Candise Holmlund, CFA, CFP®

The answer to this question is “it depends.” There are a variety of trusts with very specific structures that require detailed tax treatment.

If it is an irrevocable trust funded by an individual or entity for the benefit of another party, for example an irrevocable life insurance trust, and the trust pays out all income to the beneficiary then it is considered a pass through trust with its own tax ID number. This can also include the exemption portion of a living trust. An exemption trust is created when one person dies and their living trust splits assets based on the estate tax exemption amount.

While it is required to file a tax return for an irrevocable trust entity, the income and corresponding tax from this type of trust is passed through to the beneficiary. A K-1 income tax reporting form is generated by the original trust, sent to the IRS by the trust, and given to the beneficiary for filing with their taxes.

Another type of irrevocable trust allows for discretion in the distribution of income and can retain earnings. In this case any income received is taxed at estate and trust tax rates which are 35% for income over $11,650 annually. Any distributed income is again reported on a K-1 and given to the beneficiary for inclusion with their tax returns.

If it is a revocable trust set up by someone for their own benefit, for example a living trust, then the trust typically continues to utilize the individual (or one of the couples) social security numbers as a tax ID number. Tax reporting 1099’s are generated with the individual’s tax id and income is reported on the individual or joint tax return and paid at their prevailing rates.

** The information provided should not be interpreted as a recommendation, no aspects of your individual financial situation were considered. Always consult a financial professional before implementing any strategies derived from the information above.

In order to determine whether or not you will be assessed underpayment penalties we need to review your specific situation and compare the IRS requirements. First, penalties are charged when your total withholding and estimated tax payments do not equal the smaller of: 90% of your estimated tax for the current year OR 100% of your previous year’s tax (110% of your previous year tax if AGI is greater than $150,000).

The simplest of the two methods is to check and see whether or not taxes withheld this year are equal to or greater than 100% (110% if you AGI was greater than $150,000 in the previous year) of your previous year’s taxes. If they are, you will not be charged a penalty for underpaying estimated taxes even though your tax bill will higher this year as compared to last year.

The other method to calculate your current year taxes to avoid underpayment penalties is to pay 90% of this year’s taxes. This method requires some calculation on your part. Seeking advice from a CPA or tax professional may be warranted in this instance. There is also tax software available that can assist you with this estimation. Make sure to include all sources of income and make sure to estimate the information for the full year.

If your taxes withheld in the current year are less than 90% of your current year tax liability and you have not met the 100% or 110% requirement for the previous year, then you will be charged penalties for underpayment if the underpayment is greater than $1,000. Penalties are assessed separately for each quarter based on when the attributing income is incurred. Therefore you may owe a penalty even if you made up in the underpayment in following quarters by submitting estimated tax payments.

Given the complexities of the tax code, my colleagues and I advise clients to check with their CPA or tax professional in order to verify that transactions, such as a Roth Conversions, are handled properly from a tax perspective.

** The information provided should not be interpreted as a recommendation, no aspects of your individual financial situation were considered. Always consult a financial professional before implementing any strategies derived from the information above.