By Kenneth H. Bridges, CPA, PFS December 2025

Trusts can minimize estate tax, provide creditor protection, separate the management and control over assets from their beneficial enjoyment, avoid probate and ensure privacy. Accordingly, our clients typically employ the use of one or more trusts in their estate planning.

Trust taxation is essentially a hybrid of partnership taxation (i.e. flow-through) and individual taxation. As a general rule, if the trust retains the income it pays the tax on the income; whereas if the trust distributes its income to its beneficiaries, the beneficiaries pay tax on the income.

For income tax purposes, a noncharitable trust falls into one of three categories: (1) simple trust, (2) complex trust, or (3) grantor trust.

The words “simple” and “complex” here are misnomers, as it has nothing to do with the simplicity or complexity of the trust. A “simple trust” can be quite complex, and, conversely, a “complex trust” can be quite simple. “Simple” for these purposes simply means that the trust agreement requires that all income (but not necessarily capital gains) be distributed to the beneficiary(s) each year, whereas a “complex trust” is one whose agreement provides the trustee discretion as to whether to distribute or retain the income.

A simple trust and a complex trust are each required to file an annual Federal 1041 if the trust has any taxable income for the year or gross income of $600 or more. Many of the trusts formed by our clients will be irrevocable life insurance trusts (ILIT). An ILIT typically has no assets other than a life insurance policy. Since a life insurance policy typically produces no current income, an ILIT typically is not required to file an income tax return.

Most trust agreements provide for realized capital gain to be allocated to corpus, rather than considered current income. Accordingly, most simple trusts will incur tax on any net realized capital gains. A simple trust typically will not incur tax on noncapital gain income, since it is required to distribute such to its beneficiary(s). The simple trust will report such income, then take a distributions deduction against such, and report the income items (typically interest and dividends) on the K-1 of the beneficiary(s), who will be taxed on the income on their personal return.

A complex trust will typically be taxed on both its net realized capital gain and also any other income it receives during the year above and beyond amounts distributed to beneficiaries. Any distributions to beneficiaries up to the amount of current year income (other than capital gains and as reduced by other deductions) will be taxable to the beneficiaries as K-1 income.

Trusts move into the highest tax rate brackets very quickly. Accordingly, no tax rate bracket benefit can typically be obtained from retaining income in a trust.

Distributions to beneficiaries which exceed current year income are generally considered to come from corpus and are not taxable to the beneficiaries.

It should be noted that the charitable contribution deduction rules for trusts are very different from that of individuals. Unless a trust was formed for charitable purposes, the trustee generally has a duty to use the trust assets only for the benefit of the beneficiaries and therefore generally does not have the authority to make charitable donations. However, where a trust is permitted (or required) to make charitable contributions, such are generally not subject to the percentage of income limitations which apply to individuals.

A “grantor trust” is for income tax purposes essentially a disregarded entity, with any income of the trust being reported directly on the personal return of the grantor. Similarly, the grantor can engage in transactions with the trust (e.g. a sale of appreciated assets) without triggering any taxable gain.

Grantor trusts can be revocable (in which case the assets remain in the grantor’s taxable estate for purposes of estate tax) or irrevocable (in which case the assets are generally outside of the grantor’s taxable estate). Revocable trusts are generally used primarily to avoid the probate process and are more common in states where probate is expensive. Our clients generally tend to use irrevocable trusts in order to remove assets from their taxable estate and the potential reach of creditors.

The grantor trust rules were originally designed to prevent taxpayers from putting assets into trust in order to take advantage of the lower tax rate brackets. Under current law, trusts move very quickly into the highest rate brackets, so a trust would no longer be used for this purpose. In more recent years, the grantor trust rules have been used very intentionally by estate planners as a way to remove assets (and the future appreciation thereon) from the taxable estate and the reach of creditors, while also enabling the grantor to essentially make additional gifts (outside of the gift tax rules) equal to the amount of income tax on the income of the trust (since the tax on income of a grantor trust falls on the grantor, not the beneficiaries).

Most of the grantor trusts we see can be described as IDGTs (intentionally defective grantor trust). Typically, the intentional “defect” which causes the irrevocable trust to be a grantor trust is the right of substitution, whereby the grantor has retained the right to substitute assets of equal value (e.g. give the trust cash in exchange for an asset held by the trust). This provision can be very beneficial from the perspective of enabling the grantor to move back into his or her estate a low-basis/ high-value asset that will likely be held until death and achieve step-up in tax basis to the value on date of death (enabling the grantor’s heirs to sell the asset without incurring any income tax on the appreciation in value).

A grantor trust will lose such status upon the passing of the grantor, or possibly sooner based on the terms of the trust.

The state taxation of trusts can be tricky. If the grantor, trustee and beneficiary(s) all reside in the same state, then it is generally a safe bet that the trust will be considered to be sitused in that state. However, in situations where not all three are resident in the same state, careful consideration of the state tax filing requirements may be necessary.

For income tax purposes, an estate is the collection of assets owned by a decedent from the moment of death until such time as the assets are distributed to heirs (or, more typically, a trust for the benefit of heirs). The estate will typically adopt a fiscal year which ends as of the last day of the month preceding the date of death. The estate must file a 1041 each year, subject to the same rules which apply to complex trusts. One distinction is that estates are not subject to the estimated tax payment rules for the first two years of existence. An estate will typically go out of existence once the last of its assets have been distributed to beneficiaries.

Simple trusts and complex trusts (and estates after 2 years) are subject to the estimated tax payment rules which apply to individuals.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact your legal counsel.