Taxation of Trusts: Basic Terms and Concepts

Grantor or Non-Grantor Trust?

To understand the basic concepts of how trusts are taxed, we must first understand the concept of a grantor trust versus a non-grantor trust. All trusts are either grantor or non-grantor trusts. With a grantor trust, the trust creator retains certain powers over the trust, which may include certain powers over the trust’s assets and income. With a non-grantor trust the trust creator has no interest or control over trust assets. This distinction determines how and to whom a trust is taxed. A grantor trust is taxed to the grantor. With a non-grantor trust, the trust either pays out income to beneficiary(ies) and then taxed at the beneficiary level or is taxed at the trust level for any income accumulated in the trust.

Many plans using trusts are set up to result in trust income being taxed at an individual level (taxed to the grantor or beneficiary) rather than at the trust level (taxed to the trust). This is because the income tax brackets for trusts are significantly compressed, compared to the tax brackets for individuals. A trust reaches the top tax bracket of 37% at only $13,450 of income, as opposed to the individual bracket where the top tax rate is not reached until over $647,850 of income.1

 

Grantor Trusts

A grantor trust is a trust over which the grantor has retained certain interests or control. The grantor trust rules in IRC 671-678 prevent the grantor from taking tax advantages from assets that have not left his or her control. The grantor trust rules treat the grantor (or in some cases a beneficiary) as owner of all or a portion of the trust income and losses. The grantor is subject to tax on trust income, even if he or she does not actually receive the income.

In most cases grantor trusts do not file separate income tax returns, as opposed to non-grantor (simple or complex) trusts. Because assets in a grantor trust are still considered the grantor’s property under the grantor trust rules, the grantor generally reports the income from the trust assets using his or her own social security number on the grantor’s Form 1040.2

 

Revocable vs Irrevocable Trusts

If the grantor retains the ability to revoke the trust and revest the trust assets in the grantor, the trust is revocable, and the income is taxable to the grantor under the grantor trust rules. All revocable trusts are necessarily grantor trusts. Assets in a revocable trust are included in the grantor’s gross estate for federal estate tax purposes. Revocable trusts, also called living trusts, are one of the more frequently misunderstood trust concepts. They are used primarily as a will substitute. Assets in a revocable trust avoid the cost, time, expense, and publicity of probate. Upon the grantor’s passing, a revocable trust becomes irrevocable.

An irrevocable trust is one that, by its terms, cannot be revoked. An irrevocable trust can be either a grantor or non-grantor trust, depending on the terms of the trust and the powers retained by the grantor in the trust. An irrevocable trust is simply one that cannot be revoked, whether or not it qualifies as a grantor trust under IRS rules. All revocable trusts become irrevocable upon the death of the grantor.

 

Non-Grantor Trusts: Simple or Complex

Non-grantor trusts will generally be classified as either simple or complex for tax purposes. It’s not always an easy distinction between a simple versus complex trust. A trust may be a simple trust for one year and a complex trust for another year.3 In Form 1041, the trustee can identify whether the trust is a simple or complex trust for that particular taxable year.

For non-grantor trusts (simple and complex trusts) the trustee must obtain an employer identification number (EIN) in order to file Form 1041, the US Income Tax Return for Estates and Trusts. A trustee must file Form 1041 if the trust has any taxable income or gross income of $600 or more.

If a trustee makes distributions to the beneficiaries, the trustee must file Schedule K-1 together with Form 1041. Schedule K-1 is the IRS form that reflects the beneficiary’s share of the trust’s income, deductions, and credits. When distributions have been made to beneficiaries, the beneficiary pays the income tax. When income is retained by the trust, the trust pays the income tax. This is important because the beneficiary and trust have different tax brackets. The trust has a higher tax rate than an individual. Thus, the beneficiary will use Schedule K-1 to report his share of the trust income in the beneficiary’s Form 1040.

 

Criteria for Simple vs Complex Trusts

Under the IRS Code,4 a simple trust must pass all three criteria in a taxable year in order to be considered a simple trust (for that tax year):

  • It must distribute all income to the beneficiaries
  • It cannot distribute principal
  • It cannot make distributions to charity

On the other hand, a complex trust is a trust that does any one of the following in a taxable year (for that tax year):

  • It accumulates income
  • It distributes principal
  • It makes charitable distributions

 

Split Interest Trusts

A third type of non-grantor trust is a split interest trust. A split interest trust is a trust that has both charitable and non-charitable interests. The most common types of split interest trusts are charitable remainder trusts, charitable lead trusts and pooled income funds, each with their own set of rules under the IRS Code.

 
1 As of the 2022 tax year.

2 In some cases, a grantor trust may have its own employer identification number (EIN), in which case, even though it remains a grantor trust, it should file a form 1041. The return is marked as a grantor trust for federal tax purposes with a note that all income, expense, and other activity is being reported on the grantor’s federal tax return and not the Form 1041. The tax return filing provides the IRS notice that although the grantor trust has its own tax ID number, the income and related trust expenses are reported on the grantor’s federal tax return.

3 26 CFR § 1.651(a)-1

4 26 CFR § 1.651(a)-1