Whether you are considering establishing a trust for family members or are yourself a beneficiary of a trust, one of the most important aspects of the trust for you is how distributions are to be made directly to or for the benefit of the beneficiaries. Wanting to have a trust properly set up to meet the goals for its beneficiaries and needing to be able to plan on when and how distributions may be received is central to purpose and ultimate success of using a trust.
Let’s begin with a very common trust distribution rule, found in nearly all marital or spousal trusts that typically are created with the first death of a married couple. Such trusts, to qualify for the unlimited marital deduction, state that all of the income is payable to the surviving spouse as primary beneficiary. In addition, the spouse generally has the right to so much of the principal of the trust as is necessary to meet ongoing needs. Sounds simple, right?
The simplicity vanishes right away when we consider how the term income might be defined. The term refers to the income of the trust which generally is a direct outcome of the investments held in the trust. Income – for the purposes of distributions – may be defined in the trust itself, by statutory or regulatory language or by application of precedent and usage. In other words, income in one trust might not be income in another and what is income as defined by the IRS is not necessarily the same income that a trust beneficiary might receive.
As you can see, much depends on how the trust assets are invested since they may be divided between income producing assets such as bonds or dividend paying stocks and assets which do not tend to produce income and may be illiquid, such as real estate. Such assets often include stocks which do not pay a dividend and may produce income only when sold and gain is recognized. The investments, in turn, depend to some extent on the trust itself: who the trust is intended to provide for, what assets funded the trust, and who is the trustee responsible for administering the trust.
Any time that a trust has both current and future beneficiaries, there is an inherent conflict between those two interests. The future beneficiaries would certainly want the value of the trust assets to grow as much as possible so that there is more for them when the current beneficiary(ies) die. On the other hand, the current beneficiaries typically would like to receive as much income from the trust as possible while they are enjoying the benefits of the trust and may not be too concerned about what is left for the next generation(s). This conflict must be managed by the trustee, both in terms of the selection of investments – whether income producing or not – and in the actual distributions, including taxes and costs associated with the trust administration. All of these factors may affect the amount and timing of the distributions that will be received by the different sets of beneficiaries.
The role of income tax and your trust distributions is also an important factor. Those distributions you receive may have already been reduced by applicable taxes as well as costs, or will be reportable income to you as the beneficiary receiving the distributions. When you prepare for your personal income taxes, you will need to know what the tax impact will be and how it might affect your spending based upon or at least related to the distributions received. Your income will be reported on Form K-1 and, like a Form 1099, is provided to the IRS. Be aware that these tax forms are almost never provided to you early in the year and often will leave but little time to review and file by April 15, the due date for the previous year’s taxes. This information also plays a role in your determining and paying estimated taxes over the course of the year.
Depending (again/still) on how the trust assets are invested, both total income and type of income received by the trust will vary. The good news is that where the trust investments pay qualified dividends, the tax impact is much lower for you than it is for the same amount of interest income, ordinary income or non-qualified dividends. Commonly, qualified dividends, along with interest and non-qualified dividends, are paid directly to the income beneficiaries and those beneficiaries must report and pay income tax on the distributions at their own personal rates. In addition, tax-free interest may be received by a trust from investments such as municipal bonds, and that will be reported and passed through to the income beneficiaries as well, though little or no tax may be due.
Capital gains derived from the sale of securities owned in the trust typically are assigned to the trust, which pays the income tax on the gains. Importantly, this income is set off against the expenses of operating the trust, such as trustee, attorney and accountant’s fees. The income tax rates applicable to trusts are effectively higher than individual rates since the maximum tax bracket is reached at only $12,501 of income. This highlights how useful the distribution of other forms of income- dividends, interest and the like – is to trusts as it allows those amounts to be taxed at the appropriate bracket for the individual recipient of the distributions as opposed to the much higher rates for the trust itself.
Most trusts include specific standards governing the purpose or requirements of distributions made and these typically go beyond the “all of the income” approach first discussed above. The most common standard is that allowing distribution for the health, education, maintenance and support (HEMS) of a person. The meaning and implementation of this standard is well-settled under the law and provides more than just a safety net for the beneficiary. In fact, this standard also typically permits distributions to be made from the trust principal where necessary. Tax consequences for principal distributions are met by the trust and not the recipient and such distributions will reduce the remaining value of the trust and perhaps future income as well.
Apart from the HEMS standard, there are many trusts which specify that distributions may or must be tied to the occurrence or non-occurrence of certain specified events or behaviors. A trust often will provide that a distribution may be made to assist a beneficiary in purchasing a residence, obtaining higher education, or even in starting a business. Distributions may be made for broad uses such as travel, weddings or even the comfort of the beneficiary. On the other hand, a trust may provide that distributions may be withheld where a beneficiary is abusing drugs, unemployed, a gang member, or engaged in other behavior the creator of the trust finds undesirable. All of these types of standards, restrictions and the like are based on the goals of the person creating and funding the trust and may be enforced by the trustee.
Another aspect of the trust administration which may affect the distributions and taxes due is the timing of actions which produce income or fund a specific distribution. For example, if there is a need to make a distribution at a particular time and there is not sufficient cash available in the trust to cover that distribution, it may be necessary to sell assets in order to raise the cash. As we saw above, such a sale typically will result in assignment of the gain (or loss) realized on the sale to the trust. This could require a larger amount sold to cover both the desired distribution and the associated taxes on that sale. Proper prior planning with expected dividends and interest could help to avoid this type of problem.
The distributions that may come from a trust are not as simple as you may have thought and the trustee making those distributions has a number of factors to consider in deciding whether and how to make a distribution. You can understand how it helps you to provide the trustee with relevant information and to be patient with the constraints on the trustee and requirements which must be followed. When you understand the context of the trust and its distributions, it will help you to benefit fully from the trust and thereby make your own personal financial planning more successful.
George Chamberlin & Mentor RIA Consulting © 2018