Trust Funds and Taxes: When Is a Payment to a Beneficiary Tax-Exempt, and When Is It Taxed as Other Income?

Trust funds (in Czech: svěřenské fondy) have become one of the most effective tools in recent years for intergenerational wealth transfer, protection of family businesses, and anonymising ownership structures. However, as their popularity grows, so does the level of scrutiny from the tax authorities.

Legal Nature of a Trust Fund

Under Czech law, a trust fund is an entity sui generis, meaning it is an asset pool without legal personality. For tax purposes, however, it is treated as a legal entity. The trust itself is subject to corporate income tax (currently 21%). The real “tax alchemy” begins when the trust distributes benefits. At ARROWS, we structure trust funds on a daily basis. We often see that clients treat a trust as a “vault”—but forget that a vault must also have properly designed “doors”, otherwise withdrawals can become unnecessarily expensive.

The Trust Deed: Your Tax Constitution

Most tax problems do not originate in legislation itself, but in a poorly drafted trust deed. The deed is not merely a formal notarial document. It effectively becomes the constitutional framework of the trust and determines what counts as:

• the trust principal (assets contributed / corpus), and

• the trust’s profit or growth (income / appreciation).

If the deed does not clearly separate principal and profit, the trustee will be in a weak evidentiary position. In case of doubt, tax authorities may treat all distributions as taxable profit distributions.

Practical example

A client contributed real estate worth CZK 50 million to a trust. After ten years, the trust sold the properties for CZK 70 million. The deed did not clearly determine how capital appreciation should be treated.The trustee distributed the full CZK 70 million to the beneficiary (the settlor’s son). The tax authority argued that CZK 20 million represented trust profit and should therefore have been taxed via withholding tax, rather than treated as a tax-exempt release of assets. A lengthy dispute followed.

If the deed had been drafted with clear allocation rules, the tax exposure would have been significantly reduced.If you want your trust deed reviewed, contact us at office@arws.cz.

The Core Split: Profit Distribution vs. Return of Principal

The decisive factor is the source of the distributed funds. In practice, there are two distinct categories:

1. Profit distribution
   The trust generates profit (rent, dividends, investment returns) and distributes that profit to the beneficiary.

2. Return/release of principal
   The trust distributes assets that were originally contributed into the trust (principal/corpus).

Profit distributions are taxed via withholding tax. Distributions of principal may, under certain conditions, be tax-exempt. If a trust distributes profit, the beneficiary’s income is generally taxed at 15% withholding tax. In this respect, the trust operates similarly to a company paying dividends. ARROWS can prepare a legal tax review confirming that the distribution is structured properly and reducing the risk of disputes with tax authorities. For certainty, contact office@arws.cz.

FAQ – Practical Tips on Profit Distributions

1) Do I, as a beneficiary, have to file a tax return if the trust distributed profit to me?

Usually no, if the income is taxed at source through Czech withholding tax. The trust withholds 15%, and the beneficiary receives the net amount. However, if you receive income from a foreign trust, the situation differs and the income may need to be reported in a Czech tax return. Need help with reporting and documentation? Contact office@arws.cz.

2) What tax rate applies if the beneficiary is a foreign person?

That depends on the applicable double tax treaty between the Czech Republic and the beneficiary’s country of tax residence. The rate may be reduced, but it can also be increased (up to 35% in non-treaty cases or high-risk jurisdictions). For cross-border tax structuring, contact office@arws.cz.

Tax Exemption: Family Relationship Is the Key

A particularly important scenario arises when a distribution is classified as “other income” (Section 10 of the Czech Income Tax Act), which typically happens when the distribution is not treated as profit, but as a release of principal. Here, the crucial factor is the family relationship between the settlor and the beneficiary.

In simplified terms, the logic mirrors the historic Czech gift tax approach:

• Tax-exempt distributions:
  If the beneficiary is a close relative of the settlor in the direct line (parents, children, grandparents) or certain close relatives in the collateral line (siblings, spouse, etc.).

• Taxable distributions:
  If the beneficiary is a non-related person or a more distant relative (e.g., a friend or a distant cousin).

This rule is essential for intergenerational transfer planning. A trust can preserve the family exemption while also adding protection and control. In practice, complex family situations require caution. “Patchwork families”, stepchildren, or unmarried partners can mean the difference between 0% and 15% (or 23%) taxation—sometimes solely due to formal family status. We can structure the trust so your beneficiaries do not pay unnecessary taxes. Contact office@arws.cz.

Trust as a Holding Structure: Business Trust Funds

Many entrepreneurs use trusts not only to manage family property but also to hold shares in companies (s.r.o., a.s.). In such cases, the trust effectively becomes the “parent” in a holding structure. The tax mechanics are specific:

1) Dividends paid into the trust

If the trust holds shares in a subsidiary (e.g., 100% of an s.r.o.) for the legally required period (typically 12 months) and the ownership threshold is met (usually at least 10%), dividends paid from the subsidiary to the trust may qualify for the participation exemption.

2) Distributions from the trust to the beneficiary

This exemption does not automatically apply when the trust distributes funds to an individual beneficiary. That payment is typically treated as a profit distribution, subject to 15% withholding tax. A common misconception is that you can extract company profits through a trust completely tax-free. That is not correct. However, the trust can provide tax deferral:

• profits can flow into the trust in a tax-efficient way,

• the trust can reinvest them (e.g., acquisitions, real estate, securities),

• tax is triggered only when funds are withdrawn to an individual beneficiary.

We provide ongoing legal support to more than 150 joint-stock companies and can structure holding trust funds with long-term investment logic. If you plan to contribute company shares into a trust, consult us first at office@arws.cz.

Key Risks (and How ARROWS Helps)

Risk: Additional tax assessment + penalties

If the tax authority reclassifies a distribution (e.g., from principal release to taxable profit distribution), it may impose additional tax plus penalties. How ARROWS helps: We prepare legal opinions, trust deed reviews, and documentation designed to withstand scrutiny.

Risk: Double taxation in international structures

In cross-border cases, the same income may be taxed both in the trust’s jurisdiction and in the beneficiary’s country of residence. How ARROWS helps: International tax planning through ARROWS International and treaty-based structuring.

Risk: Loss of exemption for “non-relatives”

If the beneficiary is not a close person of the settlor (e.g., an unmarried partner), the distribution may be taxed. How ARROWS helps: Restructuring options, alternative transfer models, and risk-reducing legal design.

Holding Periods: Real Estate and Securities Held by the Trust

A trust is not only a distribution vehicle—it is often a long-term investor. A key optimisation point is the treatment of holding periods. If the trust sells real estate or securities, the income is generally taxable at the trust level (21%). Unlike individuals, legal entities (and therefore trust funds) often do not benefit from time-test exemptions known from personal taxation regimes.

How we solve this in ARROWS

If the goal is a future tax-efficient sale, the structure may need to be designed differently, for example:

• the trust releases the property to a beneficiary (where legally and tax-efficiently possible), and

• the beneficiary sells later under their personal tax regime, potentially meeting individual time-test exemptions.

This is the kind of structural detail where the wrong sequencing can cost millions. If you want to structure a trust fund efficiently and safely, contact us at office@arws.cz.