Does a Trust Avoid Income and Estate Taxes?

A trust is a legal arrangement where assets are held by one party, the trustee, for the benefit of another, the beneficiary. While trusts are often seen as a way to avoid taxes, they do not eliminate taxation. Instead, they primarily determine who pays taxes, when, and which types of taxes are affected. Income generated from trust assets is always subject to taxation, whether at the trust level, the grantor’s individual level, or the beneficiary’s individual level. Establishing a trust shifts legal ownership and control of assets, influencing their tax treatment.

General Tax Principles for Trusts

For federal income tax purposes, a trust is generally considered a separate legal entity. Unlike an individual, a trust typically files its own income tax return and may pay taxes on its retained income. However, income tax treatment varies significantly depending on whether the trust is classified as a “grantor trust” or a “non-grantor trust.”

Income generated by trust assets is taxed either to the trust, to its beneficiaries if distributed, or to the grantor who established the trust. Trusts that retain income are subject to highly compressed tax brackets, reaching the highest federal income tax rates at much lower income thresholds than individuals. For instance, in 2025, a trust could reach the top marginal federal tax rate of 37% with taxable income exceeding approximately $15,650, whereas a single individual would not reach this rate until their income surpasses $626,350. This often makes it tax-inefficient for trusts to accumulate income.

To prevent double taxation of income, the concept of Distributable Net Income (DNI) is used. DNI acts as a ceiling on the amount of income taxed to beneficiaries and serves as a deduction for the trust. When income is distributed to beneficiaries, it generally carries out the DNI, allowing the trust to deduct the distributed amount and shifting the tax liability to the beneficiaries, who often have lower individual tax rates. Any amount distributed above the DNI, which represents principal, is generally tax-free to the beneficiary.

Tax Implications of Revocable Trusts

A revocable trust, often called a living trust, does not offer income or estate tax advantages during the grantor’s lifetime. This is because the grantor retains the ability to modify, amend, or revoke the trust and regain control over the assets at any time. Due to this retained control, a revocable trust is typically classified as a “grantor trust” under Internal Revenue Code Section 671.

Under the grantor trust rules, any income generated by assets held within a revocable trust is considered income of the grantor. This income is reported directly on the grantor’s personal income tax return, Form 1040, using their Social Security number. The trust is not treated as a separate taxable entity for income tax purposes during the grantor’s lifetime, meaning all income, deductions, and credits flow through to the grantor’s individual return.

Assets transferred into a revocable trust remain part of the grantor’s taxable estate for federal estate tax purposes upon their death. Since the grantor retains full control, the transfer is not considered a completed gift. The benefits of revocable trusts are non-tax related, such as avoiding probate, facilitating asset management during incapacitation, and maintaining privacy regarding asset distribution.

Tax Implications of Irrevocable Trusts

An irrevocable trust cannot be easily modified or revoked once established. This permanence is a factor in its distinct tax treatment compared to a revocable trust. When assets are transferred into an irrevocable trust, they are generally removed from the grantor’s taxable estate, which can lead to federal estate tax savings. This removal can benefit individuals with substantial wealth exceeding the federal estate tax exemption amount.

The transfer of assets into an irrevocable trust is considered a completed gift for tax purposes. Such gifts may be subject to federal gift tax or utilize a portion of the grantor’s lifetime gift tax exemption. The annual gift tax exclusion, which allows individuals to give a certain amount per recipient each year, can be used when funding an irrevocable trust, depending on its structure and beneficiaries’ access to funds.

For income tax purposes, an irrevocable trust is treated as a separate taxpaying entity, unlike a grantor trust. The trust may pay income tax on any retained income, using its own tax identification number and subject to compressed trust tax rates. If the trust distributes income to its beneficiaries, that income is generally taxed to the beneficiaries at their individual income tax rates, and the trust receives a corresponding deduction. This ability to shift income tax responsibility can manage the overall tax burden, as individual rates are often lower than trust rates. Irrevocable trusts can be designed to achieve specific tax outcomes, such as reducing estate tax liabilities or protecting assets from creditors, by permanently transferring asset ownership.

Reporting and Identification for Trust Taxation

Most trusts are required to obtain an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). This nine-digit number serves as the trust’s tax identification number. An EIN is necessary for opening bank accounts, investing assets, and fulfilling tax reporting obligations. It can be obtained directly from the IRS website or by submitting Form SS-4, Application for Employer Identification Number.

The primary tax form used by trusts to report income, deductions, gains, and losses is Form 1041, U.S. Income Tax Return for Estates and Trusts. This form is filed by the trustee, who manages the trust’s assets. Form 1041 also reports any income accumulated by the trust or distributed to its beneficiaries. A trust may still need to file Form 1041 even if it owes no income tax, if it has taxable income or gross income of $600 or more, or if it has a nonresident alien beneficiary.

When a trust distributes income to its beneficiaries, the trustee must provide each beneficiary with a Schedule K-1 (Form 1041). This document informs beneficiaries of their share of the trust’s income, deductions, and credits, which they report on their personal income tax returns (Form 1040). The Schedule K-1 ensures that distributed income is appropriately taxed to the beneficiary and prevents double taxation.