Who Pays the Income Tax on an Irrevocable Trust's Investments?

Phil's situation: $900,000 in dividend stock, one important drafting choice

Phil is 67, lives in Naples, and recently funded an irrevocable trust with $900,000 of dividend-paying stock. Phil is a composite client I use to illustrate a question that comes up in almost every irrevocable trust consultation I have: once the money moves into the trust, who actually pays the tax on the dividends it generates?

An irrevocable trust is one the person who creates it (the settlor) cannot simply revoke or amend on their own. That is what lets it move assets out of the settlor's estate for creditor, Medicaid, or tax planning purposes. But 'irrevocable' describes whether the trust can be undone. It does not, by itself, answer the income tax question. That answer depends on whether the trust is drafted as a grantor trust or a non-grantor trust, and that distinction changes everything about Phil's next tax return.

Grantor trust status: why it is often intentional, not a mistake

Under the federal grantor trust rules, certain powers a settlor retains (even in an otherwise irrevocable trust) cause the IRS to treat the settlor as the owner of the trust's assets for income tax purposes only. When a trust is a grantor trust, all of the dividends, interest, and capital gains the trust earns are reported directly on the settlor's personal Form 1040, exactly as if the settlor still owned the stock outright.

This sounds counterintuitive. Why would someone give up control of $900,000 in stock and still pay the tax on it themselves? In my practice, I explain that this is frequently the whole point. When Phil pays the income tax out of his own pocket on income the trust earned, that tax payment is not treated as an additional taxable gift to the trust. Over years, Phil effectively transfers extra value to his beneficiaries tax-free, simply by paying the tax bill himself rather than making the trust pay it. Many irrevocable trusts built for asset protection or Medicaid planning are intentionally structured this way: irrevocable and out of the estate for transfer tax purposes, but still a grantor trust for income tax purposes.

When the trust is not a grantor trust: its own return and compressed brackets

If Phil's trust does not include the retained powers that trigger grantor trust status, it is a non-grantor trust. A non-grantor trust is treated as its own separate taxpayer. The trustee must obtain a federal Employer Identification Number (EIN) for the trust (it cannot use Phil's Social Security number) and file an annual Form 1041, U.S. Income Tax Return for Trusts and Estates.

Here is where families are often surprised. Trusts reach the highest federal income tax bracket at a very low level of retained income, far lower than an individual would. An individual does not reach the top bracket until reportable income is well into six figures. A trust that keeps its income inside the trust, rather than distributing it out to beneficiaries, can hit that same top bracket on only a small amount of undistributed income. Add the net investment income tax that applies to investment income above certain thresholds, and retained dividend income inside a non-grantor trust can be taxed more heavily, dollar for dollar, than the same income would be taxed in Phil's own hands.

Distributions, DNI, and the Schedule K-1: how income moves to beneficiaries

A non-grantor trust gets a deduction for income it distributes to beneficiaries during the year, up to the trust's distributable net income (DNI). DNI is essentially the ceiling on how much of the trust's income can be passed out to beneficiaries and taxed to them instead of to the trust. When Phil's trustee distributes dividend income to a beneficiary, that beneficiary receives a Schedule K-1 from the trust, generally in the spring, showing their share of interest, dividends, and capital gains for the year. The beneficiary reports that K-1 income on their own personal return.

• Income kept in the trust: taxed to the trust on Form 1041, at the trust's compressed brackets.
• Income distributed to a beneficiary: taxed to that beneficiary at their own individual rate, reported via Schedule K-1.
• Grantor trust status: bypasses this whole framework, since all income is simply reported on the settlor's own return regardless of what the trust distributes.

This is why trustees of non-grantor trusts often distribute income annually to beneficiaries in lower tax brackets rather than letting it accumulate and be taxed at the trust's compressed rates. It is a legitimate, common planning move, not an aggressive one.

Florida's advantage, and Phil's CPA's plan

Florida has no state income tax, and that applies to trusts administered here as much as it applies to individuals. Whether Phil's trust ends up taxed as a grantor trust on his personal return or as a non-grantor trust filing its own Form 1041, there is no Florida-level income tax layered on top of the federal result. For a Naples retiree moving out of a state that does tax trust income, this is a real and durable advantage, and one reason many families relocate irrevocable trust administration to Florida.

In Phil's case, his CPA reviewed the trust document to confirm its grantor trust status, obtained the EIN the trust will need for informational purposes, and set up a simple annual routine: track the dividend income, confirm whether any of it needs to be reported on the trust's own return or flows through to Phil personally, and revisit the distribution plan each year based on Phil's income and the needs of his beneficiaries. That kind of coordination between the trustee, the drafting attorney, and the CPA is exactly what keeps an irrevocable trust from generating tax surprises down the road.

This article is for general informational purposes only and does not constitute legal advice, nor does reading it create an attorney-client relationship. Florida estate, elder, probate, and real estate law are fact-specific and change over time. Consult a licensed Florida attorney about your individual circumstances. Arthur Simpson, Esq. is licensed to practice law in the State of Florida. Attorney advertising.