For purposes of taxing trusts, the IRS divides them into three categories: simple trusts, complex trusts, and grantor trusts.
These distinctions can result in widely different income tax bills because trusts get taxed at a higher rate than most individuals. Here are the trust income tax brackets in 2023. Trust income over $14,450 is taxed at 37%. Trusts pay short-term capital gains tax on property held for one year or less at the same rate as income tax. Trusts may pay long-term capital gains taxes of 20% on any amount over $14,650. Because trusts pay far more taxes than most trust grantors and beneficiaries, many trusts are arranged so the trusts themselves pay no taxes or as little as possible.
I. Simple Trusts
A simple trust simple distributes its income to trust beneficiaries.
A simple trust is a separate taxpayer from the grantor who transfers assets into the trust and the beneficiary who benefits from the trust. Whereas an individual files taxes with Form 1040, a simple trust uses Form 1041. A simple trust requires all income to be distributed to current beneficiaries. The beneficiaries pay taxes on the income at their own applicable tax rates. This often results in lower taxes than the trust would have to pay, although that may not be true for high income earners. A simple trust does not make distributions of trust principal to beneficiaries; only of trust income. Furthermore, a simple trust cannot make distributions to charities.
II. Complex Trusts
Uncle Sam – or whoever is filing taxes for the trust – must think a little bit harder about a complex trust.
The IRS also considers a complex trust to be a separate taxpayer. A complex trust allows the trustee to either accumulate trust income so the trust pays income tax or to distribute trust income so the beneficiary pays the tax. Thus a complex trust allows the trustee more discretion in making tax decisions than a simple trust. A complex trust also may distribute principal. Principal distributions are not taxed because the IRS presumes that it was taxed before it was put into the trust. A complex trust may make distributions to charities.
III. Grantor Trusts
The IRS considers a grantor trust to be the grantor’s alter ego.
As far as the IRS is concerned, the grantor and the grantor trust are the same person – or the same taxpayer. The grantor files the trusts’ income tax return on the grantor’s own 1040. Grantor trusts remain in the grantors’ control while the grantors are alive and well. Revocable living trusts are grantor trusts as long as the grantors are living.
At different times in its life cycle, a trust may be a grantor trust, a simple trust, and a complex trust. This can change from year to year. For example, a revocable living trust often starts as a grantor trust. At the death of the grantor, it may become a simple trust making income-only distributions to the grantor’s children. And at the death of the children, it may become a complex trust authorizing discretionary distributions of income and principal to the grantor’s grandchildren.