How Are Trusts Taxed?

Trusts are among the most powerful tools in estate planning — but they also create some of the most misunderstood tax consequences. Understanding how trusts are taxed can make the difference between a smooth estate plan and an unexpected tax bill.

Trusts can trigger income tax, estate tax, and gift tax at both the federal and state levels. The rules differ depending on whether the trust is a grantor trust (where the creator pays the tax) or a non-grantor trust (where the trust or its beneficiaries pay the tax). New York also has its own quirks such as “resident trust” rules and the estate-tax “cliff”.

This article breaks down how trusts are taxed, both Federal and New York, explaining:

How income tax applies to trusts and beneficiaries
The difference between grantor and non-grantor trusts
How estate tax and gift tax rules differ between Federal and State
Special considerations when minor children are beneficiaries

Whether you are a trustee, beneficiary, or estate-planning client, understanding these tax principles will help you structure a trust that meets your financial and family goals — while staying compliant with both federal and state tax laws.

1. Key Trust Concepts: Grantor Trust vs Non-Grantor Trust

a) Grantor Trust

A “grantor trust” is a Trust over which the settlor retains certain powers and control, such as the right to revoke the trust or withdraw the income, is ignored for federal income tax purposes. While a Trust can obtain its own tax ID number and file its own taxes, IRS Regulations allow grantor trusts to use the grantor’s social security number, and the grantor can report the trust’s income, deductions, etc. directly on the grantor’s tax returns, and New York instructs grantors to use the same filing method as for federal purposes.

b) Non-Grantor Trust

A non-grantor trust is one in which the grantor has relinquished sufficient control so that the trust is treated as a separate tax entity for income tax purposes.
– The trust itself must obtain its own EIN, file a return (Form 1041 federal), pay tax on retained income, and/or pass through income to beneficiaries who report it.
– One big practical distinction: non-grantor trusts face very compressed tax brackets at the federal level. For example, they hit the top 37% tax rate when taxable income is just over about $15,650 (2025 figures) versus individuals who hit that rate only much higher.

c) Why this matters

From a taxation standpoint, whether a trust is grantor or non-grantor determines who pays the income tax (grantor vs trust vs beneficiary) and whether you have trust-level filings. It also has implications for state income tax, estate tax planning, and gift tax strategy.

2. Income Taxation of Trusts

Federal overview

– Grantor trusts: the income and deductions are typically reported on the grantor’s own 1040 and the trust is ignored. If the Trust has its own tax ID number, the Trust is obligated to file a 1041 tax return, but for a grantor trust, only the entity information needs to be provided, together with a letter that aggregates the income and losses, for the grantor to report on their own 1040 tax return.
– Non-grantor trusts: income and deductions are reported on the trust’s 1041 tax return, and taxed to the trust at fiduciary tax rates. However, if the Trust distributes such income to the beneficiaries, the trust gets a deduction on its tax return and issues a K1 to the beneficiaries, who report the income on their own tax returns.

New York State Income Tax of Trusts

Key points for New York residents or trusts linked to New York:
– For grantor trusts under NY: If the grantor trust rules apply, the trust income is taxed to the grantor; the trust doesn’t pay.
– Under New York Tax Law a trust is a “resident trust” (taxed on worldwide income) if created by a person domiciled in New York at time the trust became irrevocable (or under the will of a resident decedent) or becomes irrevocable while the grantor was domiciled in New York.
– A “nonresident trust” is subject to New York tax only on New York‐source income if the trust is not a New York resident trust.
– There is an “exempt resident trust” exception: a resident trust may avoid New York tax if all of (1) trustees domiciled outside New York, (2) all trust property located outside New York, and (3) all income derived from non-New York sources. But if any distribution is made to a New York resident beneficiary, New York may tax that distribution.

Practical tip for New York: If you have a trust and either the trustee resides in New York, trust assets are in New York, or the beneficiaries are New York residents, you must carefully analyze whether the trust is a New York resident trust or nonresident—and whether the exempt-resident trust exception might apply (but often difficult to meet).

3. Estate Tax & Trusts

Federal Estate Tax

In 2025 the lifetime (gift and estate) tax exemption is $13,990,000.
Assets distributed to a spouse are deducted from the estate.
“Portability” allows a surviving spouse to add their deceased spouse’s unused exemption to their own.

