April 15th is a date that causes anxiety and distress for millions of people every year. Dealing with your personal income taxes can be daunting enough, but when you have a trust to account for as well, the added intimidation and stress can be overwhelming.
Understanding how your trust can be or will be taxed, however, is vital to ensure that you are getting the most out of your estate plan. It is something to be embraced rather than dreaded, because understanding your options is a valuable tool that can be used to your and your beneficiaries’ advantage.
At the most basic level, a trust’s income can be taxed three ways:
- Taxed to the Grantor;
- Taxed to the trust; or
- Taxed to the beneficiary(ies).
Which of these ways a trust is taxed depends on the type of trust, which can also be categorized in one of three ways for income tax purposes:
- Grantor trust;
- Simple trust; and
- Complex trust.
Each type has its own benefits, but a trust isn’t locked into just one type forever. A trust can be flexible and actually change how it is taxed over time. In fact, a good estate plan can control those changes to utilize different benefits at the most desirable time. Which type of trust is most beneficial is often determined by the dichotomic balance of taxes vs. control.
Grantor Trusts
As you might expect, with a grantor trust, the income gets taxed to the grantor of the trust. This includes all revocable trusts and some irrevocable trusts if the grantor retains certain control over the trust assets such as a revisionary interest, the power to control beneficial enjoyment, the power to revest, the power to distribute income to the grantor or their spouse, and specific administrative powers for the grantor’s benefit.
While the initial reaction to reporting your trust’s income on your personal tax return may be aversive, consider first that the income tax brackets for trusts are hyper-compressed. While a single individual’s income in 2026 will get taxed at the highest rate of 37% at $640,600 ($768,700 for those married filing jointly), a trust’s income will be taxed at that same maximum rate at only $16,000. Simply put, the vast majority of people will pay a lower tax rate on the income than would the trust, which can quickly add up to thousands of dollars in tax savings.
This is pretty straightforward when it comes to the actual grantor of the trust. It gets more nuanced, however, when you plan for the beneficiaries after the grantor’s death. Even after the grantor passes away, a beneficiary can be treated as the owner, or “grantor,” of the trust for income tax purposes if the beneficiary has the sole power to vest the income or principal of the trust in him or herself. This is referred to as a beneficiary deemed owner trust (“BDOT”).
With a BDOT, the same tax benefit is present by allowing income to be taxed to the individual beneficiary rather than the trust. The tradeoff in the BDOT scenario, however, is potentially excessive control. Most grantors aren’t worried about themselves having full control over assets, but when it comes to their children or grandchildren, their estate plans may be set up specifically to protect those beneficiaries either from themselves or from others. If that is a concern, grantors may want to limit the beneficiary’s control over the assets by either having a neutral trustee with discretion as to making distributions or by simply limiting the beneficiary’s own power to withdraw assets. In these cases, the grantor would have to choose between giving the tax benefits to the beneficiary or limiting their extensive control over the assets.
Simple Trusts
Simple trusts are named as such because their administration is exceedingly… simple. There is no discretion whatsoever when it comes to distributions. All trust income MUST be distributed annually and NONE of the principal can be distributed until the termination of the trust. Additionally, no charitable contributions can be made from a simple trust. It doesn’t get much simpler than absolutes such as “all” and “none” when it comes to trust administration.
Because all of the income earned in any given year must be distributed to the beneficiaries that same year, the tax liability for the income also passes through to the beneficiaries. Once again, however, the tradeoff to the tax benefit is loss of control. Simple trusts are not flexible. What if you want to let income accumulate to increase growth? You can’t do that with a simple trust. What if a beneficiary needs an emergency distribution but the income is not enough to satisfy the need? You can’t tap into the principal to supplement the insufficient income. The definitive nature of simple trusts that makes them almost effortless to administer also makes them rigid and extremely limited in their application in an estate plan.
Complex Trusts
Complex trusts are much less limited than their simple counterparts and offer greater flexibility. They provide options and allow for discretion rather than strict compliance to complete and unyielding instructions. If the trustee has the option to retain income and distribute principal, then it is a complex trust.
The flexibility of complex trusts allows for situation-specific administrative decisions that can change with the circumstances. When it comes to taxes, the same benefit vs. control balance applies, but the trustee can tip the scales in one direction or the other based on what is most beneficial for a particular beneficiary in any given year. The trustee can distribute all of the income and transfer tax liability to the beneficiary to minimize the taxes owed, or the trustee can hold on to the income, which would result in a higher tax bill being paid by the trust but would also allow the corpus of the trust to continue to grow and continue to keep it protected. Even complex trusts can have provisions that give the trustee some instruction and/or limitations to their decisions in these situations, but ultimately there is at least some level of discretion conceded to the trustee.
Conclusion
Trust taxation is an important factor to consider when deciding what type of trust is right for you, and a good estate plan can utilize the different benefits of varying trusts at the appropriate time. The attorneys at Cavich can help you build an estate plan containing a trust that balances the tax savings vs. control scale to optimally carry out your wishes.