Trust Income…. is it cash?

Your question:

My borrower/guarantor has trust income listed on 1040 Schedule E, page two. Are they actually receiving this amount? Will the 1041 K-1 confirm the actual distributions?

Linda says:

K-1s are not the same from the various tax returns:

  • The 1065 K-1 shows actual distributions, and even whether they are cash or ‘property’.
  • The 1120S K-1 shows distributions, but does not distinguish between cash or property.
  • The 1041 K-1 shows the amount the beneficiary must report and pay taxes on. It does not specify that the income was actually distributed.

Trusts are complicated and I recommend you seek the input of a senior lender if you are not sure what to request from the borrower. In this ‘answer’, I cover a few items from the IRS website instructions for ‘Form 1041 U.S. Income Tax Return for Estates and Trusts’ along with what lenders in a recent training said they ask for.

Is it a Simple Trust?

A trust may qualify as a simple trust if:

  1. The trust instrument requires that all income must be distributed currently;
  2. The trust instrument does not provide that any amounts are to be paid, permanently set aside, or used for charitable purposes; and
  3. The trust does not distribute amounts allocated to the corpus of the trust.

So if it is a simple trust, and all has been done as required, the amount on the 1040 Schedule E that is taxed is also the amount distributed.

Is it a Grantor Type Trust?

  1. A trust is a grantor trust if the grantor retains certain powers or ownership benefits. This can also apply to only a portion of a trust.
  2. In general, a grantor trust is ignored for tax purposes and all of the income, deductions, etc., are treated as belonging directly to the grantor. This also applies to any portion of a trust that is treated as a grantor trust.

So if it is a grantor type trust, you may not even notice it. Instead of being listed on Schedule E, Page two the income created by the trust will be shown on the grantor’s return as if it were his or her personal income.

Has the trust filed a 1041?

The trust will file a 1041 if: The fiduciary (or one of the joint fiduciaries) must file Form 1041 for a domestic trust taxable under section 641 that has:

  1. Any taxable income for the tax year,
  2. Gross income of $600 or more (regardless of taxable income), or
  3. A beneficiary who is a nonresident alien.

If so, you might ask for the 1041, but it still will not tell you what was actually distributed. By understanding the source of the income the 1041 could help, though, in deciding if the income is likely to continue.

Definition: Income Required To Be Distributed Currently

Per IRS Instructions: Line 9 of the 1041 is to be completed by all simple trusts as well as complex trusts and decedent’s estates that are required to distribute income currently, whether it is distributed or not. The determination of whether trust income is required to be distributed currently depends on the terms of the governing instrument and the applicable local law.

So what did the lenders say?

This training session had a large number of lenders to high-income, high net worth borrowers.

  • As a group they agreed that you need the trust agreement itself if you want to be sure what is required to be distributed. (That agrees with the IRS instructions above).
  • Another option is to get a letter from the trustee indicating what was actually distributed and the likelihood it will continue.

The lenders suggested that whether you are comfortable with just the letter or an excerpt of the trust agreement, or whether you instead need to get the entire agreement for review, depends on the importance of that income source to the loan decision you are making.

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