Income taxation of trusts can either be very simple or extraordinarily complicated. The difference depends on the type of trust which earns the income.
Revocable trusts report all income on the social security number of the grantor, the person who can revoke the trust. For all tax purposes, the assets of this trust are treated as the assets of the grantor. Accordingly, income is reported directly on the grantor's federal and state income tax returns each year, as if the trust did not exist. This is the simple part.
Irrevocable trusts can be written to have the same tax treatment as revocable trusts, with all income taxable to the social security number of the grantor. However, these trusts are rare.
Most irrevocable trusts must secure their own taxpayer identification number, and report income on that number. The trustee must file a federal income tax return, IRS Form 1041, for the trust for each year in which it earns any income. This return is due to be filed on or before the 15th day of the 4th month following the end of the taxable year. Unless a trust terminates before the end of a calendar year, this means that returns must generally be filed on or before April 15th each year.
On the Form 1041, the trustee must identify the trust as either a simple trust or a complex trust. A simple trust is a trust that requires all income to be distributed currently, does not provide for amounts to be paid or set aside for payment to charity, and does not distribute principal in that year. All other trusts are complex trusts.
For federal income tax purposes, ordinary income is generally taxable to the trust in any year in which it is accumulated within the trust, but it is taxable to the beneficiary of the trust in any year in which it is distributed to the beneficiary, or it is required to have been distributed to the beneficiary under the terms if the trust. In the first 65 days of a year, the trustee may elect to make a distribution of trust income and treat that distribution as having been made during the prior taxable year of the trust. The beneficiary who is taxable on trust income will receive a Schedule K-1 to reflect the income which is taxable to that beneficiary for the prior year. Capital gains are taxable to the trust, except in the final year of a trust.
For trust years ending before December 31, 2013, a New Hampshire interest and dividends tax return will also be required when the irrevocable trust income exceeds $2,400 in any year, if any beneficiary and any trustee of the trust is a resident of New Hampshire.
For trust years ending on or after December 31, 2013, trust income will be taxable to New Hampshire beneficiaries who receive interest and dividends reported to them on the federal income tax return for the trust. Trustees will not need to file a New Hampshire interest and dividends tax return for any year beginning on or after January 1, 2013.
The change in New Hampshire law will allow trusts to avoid payment of interest and dividends tax on accumulated income after 2012. Of course, this change will only affect complex trusts which are not required to distribute income annually, and which will pay federal tax on the accumulated income at the trust's tax rate. In order to determine whether or not this is advantageous, the rate of federal tax on accumulated trust income will need to be compared to the tax rate applicable for income distributed to the beneficiary under both federal and state law.
Trustees often hire an accountant to prepare the income tax returns for a non-grantor trust. Due to the complexity of the income tax rules, this is generally recommended for complex trusts.