Taxation of Trusts and Estates

Understanding how trusts and estates are taxed is critical for CFP candidates. These entities are separate taxpayers with their own tax brackets, filing requirements, and planning opportunities. The key challenge: trusts face highly compressed tax brackets that push income into the highest tax rate far faster than individual taxpayers.

Trusts and Estates as Separate Taxpayers

When a trust or estate is created, it becomes a separate legal entity for income tax purposes. The fiduciary (trustee or executor) is responsible for filing Form 1041, U.S. Income Tax Return for Estates and Trusts, and paying any taxes owed.

Estates and trusts receive different exemption amounts:

Exam Tip: Remember that estates get the highest exemption ($600), simple trusts get $300, and complex trusts get only $100. Qualified disability trusts receive the personal exemption amount.

The Compressed Tax Bracket Problem

This is one of the most important concepts for the CFP exam. Trusts and estates face compressed tax brackets that reach the top marginal rate at dramatically lower income levels than individuals.

2025 Trust and Estate Income Tax Brackets

Compare this to a single individual taxpayer, who doesn't reach the 37% bracket until taxable income exceeds $626,350. A trust hits that same rate at just $15,650—roughly 40 times faster!

2025 Capital Gains Rates for Trusts and Estates

This compression creates a powerful incentive to distribute income to beneficiaries rather than accumulating it in the trust, as beneficiaries typically have lower marginal tax rates.

Simple vs. Complex Trusts

The tax treatment of a trust depends on whether it is classified as a simple trust or a complex trust for the tax year.

Key Point: A trust's classification can change year to year based on its activities. A trust that normally operates as a simple trust becomes a complex trust in any year it distributes principal or accumulates income.

Distributable Net Income (DNI): The Key Concept

Distributable Net Income (DNI) is the most important concept in trust taxation. DNI serves two critical functions:

1. Sets the ceiling for the trust's distribution deduction
2. Limits the amount taxable to beneficiaries

DNI Calculation:

The distribution deduction equals the lesser of:

• Actual distributions to beneficiaries, OR
• DNI (reduced by tax-exempt income)

Example: A trust has taxable income of $20,000, including $5,000 of capital gains allocable to corpus. The exemption is $300. Tax-exempt interest is $1,000.

DNI = $20,000 + $1,000 + $300 - $5,000 = $16,300

If the trust distributes $25,000, the distribution deduction is limited to $15,300 ($16,300 DNI minus $1,000 tax-exempt income).

The Distribution Deduction

The distribution deduction is what allows income to "flow through" to beneficiaries and be taxed at their rates rather than the trust's compressed rates.

Beneficiaries receive a Schedule K-1 showing their share of trust income. The character of income is generally preserved—capital gains, dividends, and ordinary income maintain their character when distributed.

Income in Respect of a Decedent (IRD)

Income in Respect of a Decedent (IRD) is income the decedent earned but did not receive before death. This income is:

• Includable in the estate's gross income when received
• Not stepped up in basis at death (unlike most inherited property)
• Eligible for a deduction for estate taxes paid on the IRD

Common examples of IRD:

• Unpaid salary, wages, or bonuses
• Retirement account distributions (IRAs, 401(k)s)
• Deferred compensation
• Accrued interest and dividends
• Installment sale payments

Exam Tip: Unlike most inherited assets, IRD items do NOT receive a stepped-up basis at death. This is a frequently tested concept.

IRD Deduction: Beneficiaries who inherit IRD can deduct the portion of federal estate tax attributable to the net IRD. This is an itemized deduction not subject to the 2% AGI floor (one of the few remaining miscellaneous itemized deductions allowed after TCJA).

Grantor Trust Rules

A grantor trust is essentially disregarded for income tax purposes—all income, deductions, and credits are reported on the grantor's individual return. The trust does not file a Form 1041 in most cases.

A trust is a grantor trust if the grantor retains certain powers or interests:

Planning Implication: Grantor trusts can be useful planning tools because the grantor pays the income tax, allowing the trust assets to grow tax-free for beneficiaries. This is sometimes called an Intentionally Defective Grantor Trust (IDGT).

Net Investment Income Tax (NIIT) for Trusts

The 3.8% Net Investment Income Tax applies to trusts and estates with undistributed net investment income above the threshold for the highest tax bracket.

2025 NIIT Threshold for Trusts: $15,650

The NIIT is imposed on the lesser of:

1. Undistributed net investment income, OR
2. Excess of adjusted gross income over $15,650

Compare this to individual thresholds:

• Single: $200,000
• Married Filing Jointly: $250,000
• Trust/Estate: $15,650

This creates an effective top rate of 40.8% (37% + 3.8%) on undistributed net investment income for trusts above the threshold.

Planning Strategy: Distributing investment income to beneficiaries can avoid or reduce the NIIT at the trust level, though beneficiaries may still owe NIIT if their income exceeds their individual thresholds.

Tax Planning Implications

The compressed brackets create several planning opportunities and considerations:

Distribution Strategy:

• Distribute income to beneficiaries in lower tax brackets
• Time distributions for beneficiaries' lower-income years
• Consider the 65-day rule (complex trusts can treat distributions made within 65 days after year-end as made in the prior year)

Trust Design:

• Consider grantor trusts to avoid compressed brackets
• Use simple trusts when beneficiaries have low tax rates
• Consider charitable remainder trusts for tax-exempt accumulation

Investment Considerations:

• Tax-exempt municipal bonds may be more valuable in trusts
• Consider tax-efficient investments (low turnover, qualified dividends)
• Be mindful of the 3.8% NIIT on investment income

Summary Table: Trust vs. Individual Taxation (2025)