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Paul sets up a irrevocable non-grantor trust for his adult daughter Sue. He funds the trust for $200,000. In the first year, the trust earns $15,000 from investments. The trust does not distribute any money to Sue.
It is my belief that the trust will be taxed on the $15,000. That is Paul cannot pay the tax. Sue cannot pay the tax. Am I right about that?
You are correct.
A grantor trust would be taxed to the settlor (Paul).
A non-grantor trust would be taxed to either the trust, the beneficiaries, or both, depending, in part, on whether it is classified for tax purposes as a "simple trust" or a "complex trust". In a simple trust, all income is taxed to the beneficiaries. In a complex trust, distributed income is taxed to the beneficiaries and undistributed income is taxed to the trust.
A simple trust must pass all three criteria in a taxable year in order to be considered as a simple trust: (a) it must distribute all income to the beneficiaries; (b) it cannot distribute principal; and (c) it cannot make distributions to charity. Treasury Regulation § 1.651(a)-1.
While this trust cannot make distributions to charity, because Sue is the sole beneficiary, it is still not a simple trust because it is not required to distribute all of its income to Sue at least annually, and because it can distribute principal to Sue.
Therefore, since no distributions are made to Sue, this complex trust is taxed on the entire $15,000 of income at the tax rates applicable to trusts.
