Just like individuals,
trusts are subject to taxes at both the state and federal level. How a trust is taxed will vary depending on the type of trust funds. Sometimes a trust will incur the tax liability. Other times a trust fiduciary or beneficiary will incur the tax liability.
How are Trusts Taxed?
In North and South Carolina, trusts are subject to taxes when there is taxable income being generated by the assets held in trust. In other words, the trust itself is not taxed, but the income or loss of trust property is a taxable event. For instance, if there is rental property held in trust and the property is located in South Carolina, the proceeds from the rental property are subject to a 7% withholding tax rate. Trust fiduciaries must make quarterly payments of estimated income tax and the tax return due date is the same as that of the federal return.
There are also tax consequences for distributions made by the trust to trust beneficiaries. The trust may take a tax deduction when income is distributed to beneficiaries. When this happens, the beneficiary is on the hook for paying the income tax as opposed to the trust paying the income tax. However, if the distribution is due to a change in the principal amount of trust assets, then income tax liability will fall to the trust and not passed to the beneficiary. In the case of an irrevocable trust that has discretion as to the amount distributed to beneficiaries and also retains the earnings generated by trust assets, the trust will be subject to tax liability.
A trust falls in the highest federal tax bracket if it generates over $12,500 in income. Between capital gains taxes, Net Investment Taxes, and ordinary income taxes, the federal government can take a sizeable chunk out of the investment returns of a trust. This is even before state income taxes come into play. Trusts are almost always subject to capital gains taxes even if the gains have been distributed to the beneficiary. For other trust distributions made to a beneficiary, the income would pass to the beneficiary on a K-1 tax schedule and reported on the personal individual income tax return of the beneficiary.
On the State level, it is important to note that both North and South Carolina have an income tax. A trust will only be subject to taxation on “source income” made in connection with the state. This refers to things such as rental property income from property located in North or South Carolina. However, if a trust is considered to be a resident of the state, it will be subject to more extensive state taxes. A state can consider a trust a resident based on the location of the trust settlor, the trustee, or the beneficiaries. As a state resident, all of the trust income can be subject to state income taxes, not just the income made in connection with the state. Whether or not a trust is considered to be a resident of a state will depend on the state specific definition of a resident. It is also possible for a trust not to be a resident of any state and, in that case, the trust would not be subject to any state taxes, just federal taxes.
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Part of responsible, comprehensive estate planning is taking things like taxes into consideration. At
Monk Law Firm, we provide estate planning legal counsel you can trust.
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