Trusts and Taxes

Most family trusts fall into two kinds. The revocable living trust that an estate lawyer set up to avoid probate, which does nothing to your taxes while you’re alive. And the irrevocable trust that the first kind turns into when its creator dies, or that was set up for a child, a disabled relative, or a surviving spouse, which files its own return, has the worst tax brackets in the code, and sends the beneficiaries a Schedule K-1 they don’t know what to do with.

The core idea is simple once stated: a trust’s income is taxed once, either to the trust if it keeps the money or to the beneficiary if it pays the money out. Everything else is detail about which of those happened. Below is how it works from both sides, the trustee’s and the beneficiary’s, and the deadlines that make the difference between 12% and 37%.

The Revocable Trust: Nothing Happens

The IRS calls it: a grantor trust, Sections 671–677

If you can change or cancel the trust, you still own everything in it for tax purposes. The trust uses your Social Security number, its interest and dividends show up on your 1099s, and you report them on your 1040 as if the trust didn’t exist. No separate return, no separate rates, no K-1. Moving your house and brokerage account into a revocable trust is a title change, not a tax event, and the home-sale exclusion, the step-up in basis at death and everything else work the same as before.

Some irrevocable trusts are also grantor trusts, on purpose. An “intentionally defective” trust in a large estate plan, or a trust that lets the grantor swap assets, is taxed to the grantor even though the grantor can’t get the money. The attorney who drafted it will know; the first page of the trust usually says. If you are the grantor of one, the trust’s income is yours to report and the trustee should send you a statement, not a K-1.

The Day It Becomes Irrevocable

The IRS calls it: a taxable trust; Form 1041, U.S. Income Tax Return for Estates and Trusts

When the person who set up the revocable trust dies, it becomes irrevocable and becomes a taxpayer. The trustee (often the adult child named as successor) has a short list: get an EIN for the trust, retitle the accounts to the trust’s EIN, and file Form 1041 for every year the trust has more than $600 of income or any taxable income, until it is fully distributed and closed. The final return has a box to check, and the sooner it is checked the better, for reasons in the next section.

One election worth knowing: the trustee and the executor can elect to treat the trust as part of the estate for income-tax purposes for the first two years or so. That lets the trust use a fiscal year ending up to eleven months after the death, which pushes the first tax bill out a year and often gives the beneficiaries time to receive distributions before they are taxed. It is made on the first return and it is not available later.

The Trust Brackets

The IRS calls it: Section 1(e)

Trust or estate taxable income (2026)	Rate
Up to $3,300	10%
$3,300 to $11,700	24%
$11,700 to $16,000	35%
Over $16,000	37%
Net investment income over $16,000	+3.8%

A single person reaches 37% at $640,600 of income. A trust reaches it at $16,000. That is the whole reason trust taxation matters: income a trust keeps is taxed at the top rate almost immediately, while the same income paid to a beneficiary in the 12% bracket is taxed at 12%. A trust also gets no standard deduction, only a $100 or $300 exemption. The entire practice of trust tax planning is about getting income out of the box before year end, or within 65 days after it.

My mother set up the trust so the money would be handled carefully. The first year, careful handling meant leaving $30,000 of dividends in the account, and the trust paid $9,500 of tax on them. I would have paid $3,600. Careful cost us six thousand dollars.

Distributions Carry the Income Out

The IRS calls it: distributable net income, and the distribution deduction, Sections 651 and 661

Here is the mechanism. The trust computes its income for the year, roughly interest plus dividends plus rents less expenses: that is distributable net income, DNI. If the trust pays a beneficiary during the year, the trust deducts the payment, up to DNI, and the beneficiary picks up the same amount as income, with the same character (dividends stay dividends, tax-exempt stays tax-exempt). Pay out all of DNI and the trust owes nothing; the beneficiaries pay at their own rates. Pay out nothing and the trust pays at 37% on everything over $16,000.

