Who pays tax on irrevocable trust income?

The liability to pay taxes on income derived from an irrevocable trust remains a function of the way the income of the trust is distributed or retained. One Pacific Trust is adept at handling these complexities, offering specialized services to manage your trust effectively and optimize tax strategies, safeguarding your financial interests at every stage. There are three instances where this basically happens:

1. Tax on Distributed Income Paid by Beneficiaries: The beneficiaries are required to pay income taxes on the amounts they receive if income gains are distributed to beneficiaries of an irrevocable trust. The trust issues a Schedule K-1 for each beneficiary, showing that beneficiary's share of the trust income, which is then to be reported by the individual beneficiary on his or her personal tax return.
2. The Trust Pays Tax on Retained Income: If there is income retained by the trust, meaning it does not distribute earnings to the beneficiaries, the trust pays taxes on such income. Irrevocable trusts are considered separate taxable entities and have to file a tax return, Form 1041, for any generated income. Trusts come within a higher bracket of taxation, and therefore, retained income is normally taxed very high.
3. Grantor Pays Tax: Under certain circumstances, some irrevocable trusts are considered grantor trusts, wherein the powers or interests retained by the grantor may shift the burden of tax payment onto the grantor for income earned by the trust, even though such income remains in the trust or is actually distributed to the beneficiaries. It is a little more specialized and usually applied in estate planning.

In other words, beneficiaries pay taxes on any distributed income, the trust pays on retained income, and, in rare cases, when it comes to grantor trusts, tax is paid by the grantor on the trust income.