How Trusts Are Taxed: The Basics

You Should Pay As Little Tax As Possible

In a letter to French scientist Jean-Baptist Le Roy, Benjamin Franklin famously wrote, “[I]n this world, nothing is certain but death and taxes.” In addition to being inevitable, taxes are likely going to be your biggest expenses over your lifetime. Since we’d all like to avoid unnecessary expenses, there’s an incentive to find ways to reduce or eliminate your taxes. This idea has been echoed by the IRS’s Taxpayer Bill of Rights, which states “Taxpayers have the right to pay only the amount of tax legally due, including interest and penalties, and to have the IRS apply all tax payments properly.” So, as long as you’re following the law, there’s nothing wrong with trying to pay as little tax as possible.

Be Wary of Where You Get Your Tax Advice

As the public’s interest in Estate Planning and Real Estate Investing & the tax implications of these subjects has increased in recent years, so has the spread of information about these subjects online. As you can imagine, not all of this information is reputable. Social media platforms are filled with influencers, with no relevant background, experience, or skill set, eager to push their online course about how you can use a Trust to do something you should not use a Trust to do. Even when these influencers do have relevant experience, they’re often a one-trick pony, only being able to help a small number of people who haven’t previously used one specific tax strategy, so they’re unwilling to (or unable to) help many of those who reach out to them.

Also contributing to the spread of unreliable estate planning and tax information is the rise of automated estate planning software like Vanilla and Snug, designed to get certain financial professionals to step out of their roles and into the space of estate planners or accountants. These softwares are not designed to provide substantive tax or estate planning education, they’re fill-in-the-blank document preparation. Financial professionals using these automated softwares will start giving you incorrect tax advice as a sales tactic, trying to upsell you. If you are not familiar with the subject matter, as most people aren’t, you’ll hear their pitch and think “Huh, this guy’s an expert, and hey, he’s already managing my money, so why not?” While there’s a role for every professional, financial or otherwise, in your estate plan, only tax professionals like an accountant, enrolled agent, or tax attorney, should be giving you tax advice.

Trust Taxation: A Grantor's Game

The Trust's Three Roles

Trust taxation is a complex subject that could (and does) fill up textbooks and semester-long law school courses. So, to avoid getting lost in a sea of jargon, let’s start with the basics. At its core, a Trust is an agreement involving three roles:

First, there’s the Grantor. The Grantor is the creator of the Trust and usually contributes all the property placed inside the Trust.

The second role is the Trustee. The Trustee is a person or entity that agrees to manage or distribute the Grantor’s property as described in the Trust Agreement for the benefit of the Beneficiary.

The third and final role is the Beneficiary. The Beneficiary receives the benefits of the Trustee’s management of the Grantor’s property.

The rights and obligations of the Grantor, Trustee, and Beneficiary are delineated in the Trust Agreement.

The Importance of Control Over the Trust

Control over the Trust and its property is incredibly important in Trust taxation. It's often the deciding factor in determining who is taxed and the rate at which those taxes are levied. The most important of the three roles in determining who has control over the Trust is the Grantor, who created the Trust, set the terms of the Trust Agreement, and contributed the Trust's property to the Trust. As to the two other roles, the Trustee is bound by the terms of the Trust Agreement, which was created by the Grantor. And the Beneficiaries typically receive the rights to the property in the Trust and/or the earnings from Trust's property. But, control over Trust property before it is distribution is not typically among those rights given to Beneficiaries.

Grantor Trusts: Who Gets Taxed, At What Rate, Which Tax ID To Use, and Which Return To File

If the Grantor retains control over the Trust or the property in the Trust (e.g., the power to decide who receives the Trust’s income, control over the property in the Trust, the power to revoke the Trust, among others), the Trust is considered a “Grantor Trust” by the Internal Revenue Service (the “IRS.”) The IRS treats Grantor Trusts as “disregarded entities.” Disregarded Entities are not considered taxpayers by the IRS. Instead, the IRS determines who controls the disregarded entity and taxes them.