Distributions of principal are not income to anyone. If the trust holds $500,000 and earns $20,000, and pays a beneficiary $100,000, the beneficiary has $20,000 of income (all of DNI) and $80,000 of tax-free principal. The K-1 shows only the $20,000. People receive a large check, see a small K-1, and assume one of them is wrong. Both are right.

A simple trust is one whose document requires all income to be paid out every year; the beneficiary is taxed on the income whether or not the check was actually written. A complex trust lets the trustee decide; the beneficiary is taxed only on what was distributed. Most family trusts after a death are complex.

Reading a K-1 from a Trust

The IRS calls it: Schedule K-1 (Form 1041), Beneficiary’s Share of Income, Deductions, Credits

Box	What it is	Where it goes on your return
1	Interest income	Schedule B, taxed at your bracket
2a / 2b	Ordinary and qualified dividends	Schedule B; qualified at capital-gains rates
3 / 4a	Short-term and long-term capital gains	Schedule D (only if the trust passed gains out)
5	Other portfolio and nonbusiness income	Schedule E, page 2
6–8	Rental, business, farm income	Schedule E, page 2; may be passive
11	Final-year deductions: excess deductions, unused losses	Only on the trust’s last return; the loss carryovers come to you
14	Other information: tax-exempt interest, foreign taxes, net investment income	Various; code by code

A trust on a fiscal year reports to you in the calendar year the fiscal year ends. A trust with a year ending March 31, 2026 sends you a K-1 for your 2026 return, even though most of the income was earned in 2025. The K-1 is often late; trusts have until April 15 to file and many extend. If yours hasn’t arrived, the return gets extended rather than guessed.

Box 11 is the one people throw away. In the trust’s final year, unused capital losses and excess deductions pass to the beneficiaries. A $40,000 capital loss carryover from the trust becomes your capital loss carryover, usable against your gains for the rest of your life.

Capital Gains: Usually Stuck in the Trust

The IRS calls it: gains allocated to corpus, Reg. 1.643(a)-3

Under most trust documents and state law, a capital gain belongs to principal, not income. That means it is not part of DNI, a distribution doesn’t carry it out, and the trust pays tax on it at trust rates: 0% up to about $3,300, 15% to about $16,250, 20% above, plus 3.8% (verify 2026 trust capital-gain brackets). A trust that sells the family’s appreciated stock in year two and pays the beneficiaries the proceeds has still paid 23.8% on the gain itself, while the beneficiaries might have paid 15% or nothing.

There are three ways out. The trust document can give the trustee power to allocate gains to income. State law or a consistent practice of treating gains as distributed can do the same. Or the trustee can distribute the appreciated asset itself to the beneficiary, who then sells it in their own name at their own rate, with the trust’s basis. The third is the most reliable and the most overlooked. Talk to the trust’s preparer before it sells anything large.

The 65-Day Rule

The IRS calls it: the Section 663(b) election

A distribution made in the first 65 days of the year (through March 6, 2027, for 2026) can be treated as made on December 31 of the prior year. The trustee makes the election on the 1041. This is the practical fix for the trustee who gets the 1099s in February, sees $30,000 of income still in the trust, and realizes the trust is about to pay 37% on most of it. Write the checks in February, elect, and the income is the beneficiaries’ for the prior year at their rates. It is the single highest-value line on the form.

A Worked Example

Colorado

A trust that owes federal tax files a Colorado fiduciary return, DR 0105, and pays 4.40% on the same taxable income. A trust is a Colorado resident if it was created by a Colorado resident’s will, or if the trust is administered in Colorado, and resident trusts are taxed on everything; nonresident trusts on Colorado-source income only. Beneficiaries who live in Colorado report their K-1 income on their own Colorado returns through federal taxable income, and a beneficiary in another state gets a Colorado K-1 only for Colorado-source items like the sale of Colorado real estate. There is no Colorado estate or inheritance tax, so the trust’s only Colorado obligation is income tax on what it keeps.