confusing.
So when you’re looking at DNI, you start off with that total income number and you add some
things, you take away some things. Basically one big thing is you take away capital gains
because the trust itself is going to pay taxes on capital gains. Because really think about that.
The capital gains the capital appreciation of the principle, so the trust is going to bear that
burden and then you add back in capital losses and tax exempt interest, but then you can also
back out some expenses and then some other items that are a little bit more esoteric. That DNI
number is very important because that’s going to determine who pays the taxes on that income.
It’s either going to be the trust in a non-grantor trust or a beneficiary that receives it.
Theresa Marx:
So I kind of like to think, and I am often described a non-grantor trust as almost like a hybrid tax
entity. Sometimes you think about an individual that pays all their own taxes or you think of an
LLC for example that has flow through a non-grantor trust has a little bit of elements of both
where it pays some of its own income tax, but it might flow through some of the income tax to
the beneficiary. And it sounds like that’s where the DNI comes in is where we’re trying to figure
out, okay, how much might a beneficiary have to pay of that income tax?
Halsey Schreier:
Yeah, that’s a great way to put it because it’s sort of unique when you’re looking at all the
different income tax methodologies out there, whether it be partnership corporations, escort, all
individual. This is an interesting one because there is a hybrid approach, it’s either going to be
at the entity level inside the trust or it can flow out to the beneficiary owners, so the
beneficiaries. So it can get pretty complicated. So I think, and I would be remiss not to say this,
if you have questions about any of these things specific to your own situation, you really want to
make sure you consult with your tax advisors, CPAs that understand this. And this is a pretty
small area of the tax code and not all CPAs or accountants understand it or even tax attorneys.
So you want to make sure that you have the right experts at the table.
Theresa Marx:
Yep, exactly. So once DNI is determined, how do we know, how are we figuring out what
beneficiaries pay income tax or how much they pay? How does that factor into the whole
analysis?
Halsey Schreier:
So it depends, really depends at the end of the day how much each benefic beneficiary
receives. And you also, you have to calculate the DNI, and it could be different types of DNI,
whether it be, let’s say we have interest income and dividend income, which could be taxed at
different rates for individuals. So basically if we have, let’s say the DNI is equal to about $20,000
and 10,000 of it is dividend income and 10,000 is interest income and there are two
beneficiaries of trust and they each receive $10,000. So basically at the end of the day, so
$20,000 left of trust, there was $20,000 of DNI, so that DNI is fully to the beneficiaries. Now,
each beneficiary would have to sort of equal up the specific characteristics they receive. So they
would each be deemed to receive 5,000 of dividends and 5,000 of interest income so that those
tax classifications flow through to their own returns because they would be the ones responsible
for reporting that income on their tax return. Now if you had a situation where there was more
DNI that went actually out, then the trust itself would have to pay income taxes on that. So that
DNI number is really important because that sort of determines if the beneficiary is going to
cover all the income taxes associated with that or portion, and then it’s got to be prorated
among the beneficiaries according to the distributions they receive.
Theresa Marx:
Okay. So in your example, if you and I were beneficiaries of a trust and you received 10,000
throughout the year and I received 10,000 throughout the year and the trustee figured it all out
and said, okay, 20,000 of this was DNI, then you get 10,000 of that DNI and I get 10,000 of that
DNI and whatever percentage was interest income or dividend income is showing up on a K-1
that I would then use to fill out my income tax return. And same for you. I think then as you said,
the distributions almost cap what the beneficiary might have to repor.t So that if you and I each
received that $10,000 each, but there was 30,000 of DNI, we still only have to report our
$10,000 distribution. The trust has to take that extra 10,000 and it puts it on its income tax return
and reports it, right?
Halsey Schreier:
Correct. And the trust income tax return is a little more penal than their individual because the
rates, the base of the brackets are so compressed. So this is one thing, while the grantor trust is
great and everything because a grantor an individual, they don’t reach a top bracket to 600,000
or so. I mean it’s a pretty big number, but a trust reaches the top income tax bracket just over
14,000, think it’s right around 14,400. And so you’re at 37% almost right away with income. So
that’s why it is very important to have that calculation of DNI and understand what’s staying in
the trust, what’s going outside because that federal income tax rate, you jump to the top so
quickly inside the trust. So that’s something that really has to be paid attention to. Of course
there are state implications, some states are better than others in income taxes, but that
depends on where you live.
Theresa Marx:
Okay, so as you were saying, because it runs up the rates so much quicker, making sure you
understand at the end of a tax year what’s happened and really thinking about is there income
tax planning we can do in addition to just kind of basic trust planning. That should be part of the
conversation as well
Halsey Schreier:
Without a doubt. And I mean that’s something that we both sit on these committees for the trust
distributions. That comes up a lot in the end of the year and even early into the next year
because there’s some rules that allow you to sort of look back and everything to make sure that
you get that income out because the tax bracket comparison between an individual on the trust
is pretty crazy. And so it makes for income tax planning purposes, a lot of times it makes sense
to distribute that DNI and get it out to the beneficiaries because their brackets going to be a lot
of times much lower than the trust if it holds back the income.
Theresa Marx:
Well, that’s probably definitely not going to be higher, right?
Halsey Schreier:
It can’t, yeah, it’s pretty tough.
Theresa Marx:
Yeah. Yeah. Okay. So thank you for walking us through these general rules. I mean, obviously
in addition to kind of the general rules Halsey has described, there are so many nuanced rules
as we’ve mentioned a couple of times now that may apply to a particular trust depending on the
terms of that trust, the type of income actually realized in a given year. And as Halsey just
mentioned, there could also be state income tax implications, which definitely goes beyond the
scope of this current conversation. But it is important to make sure you’re talking to the trustee,
talking to your accountant if you are a beneficiary of a trust, to make sure you understand what
the implications are for you as well as for your trust. Thank you for joining us for this episode of
Wealth Planning Illuminated. We hope you found this topic interesting and that you will continue
to explore the variety of wealth planning topics available to you on this channel. Thank you and
have a great day.
Disclosure:
CIBC Private Wealth includes CIBC National Trust Company, CIBC Delaware Trust Company,
CIBC Private Wealth Advisors, incorporated, all of which are wholly owned subsidiaries of CIBC
Private Wealth Group, LLC, and the private banking division of CIBC Bank USA. All of these
entities are wholly owned subsidiaries of Canadian and Imperial Bank of Commerce. This
document is intended for informational purposes only and the material presented should not be
construed as an offer or recommendation to buy or sell. Any security concepts expressed are
current as of the date of this publication only and may change without notice. Such concepts are
the opinions of our investment professionals, many of whom are chartered financial analysts,
charter holders, or certified financial planner professionals. Certified Financial Planner Board of
Standards Incorporated owns the certification marks CFP and Certified Financial Planner in the
US. There is no guarantee that these views will come to pass.
Past performance does not guarantee future comparable results. The tax information contained
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tax advice and the information contained herein should only be used in consultation with your
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