Topic 12 · 6 min read
Basics of Trusts and Taxes
Powerful planning tools — and a favorite wrapper for scams.
A trust is a legal arrangement where a trustee holds property for beneficiaries. Real trusts do useful work in estate planning and asset protection. They do not, however, make income disappear, and any promoter who says otherwise is selling something illegal.
What to know
- Grantor trusts
- Most living trusts are grantor trusts: income is reported on the grantor's own return and nothing about the tax picture changes.
- Non-grantor trusts
- A separate taxpayer with its own return, and compressed brackets that reach the top rate at a very low income level.
- Income follows distributions
- Income distributed to beneficiaries is generally taxed to them; income retained is taxed to the trust at those steep rates.
- Legitimate uses
- Avoiding probate, protecting minors and heirs, planning for special needs, holding life insurance, and structured charitable giving.
- Abusive trust schemes
- 'Pure trusts,' 'constitutional trusts,' and offshore packages promising to erase income tax while you keep full control are fraud, and the IRS pursues them.
The tax benefit
Properly drafted trusts control the timing and recipient of taxable income, remove assets from a taxable estate, and protect beneficiaries — without eliminating tax on income anyone still enjoys.
Worked example
The compressed brackets
A non-grantor trust retaining $20,000 of income can hit the top rate, while distributing that income to a beneficiary in a low bracket taxes it far less.
Watch out for
- If you keep control and benefit, the income is still yours no matter what the document says.
- Promoter fees for abusive trusts are lost on top of the tax, penalties, and interest owed.
- Trust drafting is attorney work; templates cause expensive mistakes.
Terms from this topic
Grantor trustNon-grantor trustTrusteeAbusive trust scheme
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