Taxation Of Trusts And Estates: A Simple Guide To Inheritance

Key Takeaways

• Trusts manage and distribute assets, while estates deal with wealth transfer after death.

• Tax treatment varies for charitable, private and estate trusts, with registered charitable trusts qualifying for exemptions under Sections 11 and 12.

• No tax is levied on inherited assets, but capital gains tax applies if the beneficiary sells them.

• Income distributed by a trust is taxed in the hands of beneficiaries as per their tax slab.

Trusts are established to manage and distribute assets, while estates deal with wealth transfer after a person’s death. Taxation of trusts and estates plays an important role in financial planning, affecting trustees, beneficiaries, and estate administrators. 

In India, registered charitable and religious trusts may qualify for tax exemptions under Sections 11 and 12 of the Income Tax Act, 1961. On the other hand, private trusts and associations of persons are taxed differently. Estates may also face inheritance and capital gains tax implications.

It refers to how the government collects taxes on the income, assets, and wealth managed by trusts and estates. These taxes apply based on the type of trust or estate and how the income is distributed to beneficiaries.

• Trusts are legal entities that hold and manage assets for specific beneficiaries.

• Estates deal with assets left behind after a person’s death.

• Registered trusts may get tax exemptions under specific laws.

• Private trusts and AOPs are taxed based on their income and purpose.

• Compliance with tax laws ensures financial planning and legal protection.

Estate planning involves using trusts to manage and protect assets while ensuring tax efficiency. Here are some tax rules that apply to trusts in estate planning:

Trusts created for charitable or religious purposes may qualify for tax exemptions under Section 11 of the Income Tax Act. To retain exemptions, at least 85% of the income must be used for charitable activities.

If a trust sells property or investments, capital gains tax applies based on the asset type and the holding period.

No tax is levied on inherited assets, whether movable gold, shares, mutual funds or immovable property. However, if the inheritor decides to sell these assets, capital gains tax applies. 

Registered trusts in India can avail tax exemptions based on their purpose and activities. Charitable trusts, for instance, are exempt under Section 11 of the Income Tax Act of 1961. To qualify, they must:

• Use at least 85% of their income for charitable activities.

• Ensure all earnings are applied towards the trust's intended purpose.

Beneficiaries of trusts and estates may face tax liabilities depending on the type of trust and income received.

• Inherited Assets - No tax is levied on inherited assets, but capital gains tax applies if the beneficiary sells them.

• Trust Income - If a trust distributes income, the beneficiary is taxed based on their applicable income tax slab.

• Estates - If an estate generates income before distribution, the executor must pay taxes before transferring assets to beneficiaries.

In India, there has been no estate or inheritance tax since its abolition in 1985. Here are some strategies to minimise tax liabilities associated with wealth transfer. 

• Utilise Gift Tax Exemptions

Gifts from specified relatives are exempt under the Income Tax Act. 

• Establish Family Trusts

Creating a family trust can facilitate efficient wealth management and distribution, potentially reducing tax burdens.

• Form a Hindu Undivided Family (HUF)

An HUF is recognised as a separate tax entity, allowing for additional tax benefits.

A private trust is taxed through its trustees. According to the Income Tax Act, trustees and beneficiaries are considered taxpayers. The trust's income is either taxed directly in the beneficiary's hands or the trustees' hands.

Inheritance tax helps determine how much of an estate will be taxed when passed to heirs. 

• Wealth Distribution - Inheritance tax impacts how much heirs will receive after taxes are deducted from the estate value.

• Tax Planning - It helps minimise the tax burden, such as through gifts, trusts or insurance.

• Asset Protection - Allows individuals to plan for passing on assets efficiently while reducing tax liabilities for beneficiaries.

• Maximising Inheritance - Helps heirs receive as much of the inheritance as possible while keeping taxes in check.

It is essential to ensure compliance with the Income Tax Act. Trusts with taxable income or certain mandatory requirements must file returns using ITR 5 or ITR 7.

• ITR 5

File if the trust has taxable income above the exemption limit.

• ITR 7

File if the trust is required to file under Sections 139(4A), 139(4B), 139(4C), 139(4D), 139(4E) or 139(4F) of the Income Tax Act.

• E-filing

All trusts must e-file their income tax returns.

• Tax Audit

If the trust needs an audit, the return must be e-filed with the digital signature of the CA conducting the audit.

You can comply with income tax regulations better by eliminating these errors:

• Failing to File Returns

• Incorrectly Reporting Income

• Ignoring Capital Gains Tax

• Not Planning for Inheritance Tax

1. What is the tax treatment of income from trusts?

Income from trusts is taxed similarly to an Association of Persons. There is no tax for income up to ₹2.5 lakh, but income above this threshold is taxed according to applicable rates.

2. How do estate tax exemptions work?

It allows certain portions of an estate’s value to pass tax-free to heirs. In India, there is no estate tax, but exemptions may apply to specific assets under tax laws.

3. How can I minimise taxes on trusts and estates?

You can minimise taxes on trusts and estates by utilising deductions and gifting assets early. Strategic planning with tax-efficient investments can also reduce tax liabilities.

4. How does estate planning help in reducing tax liability?

Estate planning reduces tax liability by setting up trusts like family or irrevocable trusts. These trusts help control how assets are distributed and can offer tax benefits for the beneficiaries.

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