In the case of a Grantor Trust, the Grantor retains this type of control; so, the IRS taxes Grantor on the Trust’s property and earnings. These taxes are assessed at the Grantor’s individual income tax rate, not the Trust income tax rate. This makes sense since, as mentioned, Grantor Trusts are not considered taxpayers by the IRS.

Grantor Trusts do not need their own Tax Identification Number. Instead, a Grantor Trust can use the Grantor’s Social Security Number as its Tax Identification Number.

The Grantor of a Grantor Trust does not need to file a separate tax return for the Trust if all Trust income and allowable expenses are included on their personal return.

Non-Grantor Trusts: Who Gets Taxed, At What Rate, Which Tax ID To Use, and Which Return To File

If the Grantor does not retain control over the Trust or the property in the Trust, the IRS considers the Trust a Non-Grantor Trust. Unlike the disregarded Grantor Trust, Non-Grantor Trusts are considered a separate taxpayer from the Grantor. This is because control over the Trust and the Trust property of a Non-Grantor Trust is found in its Trust Agreement and by the Trust Agreements terms, the Grantor cannot change them. There are two main types of Non-Grantor Trusts: Simple and Complex. A Simple Trust is a Non-Grantor Trust that is required to distribute all of its income annually and does not distribute the Trust’s property to make charitable contributions. A Complex Trust is a Non-Grantor Trust that does not meet the requirements of a Simple Trust.

For Non-Grantor Trusts, this means the IRS levies taxes on the Trust at the Trust income tax rate. The Trust income tax rate is a compressed tax rate when compared to the individual income tax rate. In 2024, an individual would reach the top marginal tax rate of 37% after earning $609,350 of ordinary income. A Trust would be taxed at that same 37% rate on its ordinary income after earning $15,200. Yes, that’s not a typo, every dollar over fifteen thousand two-hundred dollars is taxed at thirty-seven percent.

In addition, Non-Grantor Trusts need their own Tax Identification Number.

And, the Trustee of a Non-Grantor Trust must file a Trust income tax return (Form 1041) every year the Trust has more than $600 in income or a non-resident alien as a beneficiary.

The Link Between Grantor & Non-Grantor Trusts and Revocable & Irrevocable Trusts

From a state-law perspective, Trusts are either revocable or irrevocable. The word “revocable” refers to the ability of the Grantor to change the Trust after it’s been created and funded. For example, the most common Trust is the Revocable Living Trust created to avoid probate. In a Revocable Living Trust, the Trust Agreement can be changed by the Grantor after it’s been created. The same goes for property placed in the Revocable Trust. The Grantor can remove the property from a revocable Trust by retitling it into the name of another person or entity.

By comparison, an Irrevocable Trust cannot be modified by the Grantor. Neither the terms of the Trust Agreement nor the property placed inside the Trust are within the Grantor’s control once it has been titled in the Trust’s name.

I’m sure you can see the overlap between concepts here. And you’re right. All Revocable Living Trusts are Grantor Trusts for tax purposes. However not all Grantor Trust are Revocable Living Trusts (a sufficient/necessary flashback for my LSAT-takers out there.) Irrevocable Trusts, on the other hand, can be Grantor Trusts, Non-Grantor Simple Trusts, or Non-Grantor Complex Trusts based on the terms of the Trust Agreement and the powers retained by the Grantor. So, reviewing the Trust Agreement of an Irrevocable Trust is essential to determining which of the three it is.

TealAcre: Your Trusted Trust Resource

This is just scratching the surface on Trust taxation. There’s much more to learn about this intersection of estate planning & tax law. And you’re curious about estate planning because you have questions. These questions can be related to what will happen to your family, your assets, or business should anything happen to you. Instead of going at it alone, let TealAcre help you get the clarity and peace of mind you’re looking for. To contact us you can:

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