People often want to set up a trust because they think it will lower their income taxes. But a trust isn’t always the magic tax-saving tool people think it is.
Let’s break down what a trust really is and how it works.
What Is a Trust?
A trust is not a company or corporation. Instead, it’s a legal relationship between three key people and a piece of property:
- The Settlor – The person who creates the trust and puts property or money into it.
- The Trustee – The person (or company) responsible for managing the trust property.
- The Beneficiary – The person who benefits from the trust property, often by receiving income or using the property.
A trust must have all three of these people, plus property, to exist. The settlor sets up the trust, the trustee manages it, and the beneficiary receives benefits from it.
How Does a Trust Work?
When a trust is created, the settlor transfers property to the trustee, who legally owns and controls it. However, the trustee must act in the best interest of the beneficiary. This is called a fiduciary duty, meaning the trustee cannot use the trust property for personal gain.
A trust agreement (a legal document written by a lawyer) spells out:
- Who the trustee and beneficiary are
- What powers the trustee has
- How and when the beneficiary can use the trust property
Who Pays Taxes on a Trust?
Once a trust is set up, the trustee is responsible for filing taxes on any income the trust makes. The rules work like this:
- The trust must file a tax return just like a person does.
- If the trustee pays money to the beneficiary, the trust can deduct that amount from its taxable income.
- The beneficiary then has to report those payments as income on their tax return.
Does a Trust Lower Taxes?
Creating a trust doesn’t automatically reduce your taxes. Whether it helps depends on:
- If you are only the settlor, or if you are also a beneficiary or trustee
- The type of trust you create
- How the trust property is managed