Does the trust need to file annual income tax returns?

Yes. Trusts are separate legal entities and are required to file annual income tax returns. Generally, if income is not distributed to the beneficiaries, it is reported by the trust. If income is distributed to the beneficiaries, it is reported by the beneficiaries. However, trusts are often designed as grantor trusts, which require the grantor to report all income earned by the trust on the grantor’s individual return. This provides several benefits:

(1) it doesn’t erode the amount the grantor has gifted to the trust, thus allowing the trust to stay as fully funded as possible;

(2) it allows the grantor to pay the tax at the grantor’s tax bracket, which is often less than the highly compressed trust tax brackets; and

(3) it allows the grantor to sell assets to the trust without recognition of gain.