What happens when you have a family member who struggles with managing money or faces financial difficulty? Could they handle an inheritance if you were to pass on? How could you still provide them with income and stability while avoiding their creditors? Many families will utilize a Texas spendthrift trust to help answer these questions.
While understanding the purpose behind a spendthrift trust is relatively straightforward, distributing its assets and determining how to tax those distributions is much more complicated. In Texas, tax responsibility depends on several factors, including how the trust is classified, who manages it, and who benefits from it.
At Robbins Estate Law, we guide families in Austin, Cedar Park, and Round Rock through trust planning with clear information about taxes. Our team of highly experienced attorneys and staff members focuses solely on estate planning, probate, and estate disputes. We use flat-fee pricing and predictable timelines so families understand each step of their plan.
What Is a Texas Spendthrift Trust?
A person creates a trust, becoming its grantor, when they:
- Create written trust terms setting out instructions to manage the trust,
- Name one or more trustees to manage the trust,
- Select one or more beneficiaries, and
- Transfer property to the trust by titling the property in the trust’s name.
Trusts separate property rights into three pieces:
- Legal ownership, which the trust has;
- The right to control property, which a trustee has; and
- The right to benefit from property, which the beneficiaries have.
The trustee manages the income, investments, and distributions from the trust to the beneficiary according to the trust’s written rules.
Spendthrift Clauses
A spendthrift trust includes a spendthrift clause that prevents the beneficiary from selling, transferring, pledging, or using their interest in the trust as collateral to borrow money. The clause also states that creditors cannot reach the interest until the trustee distributes the funds. As a result, the beneficiary cannot use their right in the trust as collateral, and their creditors cannot collect on the beneficiary’s debts from trust funds.
Trust Terms
To give those statements legal power, a spendthrift clause specifies when the trust should distribute funds to a beneficiary. Those terms might authorize distributions when, for example, the beneficiary:
- Reaches a specific age;
- Completes a defined milestone such as graduating from college; or
- Has expenses that qualify for distributions, like medical treatment, housing, or tuition.
These rules and limitations create a barrier between trust property and the beneficiary’s personal finances.
How Is a Spendthrift Trust Taxed?
Given the separation of property rights in a spendthrift trust, how they are taxed can become complex. Who pays taxes on a spendthrift trust depends on whether the Internal Revenue Service (IRS) classifies the trust as a grantor trust or a non-grantor trust, and how the trustee handles the trust income. Depending on the classification, the grantor, the trust, or the beneficiary reports the income.
Income vs. Principal
As part of managing the trust, the trustee must classify every dollar the trust receives as either income or principal. A trustee classifies money as income if the trust earned it during the year through, for example:
- Interest,
- Dividends,
- Rent, or
- Business profits.
The original property the grantor transferred into the trust, including long-term assets that can increase or decrease in value over time, is the trust’s principal.
In short, income refers to current-year earnings, while principal represents the underlying property that the trust owns. You only pay income taxes on income, not growth in the value of the trust principal.
Grantor Trusts
In a grantor trust, the grantor retains sufficient control over trust assets that the IRS treats them as the owner of trust property for tax purposes. Because of that control, the IRS views the grantor as the person who benefits from the trust’s earnings, and the grantor reports trust income on their personal tax return.
Further, distributions do not affect tax responsibility. The beneficiary does not report income, and the trust does not file a separate return for that income. The trust can pay the beneficiary every dollar it earns, and the grantor still pays all the taxes.
Simple Trusts
Simple trusts are considered non-grantor trusts. A simple trust cannot keep the income it earns and must distribute all of it on an annual basis. Because the beneficiary receives all income, the IRS assigns tax responsibility to the beneficiary and requires them to report the income on their individual tax return, paying taxes based on their tax bracket.
Complex and Multi-Tier Trusts
Complex and multi-tier trusts are non-grantor trusts with the flexibility to:
- Keep income,
- Distribute income, or
- Distribute principal.
Because the trustee chooses how to handle the income, the IRS assigns tax responsibility based on what the trust does during the year. If the trust retains income, the trust files its own return and pays taxes. If the trust distributes income, the beneficiary reports that amount on their tax return instead.
Income paid to a beneficiary becomes the beneficiary’s tax responsibility, while income retained by the trust becomes the trust’s tax responsibility. Income treated as grantor-level income becomes the grantor’s tax responsibility. With a multi-tier trust, the grantor, the trust, and the beneficiary can all be subject to tax.
What Spendthrift Trust Tax Benefits Exist?
Spendthrift trust tax benefits include:
- Steady income patterns help the beneficiary prepare for future tax years;
- The trustee controls timing, reducing unexpected income spikes;
- The trust protects assets from behavior that could create tax problems, such as risky loans or early withdrawals; and
- The trust supports long-term planning by maintaining clear and consistent distribution rules.
Spendthrift trusts can help individuals maintain financial stability even during difficult years by offering protection, structure, and predictability.
Create a Spendthrift Trust with Clear Tax Guidance
At Robbins Estate Law, our attorneys design trusts that protect assets and explain tax responsibilities in practical terms. With our strict focus on estate planning, probate, and estate disputes, we have the experience to handle and provide customized strategies for all types of estates. Our clients benefit from flat-fee pricing and detailed timelines to help keep them on track with their planning goals.
Contact Robbins Estate Law today to learn more about the benefits and drawbacks of a Texas spendthrift trust.