Nature of Trust and Estate Taxation

A trust is an arrangement in which property or income is held in a fiduciary relationship by one party (the trustee) for the benefit of another (the beneficiary). There are two types of trusts; simple and complex trusts. A simple trust has three distinct characteristics; first, in a simple trust’s entire income is distributed to its beneficiaries every year. Secondly, charitable organizations do not qualify as beneficiaries in a simple trust and lastly, a trust’s assets are not distributable to the beneficiaries during the accounting year. A complex trust is simply defined as any other trust which does not have the features of a simple trust (Hoffman, 2008).

A trust is created by a grantor who entrusts all or part of his property to a person or organization of his choice. The assets transferred to the trustee become the corpus or body of the trust. If the trust is held by an organization, the organization is legally empowered to hold the property on behalf of the beneficiary but this does not give it ownership rights. The organization therefore makes investments and distributes income to the beneficiary in accordance with the terms of the trust in addition to filing tax returns and complying with legal reporting requirements.

In most cases, the grantor selects a close and trusted family member as the trustee. However, the family member may not be the very good in handling financial matters and may make poor decisions leading to the loss of the trust assets. It is therefore more prudent to appoint a financial institution as the trustee as this guarantees sound management of the corpus (Hoffman, 2008).The financial institutions manage the trust for a fee which usually puts off most grantors. Nevertheless, the long term benefits that accrue from the services of a financial institution far outweigh the costs.


In a typical arrangement, the creation of a trust usually involves three parties; the grantor who transfers the assets or corpus to the entity, the trustee who may be an individual or organization charged with the duty of managing the trust and the beneficiary who receives income or corpus held under the trust (Hoffman, 2008). There are normally two kinds beneficiaries created by the grantor. The first type of beneficiary have an income interest from the trust’s assets while the second type of beneficiary has a remainder interest in the trust’s assets.

However, there are certain circumstances where a trust may be created by less than three parties. An individual may choose to create a trust where he is both the grantor and the beneficiary with a corporate trustee to manage his assets. This happens where the grantor is incapacitated by poor health and or old age and is unable to manage his assets. The grantor may also assign himself to be the trustee. This usually happens where the grantor wishes to transfer the corpus to a minor who may not be able to manage the assets shrewdly. By doing so, the grantor ensures that he retains control over the assets with the aim of ensuring that the beneficiary does not squander the assets (Hoffman, 2008).

The terms of a trust are outlined in the trust document. The trust document among other things; establishes the duration of the trust, the powers of the trustee with regard to the distribution of the assets held in trust and the beneficiaries of the trust. The trust document may establish the term of the trust as the lifetime of the beneficiary especially if the grantor is also the beneficiary. If the beneficiary is not the grantor, the term of the trust may be the life time of the beneficiary. If the beneficiary is a minor, the term may be until the beneficiary reaches the age of majority. The trust document may also give the trustee the obligation of distributing the income of the corpus to the beneficiaries of the trust. This kind of trust is referred to as a sprinkling trust (Hoffman, 2008). By empowering the trustee to sprinkle the income of the trusts, the income tax liability of a family unit may be manipulated by distributing more income to those family members who fall within the lower bracket of marginal tax rates.

The law of trusts and estates is generally treated as the body of law which governs the management of personal affairs and the disposition of property of an individual in anticipation of the event of the individual’s incapacitation or death. In civil law it is also referred to as the law of successions. The law of succession comes in handy in cases where the decedent did not leave a will. If successfully applied, conflict among family members can be averted. The law of trusts and estates also governs the creations of charitable trusts. In the United States, it overlaps the elder law that deals with issues that face the elderly members of society such as home care, social security and disability benefits.

Upon the death of every individual, an estate is established. This primary mandate of an estate is to gather and preserve the individual’s entire assets, meet all his financial obligations and distribute the remainder of the assets to the heirs as identified by the will or state law. As in the case of a trust, the creation of an estate requires at least three parties the decent, the executor and the beneficiaries of the estate (Hoffman, 2008). The decedent is the deceased individual whose probate assets are transferred to the estate, the executor is the appointed heir charged with managing the estate according to the decedent’s will and the beneficiaries receive assets as directed by the decedent’s will.

