Any financial move you make will have tax consequences. A trust can be an effective way to reduce income taxes if it distributes income to beneficiaries. A trust also can reduce or even eliminate costs related to wealth transfer, such as gift taxes, estate taxes and probate fees. Trusts are not subject to public records like probate assets are, so they help maintain your privacy. A trust also can protect your assets from creditors, lawsuits and potential beneficiaries’ financial mismanagement.
One downside, however, is that the taxes on a trust are complex, and there are a lot of rules and regulations to navigate. We will help you determine if a trust is a wise strategy and manage the taxes if it is.
The amount someone will pay in taxes depends on the type of trust they set up, how its income is distributed and whether the grantor is still living. The tax liability typically rests either on the trust itself or on the beneficiaries who are receiving distributions.
The IRS defines a trust as a relationship in which one person holds title to property, subject to an obligation to keep or use the property for the benefit of another. Trusts are formed under state law.
1. Assets in a trust are either principal or income
In terms of tax laws, assets in a trust are usually categorized as either “principal” or “income.” The assets that the trust owns represent its principal (e.g., stocks, bonds or real estate). Whatever those assets earn or produce are its income (e.g., dividends, interest or rent). Complex accounting rules govern the treatment of a trust’s income, expenses, taxes and distributions.
2. There are two forms of grantor trusts
For income tax purposes, a trust is treated either as a grantor trust or a non-grantor trust. The grantor is person who creates the trust. He or she is responsible for paying the tax on income that the trust assets generate. Two common forms of grantor trusts are revocable living trusts and intentionally defective grantor trusts (IDGTs).
A revocable living trust is a flexible legal agreement created during your lifetime that enables you to manage and distribute your assets while you are alive, avoid probate after your death and plan for potentially becoming incapacitated. As the grantor, you transfer your assets into the trust and act as the initial trustee, controlling the property as you normally would. At any time, you can change or cancel the trust.
Upon your death, a successor trustee will distribute the assets to your designated beneficiaries, thus enabling your survivors to avoid the time-consuming and public probate process. Assets that are transferred to a revocable living trust are included in the grantor’s taxable estate at death.
With an IDGT, the grantor has some control over the assets. He or she is responsible for paying the tax on income. In general, assets transferred to an IDGT are excluded from the grantor’s taxable estate at death.
3. A non-grantor trust is an irrevocable trust
A non-grantor trust is an irrevocable trust. The grantor gives up all control of, and benefits from, the trust’s assets. Unlike a grantor trust, this type of trust is treated as a separate legal and tax entity and is responsible for its own income taxes. We sometimes use this type of trust in estate planning to reduce estate taxes, protect assets and transfer income tax liability away from the grantor.
With an irrevocable trust, the original owner must give up control of the assets placed within it. This loss of flexibility can be a significant drawback, especially for those who prefer to maintain direct control over their property.
A non-grantor trust can be either simple or complex, depending on who is responsible for paying the income taxes. Simple trusts and complex trusts pay their own income taxes. Grantor trusts do not pay their own taxes; the grantor of the trust pays the taxes on a grantor trust’s income.
A simple trust meets three criteria: It requires mandatory distributions of all income during the taxable year, prohibits distributions of principal and prohibits distributions to charity. With a simple non-grantor trust, the beneficiaries are responsible for paying the income taxes on the income generated by trust assets, while the trust pays the taxes on any capital gains.
In contrast, a complex trust gives trustees more discretion regarding the distributions of income and principal. The tax can be paid by the beneficiaries, the trust itself or a combination, depending on the circumstances in any given year.
4. Trusts are taxed more aggressively than individuals
The amount of tax paid on income can be much greater when the trust is responsible than when an individual taxpayer is responsible.
For the 2025 tax year, the top marginal tax rate for a single filer, 37 percent, begins after $626,350 of ordinary income. A trust is subject to that rate after reaching only $15,650 of income. Both trusts and individuals may be subject to the net investment income tax (NIIT) for any undistributed investment income. This is a 3.8 percent tax on either the trust’s undistributed net investment income or the excess of adjusted gross income over $15,650, whichever is less.
In contrast, a single individual is subject to the NIIT on net investment income or excess modified adjusted gross income over $200,000, whichever is less.
A distribution to a trust’s beneficiary could result in a lower overall tax because the trust will take a deduction for the distribution. Given the higher thresholds for individual filers, depending on the beneficiary’s overall income level, he or she might be in a lower tax bracket. However, there are some limits on how much income can be allocated to distributions made to beneficiaries from a trust.
5. You will need to choose a trustee
Anyone who sets up a trust needs to choose a trustee. This individual will need to maintain accurate records of income, expenses, gains and losses so the trust can report its income and properly and calculate tax liability.
You can choose a family member, friend or professional to be your trustee. However, that person needs to have the expertise and skill to document and record trust transactions properly and apply the complicated rules of trust accounting. He or she will be responsible for keeping records of the trust’s tax filings, such as IRS Form 1041 (U.S. Income Tax Return for Estates and Trusts), documenting distributions and any taxes paid and keeping records on the fair-market value of inherited assets to calculate potential capital gains taxes in the future.
For trusts with larger principal balances, this can be a time-consuming and complicated exercise. This is why many families choose professional trustees who have experience managing complex trusts.
6. Trusts don’t benefit everyone
Trusts typically benefit people with substantial estates. In most cases, a trust would not benefit someone who has a modest estate, simple distribution wishes and beneficiaries who are financially responsible. In those cases, a will or other simple tools would likely be sufficient for specifying how an individual wants to distribute assets.
Each state has a probate threshold. If the value of an individual’s assets is below his or her state’s probate threshold, a trust might not be needed.
For example, in Wisconsin, probate is generally required for an estate with a gross value of $50,000 or more at the time of an individual’s death. Assets that are held in a trust, jointly owned assets and property with designated beneficiaries (Transfer on Death) typically don’t count toward the $50,000 threshold and may avoid probate altogether. If solely-owned assets are less than $50,000, the estate may qualify for a simplified small-estate administration process.
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For some of our clients, a trust can be the anchor of their wealth-transfer strategy. That is the case only if a trust’s potential tax liability doesn’t cancel out the benefits of setting up the trust.
We have extensive experience setting up trusts as part of our estate-planning service. Please reach out to us to find out if a trust might be an appropriate wealth-transfer strategy for your family.
