Key insights
- Grantor trusts generally report income on the grantor’s individual tax return, while non-grantor trusts may pay tax at the trust level.
- Certain irrevocable grantor trusts can provide income and estate planning advantages, including the ability to transfer future appreciation outside of a taxable estate.
- Non-grantor trusts reach higher tax brackets at relatively low income levels, making distribution planning an important consideration.
- State income tax rules can materially affect the overall taxation of a trust.
Curious about trusts and their tax benefits?
Trusts can play an important role in estate, wealth transfer, and asset protection planning, but the income tax treatment often depends on one basic question: Is the trust a grantor trust or a non-grantor trust?
Grantor trust income is generally reported by the grantor, while non-grantor trusts may pay tax at compressed trust tax rates. With estates and trusts reaching the top federal income tax bracket once taxable income exceeds $16,000, trustees and families may want to revisit how income, distributions, and state tax exposure fit into the broader plan.
What is a grantor trust?
A grantor trust is a trust that 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.
Common types of grantor trusts
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 IDGT or DIGIT), and most irrevocable life insurance trusts (ILITs) are grantor trusts. Dynasty trusts can also be structured as grantor trusts.
Grantor trust powers and estate planning
There are several powers that can be retained over an irrevocable trust to cause the trust to be a grantor trust for income tax purposes, while still removing assets from your taxable estate.
One of the most common examples is the power of substitution, which allows the grantor to exchange assets held personally for assets owned by the trust. Carefully structured grantor trust powers can provide planning flexibility while preserving intended estate tax benefits.
How grantor trusts are taxed
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 many cases, the trust doesn’t need to file a separate income tax return because income from trust assets can be reported using the grantor’s 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. This allows you to transfer an appreciating asset out of your estate in exchange for a note receivable that won’t increase in value.
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 isn’t taxable to you.
In addition, your trust’s income tax, paid by you as the grantor, isn’t considered an additional gift to the trust. Basically, 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.
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 practical to continue paying the trust’s income taxes from your personal assets. 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.
Compressed tax brackets for non-grantor trusts
A non-grantor trust’s income taxation is similar to an individual’s, but the tax brackets are much more compressed.
A trust reaches the highest federal income tax rate of 37% once taxable income exceeds $16,000. By comparison, individuals generally don’t reach the same marginal rate until significantly higher income levels.
As a result, trustees may want to evaluate whether retaining income within the trust or distributing income to beneficiaries better aligns with the trust’s objectives and overall tax position.
Net investment income tax
The net investment income tax (NIIT) of 3.8% applies to certain income retained by trusts and estates. Net investment income includes interest, dividends, capital gains, and certain passive income from rental and business activities, partnerships, LLCs, and S corporations.
Because trusts reach higher federal income tax brackets at relatively low income levels, trust income may be subject to combined federal income tax and NIIT rates significantly exceeding those paid by some beneficiaries.
Managing taxable income
Because trusts reach higher income tax brackets much faster than individual taxpayers, distribution planning can be an important part of managing a trust’s overall tax liability. When the trust document gives the trustee discretion to make distributions, income distributed to beneficiaries is generally taxed to the beneficiaries rather than retained and taxed at the trust level.
That may create a tax advantage if beneficiaries are in lower income tax brackets. But tax savings shouldn’t be the only consideration. Once income leaves the trust, it may become part of the beneficiary’s estate and may be exposed to the beneficiary’s creditors. Those outcomes may work against the trust’s estate planning or asset protection goals. Trustees should weigh any discretionary distribution against the trust terms, beneficiary circumstances, tax impact, and broader planning objectives.
Estate tax planning remains an important consideration, but many taxpayers are increasingly focused on income tax efficiency within trusts. The federal estate and gift tax basic exclusion amount is $15 million per individual, allowing many families to shift greater attention toward income tax management, trust distributions, basis planning, and state tax considerations as part of their overall wealth transfer strategy.
Trusts allowing 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 considerations
State income taxation can significantly affect the overall tax cost of a trust. States use different rules to determine whether a trust is considered a resident trust, and factors such as trustee residency, grantor residency, beneficiary residency, place of administration, and the location of trust assets may all influence the outcome.
For non-grantor trusts, trustee residency is often an important factor in determining state tax liability, although the rules vary considerably by state. Depending on the circumstances, a trust may be subject to tax in more than one state or, in some cases, no state at all.
Grantor trusts generally don’t avoid state income tax simply by appointing an out-of-state trustee because the grantor typically remains responsible for reporting trust income on their individual tax return and will, accordingly, pay tax in the state where they reside.
In addition, trusts owning businesses or investments operating in other states may have filing obligations and income tax exposure in those jurisdictions regardless of where the trust is considered a resident.
Frequently asked questions about grantor and non-grantor trusts
A grantor trust is generally treated as owned by the grantor for income tax purposes, so income and deductions are reported on the grantor’s individual return. A non-grantor trust pays tax on income it retains and may pass taxable income to beneficiaries through distributions.
The grantor typically pays income tax on the trust’s taxable income, even if the income stays inside the trust.
Yes. A non-grantor trust generally files Form 1041 and may issue Schedule K-1s to beneficiaries when income is distributed.
Relinquishing certain grantor trust powers may cause a trust to become a non-grantor trust. The death of the grantor also causes a grantor trust to become non-grantor. The tax and estate planning impact should be reviewed before making changes.
Depending on the trust terms, trustees should evaluate distributions, the 65-day election, beneficiary tax brackets, asset protection goals, and state income tax exposure.
How CLA can help with trust tax planning
Trusts can be a valuable estate planning vehicle but there are a lot of rules and considerations to weigh.
CLA can help you evaluate trust income tax planning, estate and wealth transfer strategies, fiduciary income tax reporting, and state tax exposure. Our team can work with you to align trust structure, distribution decisions, and compliance requirements with your family’s broader goals.
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