When the grantor of an intentionally defective grantor trust dies, the trust stops being a pass-through for income tax purposes and becomes a standalone taxpayer. It needs its own tax ID, files its own annual return, pays tax at steeply compressed brackets on any income it keeps, and holds its assets at the grantor’s original cost basis rather than a stepped-up basis. The successor trustee takes over immediately, and the first year involves a split between the grantor’s final personal return and the trust’s first fiduciary return.
The Trust Becomes Its Own Taxpayer
An IDGT is built around a specific “defect,” most often a power letting the grantor swap trust assets for other property of equal value. Under federal tax law, that power is enough to make the grantor the owner of the trust for income tax purposes, even though the assets sit outside the grantor’s taxable estate.1Office of the Law Revision Counsel. 26 U.S. Code 675 – Administrative Powers During life, that split is the whole point: the grantor pays the income tax, and the trust grows free of that drag while staying out of the estate.
Death ends the arrangement. The swap power can no longer be exercised, so the trust is no longer a grantor trust. From the day after death forward, the IRS treats it as a non-grantor trust with its own tax identity and its own filing obligations. The shift happens automatically by operation of law. The trustee does not elect it, and nothing in the trust document can prevent it.
Reporting Income in the Year of Death
The year the grantor dies splits in two. Income the trust earned from January 1 through the date of death still belongs on the grantor’s final Form 1040, because the trust was still a grantor trust during that stretch. Income earned from the day after death through December 31 belongs to the trust itself and goes on its first Form 1041.
The grantor’s executor files the final 1040. The successor trustee files the trust’s first 1041. Coordinating the two is one of the first practical headaches after death, and getting the split wrong tends to produce IRS notices on both returns.
A New EIN and Ongoing Filing Duties
While the grantor was alive, the trust usually reported under the grantor’s Social Security number. Once the grantor dies, the trust needs its own Employer Identification Number from the IRS.2Internal Revenue Service. When To Get a New EIN The successor trustee can apply online and receive the number immediately, then use it to open or retitle any bank and brokerage accounts.
From that point on, the trust files Form 1041 for any year it earns more than $600 in gross income.3Internal Revenue Service. File an Estate Tax Income Tax Return The return reports the trust’s income, deductions, gains, losses, and distributions to beneficiaries.4Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts Quarterly estimated tax payments may also be required to avoid underpayment penalties.
One useful mechanic: when the trust distributes income to beneficiaries, it takes a deduction for the distribution and the beneficiaries report that income on their own returns. The trust pays tax only on income it retains. For a trust designed to distribute regularly, this can take most of the sting out of the next issue.
Why Retained Income Gets Hit Hard
Trust tax brackets are compressed to a degree that catches most families off guard. In 2026, a trust reaches the top federal income tax rate of 37% on income above just $16,000. An individual does not reach that same rate until income exceeds roughly $609,000.
The full 2026 trust brackets:
- 10% on $0 to $3,300
- 24% on $3,301 to $11,700
- 35% on $11,701 to $16,000
- 37% above $16,000
While the grantor was alive, trust income was taxed at the grantor’s individual rates across much wider brackets. After death, any income the trust keeps gets squeezed into these narrow ones. That is a strong reason for trustees to distribute income to beneficiaries in lower brackets rather than accumulate it, where the trust document allows discretionary distributions.
No Step-Up in Basis on Trust Assets
This is the consequence most families do not see coming. Normally, when someone dies, assets in their estate receive a stepped-up basis equal to fair market value at the date of death. Unrealized gains disappear and heirs start fresh.
IDGT assets do not get that treatment. Because the whole point of the structure is to keep the assets out of the grantor’s taxable estate, they are not “acquired from a decedent” under the tax code’s definition.5Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent The IRS confirmed this position in Revenue Ruling 2023-2, concluding that assets in an irrevocable grantor trust where the assets are not included in the grantor’s gross estate do not qualify for a basis adjustment at death.