A trust is treated as a separate legal entity whose income is taxed in a manner almost similar to individual’s income but with some modifications. Just like individual’s, trusts are required to file tax returns and are calendar year taxpayers. However, the trust’s income is only due for taxation if no distributions have been made to the beneficiaries. The beneficiaries are then taxed on this income derived from the trust which is added to their other taxable income. This is a measure put in place to ensure that there is no double taxation.

A trustee is required to file Form 1041 for Income Tax Return on Estates and Trusts. An estate qualifies for taxation if it has a gross income of $600 or more in the tax year. A trust on the other hand qualifies for taxation if it has any taxable income. If it has no taxable income then it qualifies for taxation if it has a gross income of $600 or more. Tax returns for trusts and estates are usually due on the fifteenth day of the fourth month after the end of the entity’s taxable year (Hoffman, 2008). Any assets which form part of the trust or estate assets disposed during the taxable year resulting in capital gains are also subject to taxation. This requires the trustee to file a Schedule D together with the Form 1041. In addition, the beneficiaries are also taxed on long term capital gains. However the tax rate in this case is usually minimal, in some cases as low as 5%.

An estate or trust is allowed to utilize methods similar to those used by individuals when computing their income tax. Trusts and estates are entitled to make income tax payments using the same quarterly schedule as individual tax payers. However this provision is limited to those tax years that end two or more years after the death of the decedent with charitable trusts and private foundations being exempted from estimated tax payments. This provision is made due to the fact that the executor usually faces some liquidity challenges in the first few months of managing the estate (Hoffman, 2008).  In addition, the fiduciary entity is not compelled to use the same accounting methods as the grantor or the decedent. In terms of accounting period, the estate or trust has also the option of selecting a tax year different to that of the grantor or the decedent. The law provides that if the first year or the last year of an estate or a trust is less than a full calendar year, then the income that accrues in that year is taxed  on a pro rata basis.

In a move aimed at curbing the evasion of taxes by individuals using trusts to transfer their income, the U.S. congress has made the fiduciary entity the most highly taxed individual. Any fiduciary entity with an income of $10,450 and above qualifies for a marginal taxation rate of 35%. This makes it next to impossible for a grantor to transfer income so as to enable him to pay less tax. The law has also made the accumulation of income within an estate or a trust is also an expensive affair. Trusts with the same amount of taxable income as individuals are taxed ten percent more than the individuals. This is further illustrated in the table below.



Filing Status/Entity


Taxable Income


Marginal Income Tax Rate (%)





Trust or estate













As shown above, the trust or estate is the most highly taxed entity as compared to the other entities with similar income. This is meant to deter individuals from creating trusts or estates from creating trusts or estates so as to transfer their income therein with the intention of evading paying income tax.

On the other hand, trusts and estates are granted a personal exemption when calculating their fiduciary tax liability. Estates are granted a personal exemption of $ 600 while trusts mandated to distribute all their income are granted a personal exemption of $ 300 annually and all other trusts $ 100. For instance, Trust A is required to distribute all of its accounting income to a beneficiary X. Trust B hand is required to distribute all of its accounting income proportionately between beneficiary Y and a named charitable organization. The trustee of Trust C out of her own discretion may distribute the accounting income or corpus of the trusts to a beneficiary z. It happens that none of the trusts distribute their income during the tax year. Trusts A and B will receive a personal exemption of $ 300 while trust C will receive a personal exemption of $100 because it is not mandate to distribute all of its accounting income.

The alternative minimum tax (AMT) may apply to a trust or estate in a tax year if the fiduciary entity actively engages in activities like cashing out stock options previously held by the grantor or decedent. However, under ordinary circumstances, it is not common for AMT to apply in estates or trusts due to the complexity of the factors that determine the alternative minimum taxable income. However, should a trust or estate qualify for AMT, the derivation of the alternative minimum taxable income (AMTI) is similar to that of an individual taxpayer.  A trust or estate has also the right to claim for an annual exemption just like other taxpayers subject to AMT. In this case, an estate or trust qualifies for a $ 22,500 annual exemption (Hoffman, 2008).























Hoffman H. W.,  Raabe A. W., Smith E. J., Maloney D. M. West Federal Taxation: Corporations, Partnerships, Estates, and Trusts. 2008.
















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