middle aged couple understanding how are trusts taxed at computer
middle aged couple understanding how are trusts taxed at computer

How are trusts taxed? Understanding income, distributions, and gains

Trusts are a powerful estate planning tool, offering flexibility, control, and potential tax benefits. Understanding how trusts are taxed is essential for effective tax planning.

Trust taxation can be complex, as it varies depending on the type of trust and its activities. We’ll explore how irrevocable trusts and revocable trusts are taxed, how trust distributions are handled, and how capital gains are taxed within an irrevocable trust.

How are irrevocable trusts taxed?

Irrevocable trusts, once established, cannot be altered or revoked by the grantor. Their permanent nature influences their tax treatment significantly.

Taxation of income

Irrevocable trusts are considered separate legal entities for tax purposes. The income generated by the trust assets must be reported on the trust’s tax return, Form 1041. The trust itself is responsible for paying taxes on this income unless the income is distributed to beneficiaries.

Tax rates

Irrevocable trusts are subject to their own tax brackets, which are much more compressed compared to individual tax brackets. For 2024, for example, an irrevocable trust reaches the highest federal income tax rate of 37% on income over $14,450. The rapid escalation in tax rates incentivizes trustees to distribute income to beneficiaries, who may be in lower tax brackets.


Irrevocable trusts can deduct certain expenses related to the administration of the trust, such as trustee fees, legal fees, and other costs associated with managing the trust. These deductions help reduce the taxable income of the trust.

How are revocable trusts taxed?

Revocable trusts, also known as living trusts, are more flexible than irrevocable trusts, as the grantor retains control and can alter or revoke the trust at any time. The grantor’s control leads to a different tax treatment for revocable trusts.

Grantor trust status

For tax purposes, revocable trusts are considered grantor trusts, which means that the trust’s income is not taxed at the trust level. Instead, all income, deductions, and credits flow through to the grantor’s personal tax return. The grantor must report this information on his or her individual tax return, Form 1040, and pay any resulting taxes.


The primary advantage of a revocable trust structure is simplicity. Since the trust’s income is reported on the grantor’s tax return, there is no need for a separate tax return for the trust (Form 1041) while the grantor is alive. Additionally, the trust does not face the compressed tax brackets that apply to irrevocable trusts.

How are trust distributions taxed?

The taxation of trust distributions depends on whether the trust is revocable or irrevocable, and the nature of the income being distributed.

Revocable trusts

Since the income is reported directly on the grantor’s tax return for revocable trusts, any distributions made to beneficiaries typically do not have immediate tax consequences. However, once the grantor passes away and the trust becomes irrevocable, distributions may become taxable to the beneficiaries.

Irrevocable Trusts

In irrevocable trusts, distributions of income to beneficiaries are generally taxable to the beneficiaries. The trust can issue a Schedule K-1 to each beneficiary, detailing their share of the trust’s income. Beneficiaries must then report this income on their personal tax returns. The trust can deduct these distributed amounts from its own taxable income, thereby avoiding double taxation.

Distributions of principal

Distributions of the trust’s principal (the original assets placed in the trust) are typically not taxable to the beneficiaries, as this amount has already been taxed or was contributed by the grantor without tax implications.

How are capital gains taxed in an irrevocable trust?

Capital gains within an irrevocable trust can complicate the trust’s tax situation. Here’s how they are generally handled:

Trust-level taxation

If the trust retains the capital gains, they are taxed at the trust level. Given the compressed tax brackets for trusts, capital gains can quickly be subjected to the highest tax rate. For 2024, the maximum long-term capital gains rate is 20%, which applies once the trust’s income exceeds a relatively low threshold ($14,450).

Distribution of capital gains

If the trust document allows, capital gains can be distributed to beneficiaries. Distributing capital gains can potentially lower the overall tax burden, as beneficiaries might be in a lower tax bracket than the trust. When distributed, the capital gains retain their character as long-term or short-term in the hands of the beneficiaries, who must then report and pay taxes on these gains.

Special considerations

It’s important to note that not all trusts are structured to allow the distribution of capital gains. Trustees need to carefully review the trust document and consult with tax professionals to ensure compliance with the trust terms and tax laws.

Every situation is unique

Trust taxation is a multifaceted area that requires careful planning and consideration. Every situation is unique. Understanding the nuances can help trustees and beneficiaries manage their tax liabilities effectively. Consulting with tax professionals and financial advisors is crucial to navigating the complexities of trust taxation and making informed decisions.
If you would like to learn more or schedule a call to discuss your specific situation, please contact us today!

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