Nongrantor Trust: Federal and State Tax Rules

A nongrantor trust is a distinct legal and taxable entity, separate from the individual who creates it, known as the grantor. This separation means the trust itself, not the grantor, is responsible for reporting income and paying taxes. The trust operates under its own taxpayer identification number, managing its financial affairs independently. The defining characteristic of this arrangement is the grantor’s intentional release of control over the assets transferred into the trust, which affects how they are taxed at both the federal and state levels.

Defining Features of a Nongrantor Trust

To be classified as a nongrantor trust, the grantor must make the trust irrevocable and relinquish control over its assets. The Internal Revenue Code outlines specific powers that, if retained by the grantor, would classify the arrangement as a “grantor trust,” where income is taxed directly to the grantor.

Key powers that must be relinquished include:

• The power to revoke or amend the trust.
• The ability to control who benefits from the trust’s assets or when they receive distributions.
• The power to borrow from the trust without providing adequate interest and security.
• The ability to swap or substitute trust assets for others of equivalent value, unless it is done in a fiduciary capacity.

By forfeiting these specific controls, the grantor ensures the trust is respected as a separate taxpayer. This structural separation is the legal foundation that allows the trust to be taxed independently.

Federal Income Tax Framework

A nongrantor trust operates as its own taxpayer, requiring it to file an annual federal income tax return using Form 1041, the “U.S. Income Tax Return for Estates and Trusts.” A primary feature of trust taxation is its highly compressed tax brackets, which causes accumulated income to be taxed at the highest marginal rates much more quickly than an individual’s income.

For example, in 2025, a trust’s income is taxed at 10% for amounts up to $3,150, but the rate quickly jumps before reaching the top federal rate of 37% on taxable income over just $15,650. In stark contrast, a single individual does not hit that same 37% bracket until their income surpasses a much higher threshold. This accelerated tax schedule means that if a trust retains its earnings, a substantial portion can be consumed by federal taxes. Additionally, the 3.8% Net Investment Income Tax can apply once the trust’s income exceeds the threshold for the highest tax bracket.

The taxation of trust income is governed by Distributable Net Income (DNI), which calculates the trust’s income available for distribution and sets the ceiling for the trust’s distribution deduction. When a trust makes distributions to its beneficiaries, it can deduct that amount, up to the limit of its DNI, which shifts the tax liability from the trust to the beneficiaries. If the trust retains income, it pays the tax at its compressed rates. If it distributes income, the beneficiaries report it on their personal tax returns at their individual rates. The trustee provides each beneficiary with a Schedule K-1, which details the income they must report.

State Income Tax Planning

A primary motivation for using a nongrantor trust is the strategic management of state income taxes. This strategy depends on the trust’s “situs,” its legal residence for tax purposes. The determination of a trust’s situs often depends on factors like the location of the trustee and where the trust is administered. By carefully selecting a trustee located in a state with no income tax, such as Nevada, Delaware, Alaska, or South Dakota, a grantor can establish the trust’s situs in that jurisdiction. This allows income and capital gains retained by the trust to accumulate without being subject to any state-level income tax.

This planning is particularly valuable for trusts designed to accumulate wealth over long periods. As long as the income is not distributed, it remains sheltered from state tax. When distributions are eventually made, the beneficiary will typically pay tax in their state of residence, but the years of tax-free growth within the trust can result in significant overall savings.

To successfully implement this strategy, the trust document should explicitly state that its situs and governing law are that of the chosen tax-free state. It is also important that no trustee resides in a state that might try to claim taxing authority based on the trustee’s location. By properly structuring the trust’s administration and situs, it is possible to legally avoid state income tax on accumulated trust earnings.

Essential Roles and Fiduciary Duties

Grantor

The grantor is the individual who initiates the trust by drafting the trust document and transferring assets into it. In a nongrantor trust, the grantor’s primary role is confined to this initial setup phase. By design, the grantor intentionally and irrevocably relinquishes control over the assets and the trust’s administration, as retaining ongoing power would risk reclassifying the trust for tax purposes.

Trustee

The trustee is the legal owner of the trust’s assets and is responsible for managing them according to the terms of the trust document. This role carries fiduciary duties of loyalty and prudence, which require the trustee to act solely in the best interests of the beneficiaries and manage assets as a reasonably prudent person would.

The trustee’s administrative tasks are extensive. They are responsible for all record-keeping, making investment decisions, and ensuring the trust complies with all tax filing requirements, including filing the annual Form 1041. The trustee must also make decisions about distributions to beneficiaries, balancing the needs of current beneficiaries with the interests of future beneficiaries. This requires careful interpretation of the trust document, which may provide specific standards for distributions, such as for a beneficiary’s health or education.

Beneficiary

The beneficiaries are the individuals or entities for whom the trust was established. Their primary right is to receive distributions of income or principal from the trust as specified in the trust agreement. The timing and amount of these distributions are dictated by the trust’s terms and are executed by the trustee. Beneficiaries also have a right to be kept informed about the trust’s administration, which includes the right to receive a copy of the trust document and to get regular accountings of the trust’s financial activity.