Income Tax Implications of Grantor and Non-Grantor Trusts

So, you set up a trust as part of your estate planning. But do you know how the trust’s income will be taxed? And how does the American Taxpayer Relief Act of 2012 (ATRA), which increased income tax rates and added the new net investment income tax (NIIT), affect the taxation of trusts?

It’s important to understand the different types of trusts and how the latest income tax rules affect the trust and its beneficiaries.

What is a grantor trust?

A grantor trust is a trust you, as the grantor (the person who established the trust by gift or grant), retain certain powers over — resulting in you continuing to pay income tax on the trust income.

The most common form of grantor trust is a revocable living trust, which can be used during your life and at your death to hold and administer your assets. Revocable living trusts are a powerful alternative to wills, and typically include terms providing great flexibility during your lifetime — compared to other options providing a more rigid dispositive plan for your assets in death.

When creating irrevocable lifetime trusts to remove certain assets (and their appreciation) from your taxable estate, there’s a good chance you created a grantor trust for income tax purposes, as grantor trusts are incorporated into many effective estate planning strategies. Spousal access trusts, grantor retained annuity trusts (GRATs), defective grantor trusts (e.g., an IDGTs or DIGITs), and most irrevocable life insurance trusts (ILITs) are grantor trusts. Dynasty trusts can also be structured as grantor trusts.

There are several grantor trust powers that can be retained over an irrevocable trust while still removing assets from your taxable estate. For example, the power of substitution (i.e., the power to swap assets with the trust) is one of the most popular powers used for irrevocable grantor trusts.

A grantor trust is considered a disregarded entity for income tax purposes. Therefore, any taxable income or deduction earned by the trust will be taxed on the grantor’s income tax return. In most cases, there will not even be a requirement to file a trust income tax return, as the income of the trust assets can be reported with your social security number.

Tax advantages of irrevocable grantor trusts

Establishing an irrevocable grantor trust has many tax advantages. For example, you can sell assets to the trust without recognizing the gain on the sale. You can also loan money to the trust, and although the trust must pay you at least a minimum IRS-prescribed interest rate (called the applicable federal rate), the interest income is not taxable to you. In addition, your trust’s income tax, paid by you as the grantor, is not considered an additional gift to the trust. Basically, the trust assets can grow for the benefit of the beneficiaries, without the economic burden of paying income tax. In essence, this is a tax-free gift.

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However, at some point you may realize the trust has sufficient assets for its intended beneficiaries — perhaps your children and grandchildren. Or you may no longer find it economical to your personal finances to pay the trust’s income taxes. In these circumstances, it may be possible to give up or waive the grantor trust powers, which would then convert the grantor trust to a non-grantor trust. Regardless of whether you waive the grantor powers during your lifetime, the trust will become a non-grantor trust at your death.

What is a non-grantor trust?

A non-grantor trust pays income tax at the trust level on any taxable income retained by the trust.

If a trust makes a distribution to a beneficiary, such distribution will allocate the taxable ordinary income (but generally not capital gains) to the beneficiary, and will be taxed on the beneficiary’s personal income tax return. The trustee must complete Form 1041 and issue a Schedule K-1 to the beneficiary, showing the amount and type of income from the trust to be included on their individual tax return.

Effect of ATRA

The American Taxpayer Relief Act was not kind to trusts, especially to those that accumulate income. A trust’s income taxation is similar to individuals, but the tax brackets are very compressed. For 2024, a trust will pay income tax at the 37% tax rate when taxable income is more than $15,200. Compare this with an individual, where the same income tax bracket kicks in at $609,351 of taxable income ($731,201 for married couples filing jointly).

Trusts are eligible for the special income tax rate on long-term capital gains and qualified dividends; in 2024, the 20% capital gains rate will apply when trust taxable income exceeds $15,450. The 15% and 0% capital gains rates also apply to trusts in lower tax brackets.

