Trust Income Tax Rules

Trust Income Tax Rules

When using a trust as part of your estate plan, understanding how income from trusts is taxed is essential. The tax treatment depends on the type of trust—whether it is a grantor trust or a nongrantor trust—as well as whether the trust distributes income to beneficiaries.

Grantor Trust vs. Nongrantor Trust: Tax Treatment Explained

What Is a Grantor Trust?

A grantor trust is a trust in which the grantor retains certain powers or interests (IRC §§671–678). Common powers that trigger grantor trust status include the ability to:

• Revoke or amend the trust
• Control beneficial enjoyment
• Substitute trust assets

All revocable trusts and many irrevocable trusts are Grantor Trusts.

Taxation of Grantor Trusts (see CFR 301.6109-1 and 301.6109-4)

• The grantor is treated as the owner of the trust assets for income tax purposes.
• Usually, the trust’s taxpayer ID number is the Grantor’s social security number
• The trust’s income (and expenses) are reflected on the grantor’s individual Form 1040.
• Trust income retains its character (e.g., interest, dividends, capital gains) when passed through.

The IRS provides three options for Grantor Trusts to report income

• Trust does not have a separate Tax ID Number. Report all income and expenses directly on Grantor’s tax return (Form 1040) and do not file a Trust Tax Return.
• Trust has a separate Tax ID Number. Fill out only the entity information on the Trust’s Tax Return (Form 1041) and provide an Information Statement, then report the information on the Grantor’s tax return (Form 1040).
• If a Trust has more than 2 Grantors, the Trust must have a separate Tax ID Number, file a Trust Tax Return (Form 1041) and file Form 1099 to report the proceeds attributable to each Grantor.

What Is a Nongrantor Trust?

A nongrantor trust is a separate legal and tax entity. The grantor does not retain powers or ownership that would cause the trust to be treated as a grantor trust.

Taxation of Nongrantor Trusts

• Files IRS Form 1041
• Pays taxes on undistributed income.
• May distribute income to beneficiaries, shifting the tax burden to them.
• Issues Schedule K-1s to report each beneficiary’s share of trust income.

2025 Trust Income Tax Brackets

Trusts are subject to compressed federal income tax brackets, meaning they hit the top marginal rate at much lower income levels than individuals.

Trust Taxable Income	Tax Rate
$0 – $3,150	10%
$3,151 – $11,450	24%
$11,451 – $15,650	35%
Over $15,650	37%

Likewise, Trusts also have compressed brackets for capital gains:

Trust Capital Gains	Tax Rate
$0 – $3,250	0%
$3,251 – $15,900	15%
Over $15,900	20%

Note: Trusts may also be subject to the 3.8% Net Investment Income Tax (NIIT) on investment income above the $15,900 threshold.

How Income Distributions to Beneficiaries Are Taxed

• DNI (Trust Income) that is distributed to beneficiaries is taxed to the beneficiaries at their individual rates, not the trust’s rates.
• Beneficiaries use Schedule K-1 (Form 1041) to report their share of trust income.

Distributable Net Income (DNI)

• DNI represents the maximum amount of income that can be taxed to beneficiaries.
• DNI maintains the character of income (e.g., qualified dividends, capital gains) as it passes through.

Effect of Distributions

• Reduces the trust’s taxable income.
• Shifts income to potentially lower-bracket beneficiaries.
• Strategic distributions can lower the overall effective tax rate.

Very Few Trusts Pay Trust Income Tax Rates

Most trusts are Grantor Trusts, and therefore are taxed as if the income is earned by the individual.  Most nongrantor trusts allow, or even require, the Trustee to distribute income to the beneficiary.

If a Trust requires that the income is retained, or a Trustee determines that is in the best interest of the beneficiaries, then the Trust must pay taxes at the Trust tax rates.

Properly understanding and managing how trusts are taxed can result in substantial tax savings and smoother administration.