Simon Zhang
Simon Zhang
Income Taxation of Trusts

Income Taxation of Trusts

What is a trust? A trust is a fiduciary relationship in which one party, known as a trustor, gives another party, the trustee, the right to hold title to property or assets for the benefit of a third party, the beneficiary. Trusts are established to provide legal protection for the trustor’s assets, to make sure those assets are distributed according to the wishes of the trustor, and to save time, reduce paperwork and, in some cases, avoid or reduce inheritance or estate taxes.

All trusts have the following characteristics:

  1. A trust is created by a maker who is known as Settlor, Grantor.
  2. The person or institution responsible for following the Trustmaker’s instructions is the Trustee. The Trustmaker can be his or her own trustee.
  3. The trust Beneficiary enjoys the trust property.

Common purposes for trusts are assets safety, privacy, estate planning, and tax planning. Depending on how the trust is designed, it can be taxed in several different ways for Federal Income Tax purposes:

  1. Non-Grantor Trust (Simple and Complex)
  2. Grantor Trust
  3. Qualified Subchapter S Trust (QSST)
  4. Electing Small Business Trust (ESBT)

Non-Grantor Trusts (Simple):

Simple trusts must distribute trust income to the trust beneficiaries annually (but not capital gain), but make no principal distributions, make no distributions to charity. Trust income is taxable to the beneficiaries on their 1040. Simple trusts get a $300 annual exemption and Simple trusts must pay taxes on capital gain.

Non-Grantor Trusts (Complex):

Complex trusts can accumulate income and get a $100 annual exemption. Complex trusts are taxable as an entity and file an annual Form 1041 income tax return. When a distribution is made to the trust beneficiary, IRS considers the trust distribution as income first, then principal. In other words, no principal can be distributed unless all income has been distributed for the year. Also, ordinary income takes first place in the distribution line ahead of dividends, and dividends must be distributed ahead of capital gain. If a trust distribution is made within the first 65 days of any taxable year, it can be considered as paid on the last day of the preceding taxable year under Internal Revenue Code (IRC) 663(b). The “Income” for distribution purposes is the amount of income the trust determines under the terms of the governing instrument and applicable local law.

Grantor Trusts:

Under IRC 671 to 679, grantor trusts are not a separate income tax paying entity. The grantor of the trust includes the taxable trust income on their 1040. A grantor trust is a Revocable trust, and the grantor retains asset control. A grantor trust can own stock in an S-Corporation.

Revocable trusts are often grantor trusts and irrevocable trusts are non-grantor trusts.


QSST is one type of trust that is permitted to be an S corporation shareholder. To qualify, the individual trust beneficiary must make an election to treat the trust as a permitted shareholder.


An ESBT is a type of trust that the trust must elect to be treated as an electing small business trust to be an S corporation shareholder.

A Trust is a tool for asset protection and estate & gift tax planning. ADKF is right here to help you with any questions you may have in setting up your family trusts to transfer or preserve your family wealth.

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