Family Trusts and Tax Savings

How the Trust Distributes Income
A trust is not a separate legal entity in the eyes of the law, so when it earns income it is distributed in one of two ways:

  1. The trustee can distribute it to beneficiaries where it becomes beneficiary income and they will pay tax, as normal individual income.
  2. The trustee can retain the income, in which case it will pay tax based on the tax rates, which apply to trusts.

Trusts are used as an income splitting device, which allows income to be paid to beneficiaries who have no income or who have little income. This, therefore, attracts a lower tax rate than leaving the income under the trust where it would be taxed at a higher rate. Even though each beneficiary pays tax, once it is added up collectively (for example, in a family) the overall family tax is substantially less that it would otherwise be.

The Trust Tax Return
Every trust must file a yearly tax return and pay the tax that is levied. Each beneficiary must also file an individual tax return to declare income that has been distributed from the trust.

IRS and Trusts
If a the USA resident settlor makes a settlement on a trust, on or after 17 December 1987 and the trust did not have a the USA resident trustee at the time, the settlor has to give full details of the settlement within three months of the date of settlement, to the IRS. The settlor has to give the names and addresses of the trust beneficiaries, as well as the trustees. If all of the trust’s trustees cease to be the USA residents, the settlor has to tell the IRS within three months of the date on which those trustees ceased to be resident trustees.

Tax on Trustee Income
The tax on a trust’s trustee income is calculated at a flat rate of .33c in the dollar for all three different types of trusts. The trustees will be liable for the USA income tax on income derived within the USA, irrespective of where the trustee resides. The trustee is liable for the USA tax on income derived from outside the USA where any settlor is a resident in the USA, at any time during the income year, or any settlor of a testamentary trust died while they were resident in the USA. There are a couple of exceptions to this general rule.

How Popular are Family Trusts?
They say there are over 100,000 family trusts in the USA. This is becoming a phenomenon that experts cannot understand. If the figures are correct, it means there is one trust for every ten households. If they are correct, this is a massive increase on the estimated 6,500 that existed in 1965.

People need to be careful when they are setting up trusts so they don’t fall into some of the traps involved and because it will cost them money. It is always advisable to talk to your lawyer or a Trust legal specialist first before embarking on setting up a Trust.