In the state of Arizona, trust administration is governed by ARS Title 14 Chapter 7.
Trusts are incredibly useful estate planning vehicles, but they come with a fair number of complicating factors. For most people, it’s best to draft your trust with an experienced estate planning attorney and a qualified financial advisor. Without these professionals’ assistance, transferring assets to a trust and receiving distributions from the trust can be confusing.
For the purpose of this article we’ll focus on distributions from a trust, with a special focus on the tax basis of distributed property and how it affects a beneficiary’s income taxes.
What is Tax Basis?
An asset’s tax basis is its value for income tax purposes. When an asset is sold, the fair market value of the asset is assessed against the tax basis of the asset (basically, how much did you buy it for and how much did you sell it for?). If the fair market value is greater than the tax basis, then you will have a taxable capital gain. If the fair market value is less than the tax basis, then you will have a capital loss that can be used to offset taxable income.
Note that the beneficiary will not recognize a taxable gain or loss until they sell the asset. The beneficiary does not have to report trust income as annual income for the purpose of income taxes (unless the trust agreement requires pass-through taxation, which we’ll discuss later on in this article).
What are the Tax Implications When a Trust Distributes Property to a Beneficiary?
For starters, it’s important to recognize the difference between what happens when a trust distributes cash and when a trust distributes property. If the trust liquidates an asset before distributing cash-proceeds to the beneficiary, then the trust will recognize the taxable gain or loss, not the beneficiary. If the trust directly transfers property to the beneficiary (e.g. stocks or mutual funds), then the tax basis will depend on whether the trust is revocable or irrevocable.
Before we dive into revocable vs. irrevocable trusts, however, it’s important to note that trusts can choose to recognize capital gains and/or losses without selling the distributed assets in order to match the adjusted tax basis to the fair market value. This is possible under IRC Section 643(e)(3). Generally speaking, a trustee may do this to recognize the benefit of a capital loss, or they could simply do it out of goodwill to ease the future tax burden of the beneficiary. Whatever the motive may be, in this case it would be akin to distributing cash to the beneficiary, with no inherited capital gains or losses.
Tax Basis for Distributions from a Revocable Trust
Now, onto the basics of trusts. Revocable trusts are created during the grantor’s lifetime (the grantor being the original owner of the assets), making it a living trust. The grantor usually serves as the trustee and the beneficiary during their lifetime, and upon their death a successor trustee and successor beneficiary will take over management and distribution of trust assets (respectively). With a revocable trust, the terms of the trust can be amended at any time by the grantor, and the trust can be dissolved at will.
Because of this, assets transferred to a revocable living trust are still considered part of the grantor’s estate for tax purposes. When the grantor dies, the tax basis of the property inside the trust will enjoy a “step-up” as the adjusted tax basis is increased to the current fair market value. When the property is eventually distributed to the beneficiary, he or she will inherit the adjusted tax basis based on the step-up value.
Tax Basis for Distributions from an Irrevocable Trust
The key distinction with distributions from an irrevocable trust will be whether or not it is considered a grantor trust. If the irrevocable trust uses the grantor’s social security number, it qualifies as a grantor trust, and the trust’s income is recognized on the grantor’s individual tax returns each year. Grantor trusts do not get a step-up when the grantor dies. The asset’s adjusted tax basis is based on the values reported on the grantor’s tax returns, and carries over to the beneficiary.
If, on the other hand, a trust is issued its own tax identification number, it is not considered a grantor trust as the trust recognizes and pays its own income taxes. In this case, the property’s tax basis will be based on the trust’s adjusted tax basis (not the grantor’s), and will carry over to the beneficiary.
Note that in all of these scenarios, the adjusted tax basis would carry over to the beneficiary in each case. The only difference would be when and how the adjusted tax basis was calculated.
Determining the Holding Period for Capital Gains
The difference in taxation of long term capital gains vs. short term capital gains can be substantial, so it’s essential to understand the holding period that carries over with property distributed by a trust. Whether the trust is revocable or irrevocable, the holding period recognized by the trust carries over to the beneficiary—it does not restart when the assets are distributed.
That means that a stock that was purchased 6 months ago by the trust will carry over the 6-month holding period to the beneficiary. If the beneficiary immediately sells the stock, he or she will recognize a short-term capital gain (since it was held less than one year). If you receive property from a trust, be sure to check the inherited holding period before you liquidate any investments. Short term capital gains are subject to higher income taxes, while long term capital gains generally enjoy lower capital gains taxes.
Can a Trust Pass Income Taxes Through to a Beneficiary?
The US tax code allows entities to utilize pass-through taxation in certain situations. In this case, pass-through taxation instructions would need to be clearly defined in the trust agreement. If so, then the trustee will provide the beneficiary with a Schedule K-1 each year. The beneficiary would then report the income (or loss) from the trust in their annual tax return.
Are Distributions from an Estate Taxable?
Property that is specifically bequeathed by will is not considered income for the beneficiary. There is no gain or loss recognized as a result of the transfer, though the beneficiary will inherit a carryover tax basis. Typically, the trustee will inform the beneficiary of the tax basis and applicable holding period requirements.