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George Saenz, the Bankrate.com Tax Talk columnist Taxability of complex trust

Dear Tax Talk,
My grandfather set up a trust many years ago (maybe 50 years ago) and my father had been collecting the interest and some principal for the last 35 years, since my grandfather died. My grandfather stated upon my father's death that my sister and I would be the final beneficiaries of this trust.

When my father passed away in 2006, my sister and I each received $132,400 in 2007, which was the amount left in the trust. Some of this is capital gains taxable (according to the bank, about $22,000 each to my sister and me).

My question to you is this: Is the balance, which is not capital gains taxable, in any way taxable as income either federal or state to us? I have been told "yes" by some and "no" by others and am extremely confused and dazed. I live in Connecticut, my sister lives in Pennsylvania, my father lived in New York and the original trust set up by my grandfather was in Connecticut.

Thank you for your consideration in answering my question.
-- Joan

Dear Joan,
A trust established through after-tax dollars is referred to as the corpus of the trust. When the corpus is eventually distributed, the recovery of the corpus is tax-free to the beneficiaries. Although every state has its unique laws, this is pretty much a uniform principle of taxation.

A trust is required to prepare Form 1041 and distribute Schedule K-1 to the beneficiaries. Schedule K-1 advises beneficiaries of the amount of distributions that represents taxable income.

In some cases, distributions occurring after the end of the tax year, maybe such as yours, are considered or treated by the trust as occurring in the preceding tax year. A trust can elect under Section 663(b) to treat distributions occurring within 65 days following the end of its tax year as actually taxable to the beneficiaries in the preceding year. This allows the trust time to compute its income for the tax year and make any required distributions.

This usually occurs in simple trusts, but in the final year of a complex trust, trying to wind up its affairs, it may also occur. Page 2, Other Information Question 6 of Form 1041 will tell you if the trust made this election. Alternatively, if the trust issued a final K-1 to you, you can assume that there are no further consequences from the money you received in 2007. Just to be sure, you should ask the bank.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy-- Posted: April 10, 2007
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