Taxation of a Private Trust

A private trust is an effective estate planning tool. Whether you have a special child, an estate to protect, or a business to be transferred to next generation, formation of a private trust resolves many issues in such situations. Although there is a lot of consideration before a private trust can be created one very important element which is required to be addressed is the taxation. The primary reason is that income of a private trust is taxed differently in different structures and any ineffective planning can lead to maximization of taxation for this entity.

Here is a brief understanding on how a private trust is taxed and how you should plan it:

Assessment of a Private Trust

Trusts are independent entities and so taxed separately. Since the income of a private trust is available only to the beneficiaries, they are taxed according to the structure in which the income is received. From taxation perspective there are two structures on which income of a private trust is taxed:

Specific Trust– In a specific trust the income is specifically received by the representative assesses on behalf of a single beneficiary. Here the individual share of the beneficiary is known- for e.g. Mr. Ram will receive 25% of the total income of the trust or a minor daughter will receive the entire benefit from the trust.

Discretionary Trust– Here the beneficiaries are more than one and the individual shares of the beneficiary is not known. The income of the trust is not received by a representative but determined by the trustees.

Taxability

When the individual shares of income in a private trust is identifiable, than the income is taxed in the hand of the respective beneficiary.  But since income tax imposes the liability to pay tax on the trustees, in respect of any income which he receives or is entitled to receive on behalf or for benefit of the person, the tax can be levied and recovered from a representative assesse which is the trustee.

The same is not true for a discretionary trust. Since the share of income is not defined and trustees decide the distribution of the same among the beneficiaries, the income of such trust is assessed in the hand of the trustees only at the maximum marginal rate.

The above taxability rule is applicable when the income source of the trust is only from its assets. But the situation will be different when a trust has other sources of income such as a business.

Taxation of Business Income

It may happen that a trust start its own business and derive income from it for utilization for the objectives. In such a case, the income earned form the business belongs to the trust and not to the author of the trust or trustees. Such business income of a private (specific) trust which consists of profits and gains of business income, tax is charged on the whole income at maximum marginal rate. However there are certain exemptions where the taxability remains as per individual tax rate:

1. When a private trust is created by a will for the benefit of relatives.
2. It is created exclusively for the benefit of any relative dependent on the support and maintenance.
3. It is the only trust declared by the settlor.

In all the above cases, even if there is a business income, the income will be charged at the same rate and in term a manner as it would be taxed in the hands of the beneficiary.

One larger point to be noted is that there is no basic exemption available when the taxability is at maximum marginal tax rate.

Taxation at Rates applicable to AOPs

There are some instances in a private trust when the income of the trust can be taxed as if it were the total income of an association of persons-

1. When none of the beneficiaries has any other taxable income which exceeds the basic exemption. If there are multiple beneficiaries and even one has the taxable income, the income of the trust will be charged at maximum marginal tax rate.
2. When none of the beneficiary is a beneficiary at any other trust. If even one is beneficiary at any other trust, the income will be charged at maximum marginal tax rate.
3. The income of the trust is receivable through declaration by any person under will and it’s the only trust declared by him.
4. If the income of the trust (other than created by Will) is created before 1.3.1970, exclusively for the benefit of the relatives of the settlor, or of the members of a Joint HUF when trust is created by family, in circumstances when the relatives or members were mainly dependent on the settlor of their support r maintenance.
5. Income is receivable by trust on behalf of superannuation fund, provident fund, gratuity fund, pension fund or any other fund created exclusively for the benefit of his employees.

When you are creating a private trust you are actually creating a separate tax entity and so care has to be taken not to maximize the taxability on the income of the trust. Here are few tips on how you can ensure the taxability of the private trust income stays lower and it meets the objectives in an efficient manner:

1. Avoid any business activity from the private trust you create for the benefit of your relatives.
2. Ensure same beneficiaries are not created in more than one trust.
3. If the trust is for minor son or daughter or spouse, ensure the fund are not through father or husband since in that case the income will get clubbed with them.
4. Make private trust 100% specific beneficiary for major son or daughter so that money cannot be misused by son in future or relatives of daughter when she gets married.