Income Tax on Estates and Trusts

Trusts and estates file income tax returns that are known as "fiduciary returns," Form 1041. (A "fiduciary" is a person who holds property for the benefit of other persons. Common types of fiduciaries are executors or administrators of decedent's estates, trustees of trusts, and guardians or conservators of the estates of minors or persons declared to be legally incapacitated.)

Estates and trusts are often described as "pass-through entities" because the beneficiaries of the trust are taxed on the income that is distributed to them and the trust is taxed on the income that is not distributed. The character of the income that is distributed generally has the same character that is received by the estate or trust, so if a trust that receives qualified dividends as income distributes all its income, the income received by the beneficiary is taxed as qualified dividends.

The taxation of estates and trusts is similar to the taxation of individuals in the following ways:

• Estates and trusts can claim deductions for some of the same things for which individuals can claim deductions, such as interest that is paid, and state and local taxes. And, like other taxpayers, the expenses of producing income must be allocated between taxable and tax exempt income and the expenses attributable to exempt income are not deductible.
• The undistributed taxable income of estates and trusts is subject to progressive tax rates that are similar to the tax rates that apply to individuals, and that are based on tax brackets that are indexed for inflation like the tax brackets of individuals, but there is no 10% bracket and the brackets are much smaller than those for individuals, with the top tax rate of 39.6% (37% for the years 2018-2025) applied to income in excess of $13,050 (for the year 2021).
• The long-term capital gains of estates and trusts are subject to a top tax rate of 20%, qualified dividends are treated like long-term capital gains, and the tax on capital gains is calculated in the same way as for individuals (but subject to different brackets).
• The capital losses of an estate or trust can reduce other taxable income by only $3,000.
• Estates and trusts are subject to the 3.8% tax on net investment income, just like individuals.

There are also a number of differences between the income taxation of estates and trusts and the income taxation of individuals:

• Estates and trusts can claim a charitable deduction, but only if the governing instrument (the will or trust document) requires the payment to the charity and only if the payment must be made out of the income of the estate or trust.
• The expenses of an estate or trust that are for the collection of income or the management or preservation of income-producing property (which covers most of the costs of administering an estate or trust) are deductible in full and not subject to the 2% limit on "miscellaneous itemized deduction" if the expense is not of a kind that would customarily be incurred by an individual holding the same property. So, for example, fiduciary fees are fully deductible, but investment management fees are subject to a 2% "floor" (or are not deductible at all in the years 2018 through 2025).
• As noted above, estates and trusts are entitled to a deduction for income distributions to beneficiaries (and the beneficiaries must then include the distributions in their own income), but the income that is distributed usually does not include any capital gains (except in the final year of the estate or trust, when capital gains are considered to be distributed along with ordinary income). In the final year of an estate or trust, the estate or trust can also distribute any capital loss carry-forward to the beneficiaries, as well as any deductions in excess of income for that year.
• Estates and trusts have a deductible exemption that is like the personal exemption for individuals, but it is much smaller, and not indexed for inflation.
• Estates are entitled to an exemption of $600.
• Trusts that are required to distribute all of their income each year are entitled to an exemption of $300. (Because all income is distributed currently, the exemption usually applies only to capital gains, which are usually not considered to be income and so not distributed.)
• Trusts that can accumulate income are entitled to an exemption of $100.

Last updated on 1/3/2021.>