Trust tax/debt concerns

Question

I live in the US, and have been appointed as the trustee of an irrevocable trust with my father (who also lives in the US) as the beneficiary. My father is potentially in some debt/behind on taxes, and is additionally receiving benefits from the state. I have been assured that the trust cannot be garnished by any of these entities but my concern is on any payments made to my father.

1. Are those payments considered income for him?
   a. Will he have to report them for his taxes (this one is probably obviously yes but I'm not sure)?
   b. Can that income make him ineligible for certain government benefits.

2. Can a potential debtor garnish those payments either wholly or partially?
   a. If they are entitled to garnish said payments and they are not made aware of them, are they then able to go after the trust for any back payments not received. In other words if I pay out money to my father for years without knowing of his debts can a debtor come to me at some point in the future and say I made a mistake in not paying them out of those disbursements and sue the trust for it.
   b. If yes is there any way I can find out what debt he has, preferably on my own as he will likely not cooperate with said endeavor.

Answer 1

This applies to the U.S.:

Payments made from a trust are no longer in the trust and lose creditor protections. Unless there are other protections (e.g. state-level protections protecting certain trust distributions), once the assets are in your father's bank account/possession, a creditor may have access to those funds.

Income distributed from an irrevocable trust is taxable to the beneficiary and retains the characteristics of that income (e.g. dividends or interest) Any principal or corpus distributed is not income.

Trust income can result in benefit ineligibility (e.g. if the income is sufficient to raise MAGI/taxable income above an income limit or increase net worth above a net worth limit).

As the trustee of an irrevocable trust, your responsibility is to make distributions according to the distribution requirements of the trust. Once you do that, your job is done. It's not your responsibility to make sure debts are paid or creditors are notified (barring any laws in your jurisdiction that require it).

If your father has outstanding federal tax debts, the IRS can place liens or levies on his assets. In general, creditors are subject to the Fair Debt Collection Practices Act, which limits how creditors can go after people for their debts.

You may want to consult an attorney on this. The trust may have clauses that allow you to refuse distribution for certain reasons (which can help protect assets from your father's creditors) or it may be structured in a way that allows creditors to pierce the trust.

Answer 2

I'll add more color to Stan's answer (which is absolutely correct, +1), for your consideration.

Irrevocable Trust is a Legal Entity

The trust is an entity of its own, like a corporation or a person. It is not you (the trustee) and it is not your father (the beneficiary). It is defined and governed by the trust document, and you the trustee are bound to act as the trust document says you should act.

Fiduciary Duty

Fiduciary duty is your duty, as the trustee, to act in the best interests of the beneficiary and according to the trust document that created the trust. You cannot distribute moneys to your father that the trust document says you shouldn't, and you can't also withhold moneys from your father that the trust document says should be distributed.

Within the requirements of the trust document, you as the trustee should choose the best alternative to the beneficiary. So if the trust document is silent on the matter - you can decide what's best given the situation, but if the trust document is explicit - you follow the document.

Trusts are Taxed Higher than Individuals

Trusts are taxed at higher rates and allowed less deductions than individuals. So any income retained in the trust and not distributed will be taxed at higher rates than had it been distributed to the beneficiary.

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For completion, answers to your questions (which are the same as Stan's):

Trust Distributions Retain Character

Whatever you distribute from the trust retains the character it had in the trust.

• Distribution from income not yet taxed - taxable income to the beneficiary in the same category. Dividends - are dividends to the beneficiary. Capital gains - remain capital gains, long or short. Rental income, etc. Deductions from income also flow down to the beneficiary with the income (this is especially relevant to rental income or other types of passive income with high expenses).

• Distribution that was taxed before - is not taxable income to the beneficiary. That may be distribution of assets contributed to the trust, or income that the trust retained from prior years and didn't distribute.

Trust distributions and characterization of income are reported to the beneficiaries on form 1041 Schedule K1.

Debtors Cannot Take Over the Trust

Unless the trust explicitly states otherwise, debtors cannot take over the trust - being trust a distinctly separate entity and not your father. This is different from revocable (living) trusts which are not distinct.

What the debtors can do is garnish distributions. So whatever the trust was required to distribute to the beneficiary will go to the debtors directly (but K-1 will still list it as a distribution to the beneficiary).

This can only be done with a court order.

Talk to an Attorney you Trust

I'm not an attorney and the above is not a legal advice, obviously. If you do not trust the attorney you're working with - find a one you could trust and be satisfied with. This is a high risk situation both for you (since as a trustee you may be liable for the breach of the fiduciary duty) and for your father (since his rights as the beneficiary are affected). Make sure you work with a good attorney and clarify and confirm all the above points with them.