When a trust earns income, the trust must file an income tax return with the Internal Revenue Serivce (IRS), and in many states, with the state tax commission. Depending on state law, the size of the trust, and the amount of income, the trust may have to pay income tax, or at least file a tax return.
Every trust is created in such a way that trust income and property eventually gets disbursed to one or more beneficiaries.
Just because the trust has to pay income tax, this does not mean the beneficiary must pay income tax. Instead, the tax laws treat trust distributions as gifts to the beneficiaries. The only person who can ever be taxed on a gift is the person who gives the gift, and even then, only for extremely large gifts.
Although trust distributions are not subject to income tax, some trust distributions may be subject to the federal estate tax or inheritance tax.
While the taxation benefits of a living trust can be very beneficial, keeping accurate and current records, and paying attorneys and accountants to manage a complex living trust, can become quite expensive. The tax savings may, at some point, be outweighed by the administrative costs for managing the living trust.
- Nolo's Estate Planning Basics; Attorney Denis Clifford; 2009