If you are serving as the trustee of a trust, you may be wondering how to handle taxes and accounting for the trust. In this blog post, I will give you some general guidance on these topics, but remember that every trust is different, and you should consult a qualified attorney and accountant for your specific situation. There are many kinds of trusts with varying treatments of tax and creditor obligations.

As the trustee of a trust, your most important responsibilities are to find the trust assets (also known as marshaling the assets), secure those assets, protect the assets, and account to the beneficiaries about what the trust receives and spends. Comprehensive, accurate, and well-organized record-keeping is critical. You should keep track of all the income and expenses of the trust, as well as any distributions to beneficiaries. You should also keep copies of all the documents related to the trust, such as the trust agreement, deeds, titles, contracts, invoices, receipts, bank statements, tax returns, etc.

The taxes most trustees need to be concerned about are the estate tax, income tax, and capital gains tax. Let me explain these taxes and how they may affect your trust.

Estate Tax

The estate tax is a federal tax that applies to transferring property at death. The estate tax exemption is the amount of property that can be shared without paying any estate tax. For 2023, the estate tax exemption is $12.92 million per person (or $25.84 million per married couple). This means that if the total value of your estate (including any trust assets) is less than the exemption amount, you do not have to worry about the estate tax. However, if your estate exceeds the exemption amount, you may have to pay a 40% tax on the excess amount. The estate tax is paid by the estate or the trust, not the beneficiaries.

Income Tax

The income tax is a federal and state tax that applies to the income earned by the trust. The income tax brackets are very compressed for trusts, and they hit the highest tax bracket at only approximately $13,000 of income. Any income above that amount will be taxed at 37% (plus any state income tax). The income tax is paid by the trust or the beneficiaries, depending on whether the income is retained by the trust or distributed to the beneficiaries. If the trust retains the income, the trust pays the income tax. If the income is distributed to the beneficiaries, the beneficiaries pay the income tax and receive a credit for any tax the trust pays.

Capital Gains Tax

The capital gains tax is a federal and state tax that applies to the profit made from selling an asset that has increased in value. The capital gains tax rate depends on how long you have owned the asset and your income level. Most trusts' capital gains tax rate is 20% (plus any state capital gains tax). The trust or the beneficiaries pay the capital gains tax, depending on whether the gain is retained or distributed to the beneficiaries. If the trust retains the gain, the trust pays the capital gains tax. If the income is distributed to the beneficiaries, the beneficiaries pay the capital gains tax and receive a credit for any tax the trust pays.

One of the most significant tax-saving opportunities in the tax code is the step up in capital gains basis. This means that when an asset is transferred at death, its basis (or cost) is increased to its fair market value. This reduces or eliminates any capital gains tax that would otherwise be due if the asset is sold later. For example, if you inherited a house worth $500,000 that your parents bought for $100,000, your basis in the house would be $500,000, not $100,000. If you sold the house for $600,000 later, you would only pay capital gains tax on the $100,000 gain that happened since your parents' deaths, not the $500,000 in gain that happened since your parents bought the house.

To take advantage of this step up in basis, it is essential to establish the value of high-value assets as soon as possible, either by selling them or having them appraised, so that you have a good record for maintaining that step up. If you do not have a reliable valuation of the assets at the time of death, you may have to pay more capital gains tax later if the IRS challenges your claimed basis.

As you can see, taxes and accounting for a trust can be complicated and confusing. That's why hiring an attorney specializing in probate and trust administration, like The McKenzie Law Firm, is wise to help you navigate these issues and avoid costly mistakes. If you need assistance with your trust, please contact us today for an attorney evaluation session. We look forward to hearing from you.