TRUSTS: ALLOCATING INCOME TO BENEFICIARIES BUT TAXED TO TRUST
If a trust (or estate or succession) earns income, it will generally be included in either the trust’s income or the income of a beneficiary of the trust.
The basic rules are as follows: If any of the trust’s income is payable in a taxation year to a beneficiary, that amount is deductible in computing the trust’s income for year. The amount payable is then included in the beneficiary’s income. As a result, there is normally no double taxation (since there is a deduction for the trust, and inclusion for the beneficiary).
“Payable”, in this context, means that the income is either paid out to the beneficiary, or the beneficiary is “entitled in the year to enforce payment of it”.
In year 1, a trust earns $50,000 of interest income. Half of that is payable to a beneficiary in the year, and the other half is retained by the trust.
Result: $25,000 is included in the trust’s income and the other $25,000 is included in the beneficiary’s income.
In essence, the income of the trust is “flowed out” to the beneficiary when it is payable to beneficiary. In addition, the character of the income (interest, dividends, taxable capital gains) generally can remain the same in the hands of the beneficiary, if the trust makes the appropriate designation in its tax return.
On the other hand, losses of a trust cannot be flowed out to a beneficiary and therefore can be claimed only by the trust.
Fortunately, there is a mechanism that allows a trust to carry forward losses from previous years to offset current year gains or profit, which then can be paid out to beneficiaries free of tax.
Basically, to use this mechanism, the trust can carry forward non-capital (ordinary) losses or net capital losses to offset income or taxable capital gains in the current year, but it can do this only if it brings the trust’s taxable income for the year down to zero. This means the trust will pay no tax, and the amount of its net income (before the carry forward) can be paid out to the beneficiaries free of tax.
In year 1, a trust had a net capital loss of $20,000. In year 3, it has a net capital gain and taxable income of $15,000.
During year 3, the trust can pay the $15,000 to its beneficiaries and make a special designation in its year 3 return, so that the $15,000 will remain part of the trust’s net income and not be included in the beneficiaries’ income. As a result, the beneficiaries will not pay tax on that amount. The trust will use $15,000 of the loss carried forward from year 1 to bring its taxable income down to zero, so that it also will pay no tax.
The remaining $5,000 of the trust’s year 1 net capital loss can be carried forward to future years.