The trust keeps the grantor’s original cost basis instead. A quick example shows the stakes. The grantor transfers stock purchased for $50,000 into the IDGT. By the time the grantor dies, the stock is worth $500,000. The trust’s basis stays at $50,000. If the trustee later sells at $500,000, the trust realizes a $450,000 capital gain, taxed at those compressed trust rates unless the proceeds are distributed to beneficiaries.
The estate tax savings from keeping assets out of the gross estate often outweigh the lost step-up, but it is a real trade-off, and it is locked in once the grantor dies.
What Happens to an Outstanding Promissory Note
Many IDGTs are funded through an installment sale: the grantor sells appreciated assets to the trust in exchange for a promissory note. While the grantor is alive, the sale is ignored for income tax purposes because the grantor is treated as dealing with themselves. No gain is recognized, and the interest payments are not taxable income.
Death splits the note along the same estate-versus-income-tax line that defines the whole IDGT structure. The outstanding balance is included in the grantor’s gross estate because the grantor owned the note personally. But because the original sale was a non-event for income tax purposes, the unpaid balance is generally not treated as income in respect of a decedent, and the note should receive a basis equal to its value as included in the estate.
The trust’s assets, meanwhile, keep their carryover basis. The trust still owes the remaining payments, which now go to the grantor’s estate or whoever inherits the note. For the first time, those payments are real transactions between two separate taxpayers.
The Successor Trustee’s First Tasks
The person named as successor trustee has legal duties the moment the grantor dies, including a fiduciary duty to act in the beneficiaries’ best interests and follow the trust document. The first few months typically involve:
- Obtaining a new EIN for the trust and retitling or opening accounts under the trust’s new tax identity.
- Inventorying all trust assets, including real estate, investment accounts, business interests, and personal property, with accurate date-of-death valuations.
- Notifying beneficiaries of the grantor’s death and their interest in the trust. Most states require written notice within a set timeframe, commonly 30 to 60 days.
- Paying trust debts and expenses, including professional fees and tax liabilities.
- Coordinating with the grantor’s executor on the split-year income tax reporting and any estate tax filings.
Non-professional trustees often underestimate how much accounting and tax work the first year demands. A CPA experienced with fiduciary returns is worth the cost for most successor trustees.
How and When Assets Get Distributed
Distribution depends entirely on what the trust document says. Some IDGTs terminate at the grantor’s death, with assets passing outright to named beneficiaries. Others continue for years or across generations, with the trustee making distributions on a schedule or for defined purposes such as education or health care.
If the trust continues, the trustee keeps managing the assets, filing Form 1041 each year, and distributing according to the trust’s terms. Discretion exists only where the document grants it. A direction to “distribute all income annually” leaves no room to accumulate; a grant of “sole discretion” opens up planning around the beneficiaries’ tax brackets.
For trusts that terminate, the trustee should not rush to distribute everything before settling final tax obligations. Holding back a reasonable reserve for taxes owed on the final 1041 is standard practice. Once debts, expenses, and taxes are paid, the remaining assets pass to the beneficiaries as the document directs, and the trust can be formally closed.
Does the Trade-Off Still Make Sense in 2026?
An IDGT exists primarily to move assets out of the grantor’s taxable estate, so the value of the strategy depends on how much room the federal estate tax exemption gives you. For 2026, the basic exclusion amount is $15,000,000 per individual, following an increase signed into law in mid-2025.6Internal Revenue Service. What’s New – Estate and Gift Tax
For estates well above that threshold, an IDGT that successfully moved assets out before death has done exactly what it was designed to do: those assets and their subsequent appreciation escape estate tax, and the carryover basis is the price. For estates near or below the exemption, the lost step-up may cost more in future capital gains tax than the estate tax savings justify. Families in that range should revisit the structure with an estate planning attorney while the grantor is still able to make changes, because once the grantor dies, the basis question is settled.