As part of running a trust fund or being a beneficiary of a trust fund you need to have some understanding of taxes. As always, if taxes are not your specialty get professional help I am only writing from my own experience.
Every year I need to review the taxes for each of the trust funds that I run. Here are the elements of determining taxable items:
1. interest income – every brokerage account is attached to a money market account, which bears interest. When you put funds into the trust, it starts out in the money market account and earns interest until you make an investment, and as you earn dividends, the dividends also go into your money market account. You also may opt to NOT invest a portion of the cash that is in your money market fund, because you are waiting or are afraid of the market, so it will also earn interest until you invest it in stock. Generally, your interest income nowadays will be puny because rates are extremely low right now (less than 2%) on short term money market funds and unless you have large balances the amounts are trivial. For tax purposes, unless your money market account invests in tax-exempt (municipal) securities, you will pay taxes on this interest income, generally at the highest taxable rate
2. dividend income – many, but not all, stocks pay dividends. Dividends may be paid out quarterly, semi-annually, annually, or on special occasions. The “dividend yield” takes the current payout plan of the company divided by the stock price, to see what the stock would pay if it is the equivalent of an interest bearing bond or CD. Right now, for example, Procter and Gamble pays out a dividend with a 3% yield. When a stock price plunges, the yield can get very high, but that is a sign that the stock may reduce payouts – for example right now Nokia has a yield of 10%. Dividends are taxable when received, and they generally are eligible for a reduced taxable rate of 15% if they are “qualified” and US based.
3. capital gains and losses – when you buy or sell a stock, you earn capital gains or losses on the difference between the price you paid for the stock and the price you sold it for (including commissions). Thus if you bought a stock at $10 / share and bought 20 shares, and then you sold that stock for $15 / share, you’d have a capital gain of ($15 – $10) * 20 or $100. If your “holding period” of the stock was less than 12 months, it would be a short gain, and if your holding period was greater than 12 months, it would be a long term gain. Generally long term capital gains are eligible for favorable tax treatment. Note that all capital gains and losses are “netted” against each other, and you can roll-forward your losses. For practical purposes this means that the VAST majority of Americans won’t be paying capital gains taxes for years to come, since most of their existing stocks are trading for less than what they paid for it. Even if you want to sell a stock for a gain, it is easy to find something to sell for an equivalent loss to avoid paying taxes.
Portfolio one – $352 in dividends, $32 in interest, and a long-term loss of $590 on a sale of GE stock
Portfolio two – $188 in dividends, $22 in interest, and a short-term loss of $761 on a sale of ICICI (IBN) stock
Portfolio three – $21 in dividends, $11 in interest, and a short-term loss of $550 on a sale of ICICI (IBN) stock
Filing requirements are complicated. For this purpose I am discussing whether or not you need to file a return on a given trust fund.
For 2008, if your “unearned” income (basically interest, dividends and gains / losses on sales) is less than $900, you don’t have to file. Based on the above items, they do not need to file. In prior years, we sold some stocks off for gains that pushed them beyond the filing thresholds and we did need to file.
There is an IRS publication 929 (they go by number) which attempts to explain all of this. I would recommend going to www.irs.gov and look for this publication (it is a PDF), download it, and read it. In another post I will explain some of the complexities the best I can.