Trust Income Taxation

Understanding how trusts are taxed for income tax purposes is essential for effective estate planning. The income tax treatment depends primarily on whether the trust is classified as a grantor trust or a non-grantor trust, and whether a non-grantor trust is "simple" or "complex."

Grantor Trusts vs. Non-Grantor Trusts

The fundamental distinction in trust taxation is between grantor and non-grantor trusts:

Grantor Trust Rules (IRC Sections 671-679)

Under IRC Sections 671-679, a trust is treated as a grantor trust if the grantor retains certain powers or interests. When this occurs, the trust is ignored for income tax purposes, and all income, deductions, and credits are reported on the grantor's personal tax return.

Powers That Trigger Grantor Trust Status (Dalton Reference)

A trust becomes a grantor trust if the grantor or a nonadverse party retains any of the following powers:

1. Reversionary Interest (IRC 673)

• Grantor retains a reversionary interest worth more than 5% of the trust value

2. Power to Control Beneficial Enjoyment (IRC 674)

• Power to control who receives income or principal
• Power to add beneficiaries (other than afterborn children)
• Power to distribute income or principal to grantor, grantor's spouse, or their creditors

3. Administrative Powers (IRC 675)

• Power to deal with trust assets for less than adequate consideration
• Power to borrow from the trust without adequate interest or security
• Power to reacquire trust assets by substituting assets of equivalent value
• Power held by a nonadverse party to vote stock or control investments

4. Power to Revoke (IRC 676)

• Any power to revoke the trust and revest assets in the grantor

5. Income for Benefit of Grantor (IRC 677)

• Trust income may be distributed to the grantor or grantor's spouse
• Trust income may be accumulated for future distribution to grantor or spouse
• Trust income may be used to pay life insurance premiums on grantor's or spouse's life

6. Power Held by Another Person (IRC 678)

• A person other than the grantor has power to vest corpus or income in themselves

Intentionally Defective Grantor Trusts (IDGTs)

An IDGT is strategically designed to be a grantor trust for income tax purposes while being irrevocable for estate tax purposes. This provides dual benefits:

• Grantor pays income taxes, allowing trust assets to grow tax-free
• Assets are outside the grantor's taxable estate
• The grantor's payment of trust income taxes is not treated as an additional gift

Non-Grantor Trust Taxation

When a trust does not qualify as a grantor trust, it is taxed as a separate entity. Non-grantor trusts are further classified as simple or complex trusts.

Simple Trusts

A simple trust must meet ALL of these requirements:

• Requires distribution of all income annually
• Cannot distribute principal (corpus)
• Cannot make charitable contributions
• Receives a $300 exemption

Complex Trusts

A complex trust is any trust that is NOT a simple trust. A complex trust:

• May accumulate income
• May distribute principal
• May make charitable contributions
• Receives a $100 exemption

Note: A trust's classification can change from year to year. If a simple trust distributes principal in a given year, it becomes a complex trust for that year.

Simple vs. Complex Trust Comparison

2025 Trust Income Tax Brackets

Trusts and estates face highly compressed tax brackets, reaching the top marginal rate much faster than individual taxpayers:

Comparison: An individual taxpayer doesn't reach the 37% bracket until taxable income exceeds $626,350. A trust reaches 37% at just $15,650 - a difference of over $610,000!

Capital Gains Rates for Trusts (2025)

Net Investment Income Tax (NIIT)

Trusts may also be subject to the 3.8% NIIT on the lesser of:

• Undistributed net investment income, OR
• The excess of AGI over $15,650 (2025 threshold)

Distributable Net Income (DNI)

Distributable Net Income (DNI) is a critical concept in trust taxation that serves two purposes:

1. Limits the trust's distribution deduction
2. Caps the amount taxable to beneficiaries

DNI Calculation

DNI is calculated by taking the trust's taxable income and making these adjustments:

How Distributions Carry Out Income

When a trust makes distributions to beneficiaries:

1. The trust receives a distribution deduction (limited to DNI)
2. The beneficiary includes the distribution in their income (limited to DNI)
3. This prevents double taxation and allows income to be taxed at potentially lower individual rates

Key Rule: Distributions carry out DNI to beneficiaries on a pro-rata basis. The character of income (ordinary, capital, tax-exempt) flows through to beneficiaries.

The Tier System (Complex Trusts)

Complex trusts use a two-tier system for allocating DNI:

Tier 1: Required income distributions (specific amounts the trust must distribute) Tier 2: Discretionary distributions (amounts trustee chooses to distribute)

Tier 1 distributions are allocated DNI first. If DNI remains, Tier 2 distributions receive their share.

The 65-Day Rule

Under IRC Section 663(b), a trustee of a complex trust may elect to treat distributions made within the first 65 days of a tax year as if made in the prior year. This allows post-year-end planning to optimize tax outcomes.

2025 Application: Distributions made January 1 - March 6, 2025, can be treated as 2024 distributions if the trustee makes the election on the 2024 Form 1041.

Tax Planning Strategies

Given the compressed trust brackets, consider these strategies:

1. Distribute income to beneficiaries in lower tax brackets
2. Use grantor trust status strategically (grantor pays tax, trust assets grow)
3. Time distributions using the 65-day rule
4. Invest in tax-efficient assets (growth stocks, municipal bonds)
5. Consider trust decanting to modify unfavorable terms

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Quiz: Trust Income Taxation

Question 1: A trust has $50,000 of taxable income in 2025 and makes no distributions. Approximately how much federal income tax will the trust owe (ignoring NIIT)?

A) $5,000 B) $12,000 C) $16,200 D) $18,500

Answer: C

Explanation: Using 2025 brackets: 10% on first $3,100 = $310; 24% on next $8,050 ($3,101-$11,150) = $1,932; 35% on next $4,500 ($11,151-$15,650) = $1,575; 37% on remaining $34,350 = $12,710. Total: approximately $16,527. The closest answer is C.

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Question 2: Which of the following powers would NOT cause a trust to be treated as a grantor trust?

A) The grantor retains the power to substitute assets of equivalent value B) Trust income may be used to pay premiums on the grantor's life insurance C) An independent trustee has discretion over distributions to beneficiaries D) The grantor can revoke the trust at any time

Answer: C

Explanation: An independent trustee having discretion over distributions does not trigger grantor trust status under IRC 671-679. The other options - power to substitute assets (administrative power), paying grantor's life insurance premiums, and power to revoke - all cause grantor trust treatment.

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Question 3: A complex trust has DNI of $40,000. The trustee distributes $25,000 to Beneficiary A and $35,000 to Beneficiary B. How much income does each beneficiary report?

A) A: $25,000; B: $35,000 B) A: $16,667; B: $23,333 C) A: $20,000; B: $20,000 D) A: $25,000; B: $15,000

Answer: B

Explanation: Total distributions ($60,000) exceed DNI ($40,000), so DNI is allocated pro-rata. Beneficiary A: $25,000/$60,000 x $40,000 = $16,667. Beneficiary B: $35,000/$60,000 x $40,000 = $23,333. The excess distributions ($20,000 total) are treated as non-taxable return of principal.