Trusts are valuable for estate planning, but their tax treatment is unique. Unlike individuals, trusts are separate tax entities with their own filing requirements and income distribution rules. When a trust is set up—either during someone’s lifetime or at death—it generally must file its own tax return and may owe tax on its earnings. The trustee is responsible for managing the trust, filing required returns, and paying any taxes due, ensuring compliance with both federal and state tax laws. Understanding these rules helps trustees fulfill their duties and allows beneficiaries to avoid tax-time surprises.
Trusts are generally taxed on income that is retained (not distributed to beneficiaries), while income that is distributed or required to be distributed to beneficiaries is typically deductible by the trust and taxable to the beneficiaries. This is accomplished through the income distribution deduction, which allows the trust to deduct amounts paid, credited, or required to be distributed to beneficiaries, up to the amount of the trust’s distributable net income (DNI).
There are different types of trusts, each with specific rules:
● Simple Trusts: Must distribute all income currently, cannot distribute principal, and cannot make charitable contributions. The trust takes a deduction for all income distributed, and beneficiaries are taxed on that income—even if it’s not actually received.
● Complex Trusts: May accumulate income, distribute principal, or make charitable contributions. Any income not distributed is taxed to the trust, while amounts distributed or required to be distributed are taxed to the beneficiaries.
● Grantor Trusts: If the grantor retains certain powers or interests, the trust is ignored for income tax purposes. All income, deductions, and credits flow directly to the grantor’s personal tax return, and the trust itself is generally not taxed as a separate entity.
Understanding how trust income is allocated and taxed helps trustees comply with their responsibilities and allows beneficiaries to plan for their tax liabilities.
● Understand the trust document and state law: Trustees must review the governing instrument and local regulations to determine whether trust income must be distributed, can be accumulated, or distributed at the trustee’s discretion. This affects both the trust’s legal classification and tax treatment.
● Track distributable net income (DNI): DNI sets the limit for both the trust’s income distribution deduction and the amount of income taxable to beneficiaries. It is usually the trust’s taxable income, with some adjustments—such as including tax-exempt interest and not counting capital gains allocated to principal unless distributed.
● Allocate deductions correctly: Deductions must be divided between income and principal, and between trust and beneficiaries, in accordance with the trust’s terms and law. Deductions like administration expenses are allowed only if they would not have been incurred if the property were not held in trust.
● Be mindful of compressed tax brackets: Trusts reach the top federal income tax bracket much more quickly than individuals. For 2025, income above about $15,450 is taxed at the highest rate.
Trustees must file Form 1041, U.S. Income Tax Return for Estates and Trusts, when a trust has $600 or more in gross income or any taxable income. On this form, you’ll report:
● The trust’s income
● Deductions and credits
● Distributions made to beneficiaries (using Schedule K-1)
Tax Tip: Use a checklist to make sure you include all necessary schedules and attachments, including Schedule K-1 for each beneficiary and any required foreign reporting forms.
DNI determines the maximum amount of income that can be taxed to beneficiaries and deducted by the trust. It includes taxable income with certain adjustments (e.g., excluding capital gains unless allocated to income).
Accurate DNI tracking is essential for trust administration. Only income up to the DNI cap can be deducted by the trust and taxed to beneficiaries; any amounts distributed above DNI are considered principal—not deductible by the trust and not taxable to beneficiaries.
Tax Tip: Track DNI closely throughout the year, and review calculations before making distributions. Good records will help avoid errors, support year-end filings, and ensure you take full advantage of allowable deductions and avoid IRS surprises.
Trusts with foreign income, foreign beneficiaries, or foreign trust interests must follow additional tax rules:
● Foreign income: U.S. trusts must report all foreign-source income on Form 1041. Foreign tax credits may be claimed for taxes paid abroad using Form 1116, but credits must be allocated proportionally between the trust and beneficiaries.
● Foreign beneficiaries: If a trust distributes U.S. source income to a nonresident alien beneficiary, it must generally withhold U.S. tax and report on Forms 1042 and 1042-S. Distributions of principal are usually not subject to withholding.
● Foreign trusts: U.S. persons who create, fund, or receive distributions from a foreign trust may need to file Form 3520. Foreign trusts with U.S. owners must file Form 3520-A. Not filing these forms can lead to significant penalties.
● Additional reporting: U.S. persons must also file FBAR (FinCEN Form 114) and/or Form 8938 if a foreign trust holds reportable financial accounts.
Tax Tip: Keep detailed records of all foreign income, distributions, and foreign taxes paid. Good documentation will help you properly allocate credits and stay compliant, reducing the risk of double taxation and IRS penalties.
● Distribute income to beneficiaries in lower tax brackets to help minimize overall tax liability.
● Deduct administrative and investment expenses against the trust’s taxable income for maximum savings.
● Review state and international tax rules—some may impose additional taxes on the trust or its beneficiaries.
State Tax Note: State income tax rules for trusts vary widely. Some states tax trusts based on the residence of the grantor, trustee, or beneficiaries, or the location of trust administration. Trustees should review state law to determine potential state tax exposure.
International Tax Note: Trusts with foreign assets, foreign beneficiaries, or foreign-source income must comply with additional reporting and withholding requirements. Failure to do so can result in significant penalties
Tax Tip: Timing distributions before year-end can help reduce trust-level taxes as long as it aligns with the trust’s terms and goals.