Do I Have to Pay Tax on Distributions From an Irrevocable Trust?
A trust is a relationship where a trustee holds property for the benefit of another. Find out how tax applies to an irrevocable trust here.
They Call It A Trust For A Reason.
Are you unsure whether you need to pay tax on distributions from an irrevocable trust? A trust requires a trustee to hold and manage the property for the benefit of third parties known as beneficiaries. They are useful in administering estates and ensuring that the settlor’s (creator of the trust) uses the property in the way the settlor wants. The courts have held that a trust is not an entity but rather a legal relationship that exists between parties. They are also an effective means of tax minimisation if used correctly. This article will explore some of the aspects of an irrevocable trust and whether taxes affect distribution.
What’s the difference between an irrevocable and revocable trust?
Different types of trusts have different purposes. For example, parents often hold money or property for their children in a discretionary trust. Such trusts allow them to change the amount beneficiaries receive at their discretion. Taxation occurs differently depending on the category. Some of the categories of trusts include:
A revocable trust
Furthermore, Revocable trusts allow the settlor to change at the trust at their will. They can remove or add beneficiaries, or reduce the benefit beneficiaries receive or alter the trust deed or terminate a trust. These types of trusts essentially allow the settlor to control the property under section 102 of the Income Tax Assessment Act 1936. Revocable trusts are treated as grantor trusts for tax purposes, meaning that those who created the trust include any income received on their tax returns.
An irrevocable trust
However, irrevocable trusts are trusts that cannot be changed by the settlor. The trustee has full control over the trust and must act according to the guidelines in the trust deed. A testamentary trust or will is an example of a trust which cannot be changed. The trust only comes into effect once the will has past. Yet, irrevocable trusts are generally considered separate entities for tax purposes. Any income that the trust assets only creates a tax liability for the trust itself and the trust can also take related deductions to reduce its taxable income.
What tax applies to an irrevocable trust?
Tax and trust law becomes difficult where the trust makes distributions to beneficiaries. A simple way to think about tax implications is the more control you have, the higher the chances are for tax implications. Irrevocable trusts don’t pay taxes on any income the property generates. The trustee will, however, be liable to pay taxes for the income the trust property generates. Therefore, the beneficiary can shield themselves from the Tax Act. It is essential to recognise that trusts can not be used to defeat creditors or for fraudulent purposes.
In conclusion, always consider how different aspects of a trust can affect your taxable income. Trusts can be costly to set up and maintain and often involve complex terms. It is always best to speak with an Estate Planning Lawyer for personalised advice on what type of trust is right for you.
Josh is a Legal intern at Lawpath. He is a Commerce/Law student at Macquarie University. He has an interest in cyberlaw and blockchain technology.