A trust can pay income taxes instead of its beneficiaries, and whether it does comes down to one thing: whether the trustee distributes the income or keeps it inside the trust. Income that stays in the trust is taxed to the trust. Income that goes out to beneficiaries is taxed to them on their personal returns. The trust claims a deduction for what it distributes, so the same dollar isn’t taxed twice.1Internal Revenue Service. 2025 Instructions for Form 1041 and Schedules A, B, G, J, and K-1 The catch is that trust tax brackets are brutally compressed — a trust hits the top 37% federal rate at just $16,000 of taxable income in 2026 — so having the trust absorb the tax is usually the expensive option.2Internal Revenue Service. 2026 Form 1041-ES Estimated Income Tax for Estates and Trusts
Who Pays Depends on the Type of Trust
Trust income taxation runs on a pass-through principle, but the type of trust decides whether the trustee even has a choice about who pays.
Grantor Trusts: The Grantor Pays, No Matter What
A grantor trust is one where the person who created it kept enough control that the IRS ignores the trust for income tax purposes. All income, deductions, and credits flow straight through to the grantor’s personal return, whether or not any money was actually distributed.3Office of the Law Revision Counsel. 26 USC 671 – Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners Revocable living trusts are the common example. The beneficiaries don’t report trust income, and the trust itself usually doesn’t file. The question of the trust paying instead of beneficiaries doesn’t really come up here, because the grantor absorbs everything.
Simple Trusts: Beneficiaries Pay
A simple trust is required by its governing document to distribute all income every year. It can’t make charitable contributions and can’t distribute principal.4Office of the Law Revision Counsel. 26 USC 651 – Deduction for Trusts Distributing Current Income Only Because all ordinary income has to go out the door, the distribution deduction essentially zeros it out at the trust level, and the beneficiaries pay the tax on their own returns. The trustee has no discretion to park income inside the trust. Capital gains are a different story, and they’re covered below.
Complex Trusts: The Trustee Chooses
A complex trust gives the trustee discretion over how much to distribute and when. The trustee can accumulate income inside the trust, draw from principal, or send money to charity.5Office of the Law Revision Counsel. 26 USC 661 – Deduction for Estates and Trusts Accumulating Income or Distributing Corpus This is where the “who pays the tax” question actually has a live answer. Retain income, and the trust pays. Distribute it, and the beneficiary pays. Within limits.
Distributable Net Income Caps What You Can Shift
Distributable net income, or DNI, sets the ceiling on how much trust income can be taxed to beneficiaries in a given year. It’s roughly the trust’s taxable income before the distribution deduction, with adjustments. The most important adjustment: capital gains allocated to the trust’s principal are normally excluded from DNI.6Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
How it plays out: say a complex trust earns $10,000 of interest and dividend income (its DNI) and the trustee distributes $8,000 to a beneficiary. The beneficiary reports $8,000. The trust keeps $2,000 and pays tax on that. Distribute the full $10,000, and the entire ordinary-income tax bill shifts to the beneficiary; the trust owes nothing on that income.
Anything distributed beyond DNI is treated as a tax-free return of principal to the beneficiary.7Internal Revenue Service. SOI Tax Stats – Definitions of Selected Terms and Concepts for Income From Trusts and Estates A trust with $10,000 of DNI that distributes $15,000 passes $10,000 of taxable income to the beneficiary and $5,000 tax-free. The distribution deduction also tops out at DNI, so trustees can’t manufacture a bigger deduction by over-distributing.
Why Keeping Income in the Trust Costs So Much
Federal brackets for trusts are compressed to the point of being punitive. An individual single filer doesn’t reach the top 37% rate until taxable income exceeds roughly $626,000. A trust gets there at $16,000. The full 2026 schedule for trusts and estates:2Internal Revenue Service. 2026 Form 1041-ES Estimated Income Tax for Estates and Trusts
- 10% on taxable income up to $3,300
- 24% from $3,301 to $11,700
- 35% from $11,701 to $16,000
- 37% over $16,000
A trust retaining $50,000 of ordinary income will owe substantially more than a middle-bracket beneficiary would owe on the same amount. That gap is the main reason trustees distribute whenever the trust document allows and the beneficiaries’ circumstances make sense.
There’s also a second layer. Trusts owe a 3.8% net investment income tax on the lesser of their undistributed net investment income or the amount by which their adjusted gross income exceeds the top-bracket threshold.8Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax For 2026, that threshold is the same $16,000.2Internal Revenue Service. 2026 Form 1041-ES Estimated Income Tax for Estates and Trusts A trust holding $50,000 of retained investment income would owe 3.8% on $34,000, adding about $1,290. Distributing investment income to beneficiaries shrinks or eliminates the NIIT at the trust level, though beneficiaries may owe their own NIIT depending on their income.
Capital Gains Usually Stay With the Trust
Capital gains follow different rules from interest and dividends and catch a lot of trustees off guard. By default, capital gains realized by a trust are allocated to principal rather than income. Because they sit in principal, they’re excluded from DNI, can’t flow through on the K-1, and the trust pays the tax itself.6Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
There are exceptions. Capital gains can be pulled into DNI (and taxed to beneficiaries) when the trust document or state law allocates gains to income, when the trustee consistently treats gains as part of distributions on the trust’s books, when gains are actually distributed to a beneficiary, or in the trust’s final year. The trust instrument’s language controls, and trustees who want flexibility to pass capital gains through should confirm the document contemplates it.
For gains the trust keeps, the compressed brackets bite again. The 20% long-term capital gains rate kicks in at a far lower income level than for individuals, and the 3.8% NIIT stacks on top once income clears $16,000.
The 65-Day Rule Gives Trustees a Second Look
Trustees rarely know in December exactly what the trust earned or what should be distributed to minimize tax. The 65-day rule gives them a window: distributions made within the first 65 days of a new tax year can be treated as if they were made on the last day of the prior year.9Justia Law. 26 USC 663 – Special Rules Applicable to Sections 661 and 662 That lets the trustee look at final numbers and decide retroactively to push income to beneficiaries instead of letting the trust pay at compressed rates.
The election is made by checking a box on Form 1041 when the return is filed, and it’s irrevocable for that year. Miss the window and the chance to shift that year’s income is gone.
State Income Taxes Can Add to the Bill
Federal is only part of it. Most states that tax income also tax trust income, and the rules for whether a trust is a “resident” of a particular state vary widely. Common factors include where the trust was created, where the grantor lived, where the trustee is located, where the trust is administered, and where the beneficiaries live. Some states weigh just one factor, others several. A trust created by a New York resident but administered in Florida by a Florida trustee might be claimed by both states or neither, depending on each state’s rules. Combined federal and state tax on retained trust income can easily push the effective rate above 40%.
Charitable Remainder Trusts Are a Separate Regime
One exception to the whole framework above: a properly structured charitable remainder trust is exempt from federal income tax on its earnings.10eCFR. 26 CFR 1.664-1 – Charitable Remainder Trusts These trusts pay income to a non-charitable beneficiary (often the grantor) for a period of years or for life, then distribute what remains to a qualified charity. Because the trust itself owes no annual tax, investment gains compound without drag. The beneficiary receiving annuity or unitrust payments reports that income personally, with the character determined by a tiering system that treats the most heavily taxed income as distributed first. Charitable remainder trusts don’t use the DNI framework described above and come with their own qualification requirements and excise tax rules.