Yes, trust income must be reported, but the method of reporting depends on the type of trust—either a grantor trust or a non-grantor trust. The distinction between these two categories determines whether the trust itself is responsible for reporting and paying taxes on the income, or whether that responsibility falls on the individual who created the trust (the grantor).
Grantor Trusts
In a grantor trust, the grantor (also known as the trustor or settlor) retains significant control over the trust’s assets. This includes the right to revoke the trust, amend its terms, or otherwise benefit from its property. Because of this retained control, the IRS treats the trust's income as if it still belongs to the grantor for tax purposes.
- Reporting: The income, deductions, and credits of a grantor trust are reported directly on the grantor's individual income tax return (Form 1040), typically using Schedule E or other appropriate schedules.
- Form 1041 Filing: In most cases, the trust does not need to file a Form 1041. However, trustees may submit a Form 1041 as an informational return to indicate that the trust is a grantor trust and that income is being reported on the grantor’s return. This helps create a clear record for the IRS and beneficiaries.
- Tax Liability: The grantor is personally responsible for paying taxes on all the income generated by the trust, even if the income remains within the trust and is not distributed.
Non-Grantor Trusts
In contrast, a non-grantor trust is considered a separate legal and taxable entity. The grantor has either given up control of the trust or established it in such a way that they are no longer treated as the owner for tax purposes.
- Form 1041 Required: A non-grantor trust is required to file Form 1041, U.S. Income Tax Return for Estates and Trusts, if any of the following apply:
- The trust has any taxable income, even as little as one dollar.
- The trust has gross income of $600 or more, regardless of whether it ultimately owes tax.
- The trust has a beneficiary who is a nonresident alien.
- Income Taxation: Depending on whether the trust distributes income to beneficiaries, the tax burden may fall on the trust itself or be passed through to the beneficiaries via Schedule K-1. If income is retained, the trust pays tax at its own rates (which are typically steeper than individual rates). If income is distributed, the beneficiaries report and pay tax on their share.
- Deductions and Distributions: The trust may deduct amounts that are distributed to beneficiaries, effectively shifting the tax liability from the trust to the recipient. Accurate recordkeeping and proper preparation of Schedule K-1s are essential to avoid IRS scrutiny.
If you require assistance with trust tax reporting, contact Watter CPA today for expert guidance.
