Who pays income tax on income earned by trust assets — the grantor, the trust, or the beneficiary?

Three possibilities — and the right answer depends on the trust's tax characterization.

Three tax categories:

1. Grantor trust:

If the trust is "grantor-owned" for tax purposes under IRC §§ 671-679, ALL trust income flows through to the grantor's personal Form 1040. The trust files an informational Form 1041 but pays no tax itself.

Trusts are grantor trusts when the grantor retains certain powers:

• Power to revoke (revocable trusts are always grantor trusts)
• Power to substitute property of equivalent value
• Income payable to grantor or grantor's spouse
• Power to control beneficial enjoyment
• Reversionary interest greater than 5% in present value

Intentionally Defective Grantor Trusts (IDGTs) are designed to BE grantor trusts for income tax (grantor pays tax) while NOT being grantor-owned for estate tax (trust assets are out of grantor's estate). This is the most powerful estate-planning structure in the modern toolkit.

2. Non-grantor trust with distribution:

If the trust is not a grantor trust AND it distributes income to beneficiaries during the year, the income is taxed to the BENEFICIARIES (via K-1) rather than the trust. The trust gets a deduction for distributed income.

Specifically, the trust deducts up to the distributable net income (DNI) distributed. DNI is the trust's taxable income with certain adjustments. Income within DNI is taxed to beneficiaries; capital gains are typically taxed at the trust level unless explicitly allocated to beneficiaries.

3. Non-grantor trust with no distribution (accumulation):

If the trust is not a grantor trust AND it retains income (doesn't distribute), the TRUST pays tax on Form 1041. At compressed brackets:

The 37% top bracket kicks in at $15,200 — meaning a trust with even modest retained income pays roughly the same top rate as a millionaire individual.

This compression is INTENTIONAL — it's designed to push trustees to distribute income to beneficiaries (where it's taxed at lower individual rates) rather than accumulate. Accumulation trusts pay a significant tax penalty.

Worked example — three scenarios:

The trust earns $50,000 of interest and dividends in 2024.

Scenario A: Grantor trust. Grantor's personal return includes $50K of additional income. Grantor pays tax at their marginal rate (say 32%): $16,000. Trust pays $0.

Scenario B: Non-grantor, fully distributed to one beneficiary at 24% marginal rate. Beneficiary K-1 shows $50K. Beneficiary pays tax: \$50K × 24$0.

Scenario C: Non-grantor, fully retained. Trust Form 1041 shows $50K. Trust pays roughly: $1,580 (first $15,200 at lower rates) + $34,800 × 37% = $14,456. Total trust tax: ~$15,300.

Strategy implications:

• IDGTs are popular because the grantor pays trust income tax personally (effectively a tax-free additional gift to the trust beneficiaries), keeping the trust corpus growing tax-free.

• Distribution-and-recharacterise strategies push income to lower-bracket beneficiaries (e.g., a child in college with no other income).

• Accumulation is penalized by the compressed brackets, so trusts that need to grow corpus do so via untaxed gain (deferred until realization or never if held).

For the exam:

CFA L3 tests this conceptually. You should know:

• Three categories: grantor trust, non-grantor with distribution, non-grantor with accumulation
• Compressed trust brackets make accumulation costly
• IDGTs are the modern sophisticated structure
• DNI determines distribution deductibility