A trust may or may not be included in a person’s estate. This depends on the terms of the trust, the rights and powers of the decedent.

New York State Estate Tax

In 2025 the New York estate tax exemption is $7,160,000.
New York has a notorious “cliff”: if an estate exceeds 105% of the exemption (i.e., $7.518 M) the full estate becomes taxable rather than just the amount over the exemption.
New York does not impose a state‐level gift tax, but gifts made within three years of death may be added back into the taxable estate (“clawback”).
Trusts are often used in New York estate planning (e.g., bypass trusts) to ensure that assets are removed from the taxable estate and that you don’t cross the cliff threshold.

Trust implications: If you fund an irrevocable trust (non-grantor) and relinquish control, you may reduce your taxable estate. But if you retain certain powers (making it a grantor trust), then the trust assets may still be included in your estate for New York estate tax purposes. Also, residency and nexus rules matter (where you live, where trust is located).

4. Gift Tax & Trusts

Federal Gift Tax

When you transfer assets during life (e.g., into an irrevocable trust for children), if the gifts exceed the annual exclusion ($19,000 per recipient in 2025), you need to report the gift to the IRS. Unless you choose to pay gift tax now, any reported gift will use up some of your lifetime exemption ($13,990,000. in 2025). After you’ve used up your lifetime exemption, you’ll need to pay tax on any further gifting.

Trusts often form the vehicle for such transfers: you might fund an irrevocable trust for a beneficiary (child or grandchild) and treat the funding as a gift.

New York Gift Tax

New York does not impose its own separate gift tax. However, the “clawback” rule requires adding any gifts made by a New York resident within three years of death back into the New York taxable estate

Gift Tax & Trust Funding

When you fund a trust (especially irrevocable) you are making a gift (or partial gift) to the trust’s beneficiaries — you should consider:

Whether the transfer is truly a completed gift (i.e., you have given up control) or whether you’ve retained powers (which might push it into your estate).
The gift tax ramifications (federal) and state residency/nexus implications.
If the trust is a grantor trust (you retain powers), then you may not have made a completed gift for gift tax purposes (and the trust income remains taxable to you).
If the trust is a non-grantor trust and properly structured, you may remove future appreciation from your estate, provide for beneficiaries, and reduce estate tax exposure.

5. Practical Steps & Planning Considerations

For Income Tax Planning:

Determine residency/situs of the trust: Where is the trustee domiciled? Where are trust assets located? What is the source of income? Is the trust a resident trust or a nonresident trust?
Decide whether you want the trust to be a grantor or non-grantor trust, and whether the trust should be a completed gift or an incomplete gift for gift and estate tax purposes.
For trusts with minor children beneficiaries: consider the timing of distributions (taxed to child at child’s bracket vs trust pays higher tax).
If a trust has assets or business links in New York, plan to minimize state source income and asset/trustee nexus.
Make sure to file the appropriate state returns (NY IT-205).

For Estate & Gift Tax Planning:

If you are New York domiciliary and your estate value may approach the New York exemption (~$7.16 M in 2025), use trusts (e.g., irrevocable non-grantor trusts, credit shelter trusts) to reduce taxable estate.
Beware the New York estate tax “cliff”: crossing 105% of exemption triggers tax on entire estate.
Gifts into trusts: treat funding of a trust as a gift, consider annual exclusion use, lifetime exemption, and for New York the three-year look-back.
For minors: if you fund a trust for children/grandchildren, ensure the trust documents contemplate their age of distribution, state tax, income tax and generation-skipping tax (if applicable).

6. Final Thoughts

Trust taxation is complex, particularly when you operate in a state like New York, and when you have trust assets, beneficiaries or trustees residing in more than one state. Key takeaways:

Always determine the type of trust (grantor vs non-grantor) and trust domicile/situs.
For income tax: know whether the trust will be taxed as a separate entity or the grantor will pay; also know state rules about residency and source income.
For estate and gift tax planning: trust funding, timing of gifts, distributions, and state-level peculiarities (New York’s cliff) matter.
For minors: think about the tax impact of distributions, the age of beneficiaries, trustee powers, and administrative requirements.
Because trust taxation often involves interplay of federal law and multiple state laws, you should consult an estate-planning attorney and a tax advisor familiar with New York trust taxation before implementing a trust.