Net investment income

The net investment income tax (NIIT) of 3.8% applies to certain income retained by trusts and estates if taxable income exceeds $14,450. Net investment income includes interest and dividend income and capital gains, but also includes passive income from rental and business activities, and from pass-through entities such as partnerships, limited liability companies (LLCs), and S Corporations.* As a result, many trusts and estates will be taxed in 2023 at 40.8% on ordinary income and 23.8% on qualified dividends and long-term capital gains, plus state income taxes.

Individual beneficiaries may be eligible for lower tax brackets. The NIIT does not affect single beneficiaries unless their adjusted gross income (AGI) exceeds $200,000, or beneficiaries who are married filing jointly with AGI exceeding $250,000.

Managing taxable income

This difference in income tax brackets between trusts and individual beneficiaries presents an opportunity to effectively manage the trust’s taxable income. If the trust’s distribution provisions allow discretionary distributions, a trust distribution will result in income taxed at the beneficiary level.

There’s a good chance beneficiaries are in lower income tax brackets. However, keep in mind the estate planning and asset protection objectives of the trust. To the extent income is distributed from a trust, the income will be included in the beneficiary’s estate, and will also be subject to beneficiary’s creditors, contrary to the original objectives of the trust. Therefore, the trustee should carefully consider discretionary distribution considering all the facts and circumstances.

ATRA also made the federal estate tax exclusion $5 million, which permanently indexed it for inflation, but the 2017 Tax Cuts and Jobs Act temporarily doubles taxpayers’ lifetime exemption through December 31, 2025. The exclusion is $13.61 million for 2024, but will be reduced by half in 2026 unless Congress provides additional relief. ATRA reduced the number of taxpayers subject to federal estate tax. Therefore, income tax planning may be more important than estate tax planning for many taxpayers.

Trusts that allow the trustee to make discretionary distributions may consider making distributions within 65 days of the end of the tax year and electing to treat such distributions as if they occurred on December 31 of the preceding calendar year. This allows a trustee the flexibility to manage the trust’s taxable income and make a distribution decision based on trust income after gathering all the information for the tax year.

State income tax complications

Like individuals, trusts may be subject to income tax because they are residents of a state imposing income tax. States imposing income tax also establish specific rules to determine if a trust is a “resident” or “non-resident” of that state. Often a trustee’s residency determines where a trust is domiciled, so it’s imperative to consider the state income tax cost of a potential trustee who lives in a state assessing income tax. For example, a Nevada resident funding a non-grantor trust for their Nevada-based children with a New York trustee may subject the trust’s income to a tax rate as high as 8.82 percent.

Conversely, for a New York resident funding a non-grantor trust for their New York-based children with a Nevada trustee may alleviate the trust’s assets from paying New York state income tax as Nevada doesn’t have its own income tax.

While non-grantor trusts’ state residency and state income tax liability is often determined based on where the trustee lives, individuals funding grantor trusts don’t absolve themselves of state income tax by choosing an out-of-state trustee. For example, a New York resident funding a grantor trust with a Nevada trustee will still be required to pay New York state income tax on the trust’s income tax. While states typically assess lesser rates of income tax to individuals than trusts, these rules could defray the perceived income tax savings of using a grantor trust.

While the residency of a trustee is often a significant factor in determining a trust residency, it’s important to recognize it’s not the only factor — states impose a myriad of very inconsistent regimes. States often consider other factors such as beneficiary residence, grantor residence, location of administration, and trust assets’ location. It’s possible a trust could be a resident of multiple states or no states at all.

As with individuals, trusts owning investments or businesses with activity in a state other than the trust’s state of residence may be obligated to pay income tax to the state where the business or investment earned income.

Tax considerations

Irrevocable trusts established for estate planning purposes may have some interesting income tax considerations. Be aware of who pays the income tax on the trust income, the opportunities with grantor trust planning, and the income tax effect and distribution planning opportunities for non-grantor trusts.

How we can help

Trusts can be a valuable estate planning vehicle but there are a lot of rules and considerations to weigh. Work with a team of experienced estate planning CPAs to discover favorable options for your estate and wealth transfer goals.

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