Trust administration is a fiduciary duty that many individuals don’t pay attention to until they become a trustee. Usually, this happens when the benefactors of a grantor trust pass away. At that point, the trust becomes an irrevocable trust and the successor trustee takes over.
And one of the first questions that most people ask about trustee fees is: “Are they taxable income?” As a general rule, trustee fees are tax-deductible to the trust and considered taxable income to the trustee.
The second question might be: “Are trustee fees subject to self-employment tax?”
Fiduciaries acting in a nonprofessional fiduciary capacity are not subject to self employment taxes while a professional trustee will report trustee fees as self-employment income subject to self-employment tax.
This in-depth article will break down the nuances of trustee fees so that you have a better understanding of how you should report them on your tax returns.
However, this article is for educational purposes only. This article is not a substitute for professional investment advice, tax advice, or legal advice. Please consult a tax professional for in depth information about how to report trustee fees for tax purposes.
Are trustee fees taxable?
There are actually 3 possible questions to this question:
When trustee fees are not considered taxable income.
Trustee fees are not considered taxable income if the trustee waives them. This might occur in a situation where the successor trustee is also a beneficiary of the trust.
In most states, a beneficiary who also serves as trustee might be eligible for reasonable compensation. However, trustee fees are taxable income.
Therefore, the beneficiary has the right to waive the fee. This would allow that money to be disbursed to the beneficiaries tax-free.
And if there is only one beneficiary of the trust, then it would almost always be in their best interest to do this, unless the decedent’s estate is subject to estate tax.
When trustee fees may be taxable as ordinary income.
If a trustee decides to accept trustee fees, then those fees become an income tax deduction for the trust. At the same time, the trustee must include those fees as taxable income on their individual tax return.
However, a nonprofessional executor or trustee, who doesn’t have any particular expertise in such a role does not have to pay self-employment tax. This might happen when handling the estate of a deceased friend or family member.
According to IRS Publication 525-Taxable and Nontaxable Income, if the personal representative (trustee) is acting in a non-professional capacity, they will include such fees as income on Schedule 1, Line 8z (other income), of their tax return.
Taxpayers report this income on Schedule 1. Therefore, it is not subject to FICA or SECA tax withholdings.
When are trustee fees subject to self-employment tax?
Conversely, if the personal representative or trustee is handling the administration of the estate in a professional capacity, then such income will be reported on Schedule C as self-employment income in the given tax year.
We should probably take a brief look at self-employment income, why it exists, and what is subject to self-employment taxes.
What is self-employment income?
To properly explain the self-employment tax issue, it makes sense to take a step back to look at how Medicare and Social Security are funded.
What is FICA?
FICA, or Federal Insurance Contributions Act, is the means by which Social Security and Medicare are funded. FICA taxes are imposed on payroll income, and the responsibility is split evenly between employer and employee.
Both employer and employee pay 6.2% of the employee’s income for Social Security, for a total of 12.4% of the employee’s total income. An income limit applies to this deduction, after which no more Social Security deductions are taken.
In 2023, that earnings limit is $160,200.
Both employer and employee pay 1.45% of the employee’s income for Medicare, for a total of 2.9% of the employee’s total income. Unlike Social Security, this deduction is not subject to an income limit.
For earners making more than $200,000 per year in wages, employers are required to withhold an additional 0.9% of the employee’s wages in excess of $200,000 each year.
Self-Employment Contributions Act
The Self-Employment Contributions Act of 1954, also known as SECA, simply makes self-employed individuals responsible for paying both parts of FICA. This applies to anyone who is:
- An independent contractor
- A self-employed individual
- A sole proprietor
- Owner of a single-person LLC or S-corporation
In other words, if you are your own employer, you’re responsible for paying the employer’s side of the FICA taxes as self-employment tax. The good thing is that you’re eligible for an income tax deduction. The allowed deduction is 50% of the total self-employment tax on Schedule SE of your income tax return.
So the primary question now is: How can you tell if you’re in a professional capacity or nonprofessional capacity?
Nonprofessional fiduciaries vs. professional fiduciaries
Usually, the trustee of a trust will not have a problem understanding whether or not they are operating in a professional capacity. However, there are a couple of references to help better understand whether these earnings are subject to self employment taxes.
IRC § 1.1402(c)-1: Trade or business
This section of the Internal Revenue Code defines the prerequisites for an individual to have earned income from a trade or business that would be considered self-employment income:
In order for an individual to have net earnings from self-employment, he must carry on a trade or business, either as an individual or as a member of a partnership.
In other words, if the trustee fees are earned in a manner that doesn’t reflect the trustee’s professional trade or business, then it cannot be considered self-employment income.
Rev. Rul 58-5
According to IRS Rev. Rul 58-5, non-professional executors and fiduciaries will be considered as not receiving income from a trade or business unless the following conditions are met:
- There is a trade or business among the assets of the estate,
- The executor actively participates in the operation of this trade or business,
- The fees of the executor are related to the operation of the trade or business.
The revenue ruling goes on to cite several examples. In these examples, several factors help to determine whether the trustee fees are subject to self-employment taxes. These factors include:
- Allowable trustee or executor compensation based upon state law or a court order
- Passive involvement versus participating in extensive management activities
- Whether the trustee is engaged in managing the trust assets to help earn income
For additional information based upon your specific circumstances, you should definitely discuss your case with a tax professional.
Are expenses related to managing a trust reimbursable to the trustee?
Generally speaking, expenses related to managing a trust should be paid by the trust. If a trustee pays for certain out of pocket expenses, the trust should reimburse those expenses accordingly. Common examples might include travel, tax preparation, or bookkeeping and accounting functions.
The trustee does not have to report reimbursed expenses as taxable income. However, the trustee should keep detailed accounting of all expenses for audit purposes.
In most instances, trust administration will not result in the trustee having to pay self-employment tax. In some cases, a trustee may need to consider part or all of their trustee fees as self-employment income.
If you want to learn more about tax topics, please check out our tax planning archives!