How is My Trust Taxed in Colorado?

Setting up a trust is a good way to protect your assets or provide for your heirs. For the average person, there are a lot of questions associated with establishing a trust. It can be a complex task and it’s important to understand the ramifications.

At Brestel Bucar, we understand that you might not be sure how setting up a trust will impact your taxes. In fact, one of the most common questions we hear from our clients is this:

How are trusts taxed in Colorado and is there anything I can do to reduce the tax burden for my heirs?

That’s an extremely important question. The truth is that the tax issues surrounding estate planning can be confusing and overwhelming. We have the experience necessary to help you. Here’s what you need to know about trusts and taxes in Colorado.

The Law Regarding Trusts in Colorado

Let’s begin with some recent legislative changes in Colorado. In 2018, the Colorado General Assembly passed the Colorado Uniform Trust Code, which made significant changes to the way trusts are taxed in our state. The new law took effect on January 1, 2019.

The first thing you need to know is that the new CUTC brings Colorado’s trust laws into line with what most other states are doing. As of 2019, 33 states have uniform trust codes similar to the new Colorado law.

The other provisions of the CUTC are as follows

  1. The new rules apply to trusts that were established prior to January 1, 2019 as well as to new trusts. Specifically, the law says, “to [all] express trusts, charitable or noncharitable, and trusts created pursuant to a statute, judgment, or decree that requires the trust to be administered in the manner of an express trust. This code does not apply to a business trust, a security arrangement, a trust created by a deposit arrangement in a financial institution, or any arrangement under which a person is a nominee or escrowee for another.”
  2. Disclosures regarding Colorado-based trusts are limited to qualified beneficiaries only, which the CUTC defines as “a distributee or permissible distributee of trust income or principal.”  
  3. Trusts may be amended in a private agreement provided that the agreement does not violate the material purpose of the trust. 
  4. The CUTC allows the person or people who established the trust to opt out of allowing anybody else to change it.
  5. Trustees can send beneficiaries a notice of their intention to disburse funds and the beneficiaries have up to 30 days to object under the new law.

As we mentioned, the new law brings Colorado in line with what most other states are doing. However, there are some concerns because it makes trusts more vulnerable in some situations.

How Do Colorado Tax Laws Affect Trust Disbursements?

People set up trusts for many reasons, including limiting the tax burden on their beneficiaries and heirs. There are two basic options:

  1. The Revocable Living Trust is set up while the grantor is still alive. As long as the grantor lives, the money in the revocable trust is not taxed as a separate entity. It also allows the grantor to make changes to the trust, alter the beneficiaries, and remove money as needed. The grantor should designate a successor trustee who will take over administration of the trust if the grantor becomes incapacitated or dies.
  2. An Irrevocable Trust is just that, irrevocable. It typically cannot be amended, modified, or revoked after it is created. Any Revocable Living Trust set up in Colorado will automatically become an Irrevocable Trust upon the death of the grantor. At that point, the trust will need a new tax identification number. (A revocable trust is considered part of the grantor’s assets, while an irrevocable trust is typically its own separate entity.) The trust itself may need to pay taxes; however, many trusts choose simply to distribute income to the beneficiaries.

If an irrevocable trust distributes all its income to the trust’s beneficiaries, the trust itself will not be required to pay taxes. However, beneficiaries may be required to pay taxes on the money they receive.

When the beneficiaries of a trust receive disbursements from the trust, it becomes their responsibility to pay taxes on the money they receive. The taxes must be reported as income to both the IRS and the state of Colorado.

If you are not the grantor of a trust, then you won’t need to worry about taxes on the trust itself. That’s the job of the grantor or the trustee.

However, if you are a beneficiary, you must adhere to Colorado state laws about the taxation of the funds you receive. In most cases, they will be taxed as regular income.

Colorado state law says that:

Every resident estate and trust or every nonresident estate or trust with Colorado source income must file a Colorado income tax return if it is required to file a federal income tax return or if it has a Colorado tax liability.

In other words, all beneficiaries may be required to file a Colorado tax return if they are required to file a federal income return or have Colorado tax liability.

Each beneficiary of a trust who receives a disbursement should receive IRS Form K-1 from the trust. The form will indicate how much of the distribution is from the trust’s principal and how much from income. The beneficiaries are required to pay taxes only on income distribution, not on the principal. That’s because the IRS and other taxing agencies assume that taxes have already been paid on the trust’s principal.

At the time of the grantor’s death, the value of the trust’s principal is evaluated and used as the new basis for any future disbursements. The grantees will pay income taxes, as stated above, only on the income of the trust and not on its principal.

What Can You Do to Reduce the Trust Tax Liability for Your Beneficiaries?

Here are some pointers to help you minimize the taxes paid by both the trust itself and by its beneficiaries.

  1. Income distributed by a trust retains its character. In other words, if a trust retains income from a previous year and has paid taxes on it once, it should not be taxed again. It will also be able to deduct previously-taxed distributions on the trust’s tax return, although beneficiaries may still be required to pay taxes on the income as it’s disbursed.
  2. Because income is taxable and the principal of a trust is not, each disbursement of a trust should specify how much of the disbursement is income and how much is principal. It is also the trust’s responsibility to fairly distribute principal and income among beneficiaries to spread out the tax burden.
  3. The trust documents themselves should specify how income and expenses of the trust are allocated, i.e., if they are allocated to principal or income. As a rule, most states using the Uniform Principal and Income Act allocate:
    1. Operating income, operating expenses, depreciation of trust assets, taxes on accounting income, and interest, dividends, rents and royalties to accounting income; and
    2. Capital gains and losses, casualty gains and losses, insurance recoveries, extraordinary repairs and capital improvements on trust assets, and taxes on the principal of the trust to the principal.
  4. You can minimize taxation of the trust itself by distributing income before the end of the tax year. Any disbursements that are made are deductible for the trust and taxable for the beneficiary. By contrast, retained income is taxable for the trust only. Since trusts are generally taxed at a higher rate than individuals, this can reduce the tax liability by spreading it out among the various beneficiaries of the trust.
  5. Name multiple beneficiaries to reduce the taxes they’ll need to pay. This is an especially effective tactic if you have children and grandchildren you want to help with a trust. If you name only your children – and assume they’ll use the income to help their children – the trust’s income might push them into a higher tax bracket. By contrast, naming your grandchildren individually may keep your children in a lower tax bracket.

Conclusion

Setting up a trust to manage your money and distribute it to beneficiaries after your death is a good way to protect assets and avoid probate with your estate if the trust is funded properly. However, it’s important to understand the specific laws regarding taxation of trusts in Colorado. 

Do you need help structuring a trust to minimize your trust tax burden in Colorado? Click here to learn more about our expertise with trusts, wills, and probates, and to fill out a contact form.