How Non-Grantor Trusts Are Taxed

For Texas residents, understanding how trusts are taxed is an essential part of effective estate planning. A non-grantor trust, in particular, can offer significant benefits, but it’s important to understand the unique income tax implications that come with this type of trust. Our Katy, TX revocable living trust lawyer who is licensed in Texas, Kentucky, Pennsylvania, and South Dakota is here to explore how non-grantor trusts work and their taxation, with a focus on how they impact residents of the Lone Star State.

What Is A Non-Grantor Trust?

A non-grantor trust is a trust where the grantor (the person who creates the trust) does not retain control or significant benefits from the trust’s assets. Once the trust is established, the grantor cannot modify or revoke it. Unlike a grantor trust, where the income is taxed to the grantor, a non-grantor trust is treated as a separate taxable entity for income tax purposes.

This distinction is especially relevant for Texas residents who want to ensure that their trust assets are managed efficiently while minimizing tax burdens.

How Income Is Taxed In A Non-Grantor Trust

A non-grantor trust must file its own income tax return using IRS Form 1041. The trust’s income is taxed in one of two ways:

1. Income Retained by the Trust: If the trust retains the income, it will pay income taxes on that amount at the trust’s tax rates. These rates are highly compressed, meaning the trust reaches the highest marginal rate (37% in 2024) at much lower income levels than individuals. For example, a non-grantor trust’s income over $14,450 is taxed at the top rate of 37%, compared to $578,125 for individual filers.
2. Income Distributed to Beneficiaries: If the trust distributes income to its beneficiaries, the beneficiaries are responsible for paying income taxes on the distributed amount. The trust can deduct these distributions, effectively shifting the tax liability to the beneficiaries. Beneficiaries report the income on their personal tax returns and pay taxes based on their individual tax rates.

For Texas residents, these rules mean careful planning is needed to optimize distributions and avoid unnecessary tax burdens. As our firm knows well, we have worked in these trusts since our founding in 2021.

Types Of Income In A Non-Grantor Trust

Non-grantor trusts may generate various types of income, and each is taxed differently:

• Ordinary Income: This includes interest, dividends, and rental income. Ordinary income is taxed at the trust’s or the beneficiary’s ordinary income tax rates.
• Capital Gains: Capital gains are generally taxed to the trust unless they are distributed to beneficiaries. Long-term capital gains benefit from lower tax rates, but the trust’s compressed tax brackets mean it may reach the highest rate more quickly.
• Tax-Exempt Income: If the trust earns tax-exempt income, such as interest from municipal bonds, it is not subject to federal income tax. However, it may still be reportable on Form 1041.

For Texans, understanding these smart estate tax strategies is crucial for maximizing the financial benefits of a trust while staying compliant with tax laws.

Deductions Available To Non-Grantor Trusts

Non-grantor trusts are allowed certain deductions to reduce taxable income. Common deductions include:

• Distributions to Beneficiaries: As mentioned earlier, income distributed to beneficiaries is deductible by the trust.
• Trust Administration Expenses: These are costs necessary for the operation and management of the trust, such as trustee fees, legal fees, and accounting expenses.
• Charitable Contributions: If the trust’s terms allow, it can deduct charitable contributions made from the trust’s income.

For Texas residents who value philanthropy, this can be a great way to support local charities while reducing the trust’s taxable income.

Special Considerations For Non-Grantor Trusts In Texas

1. State Income Taxes: Texas does not impose a state income tax, which is a significant advantage for residents. While federal income tax rules still apply, the absence of state income tax makes Texas an attractive state for trust planning.
2. Trust Administration: Texas offers a favorable legal environment for administering trusts. However, choosing the right trustee and ensuring compliance with both state and federal laws is essential.

For Texans, these considerations can simplify trust administration and help ensure that assets are preserved for future generations.

Advantages And Disadvantages Of Non-Grantor Trust Taxation For Texas Residents

Advantages:

• Separate Tax Entity: A non-grantor trust’s income is not included in the grantor’s personal income, which can help reduce the grantor’s overall tax liability.
• Flexibility in Distributions: The trust can choose to retain income or distribute it to beneficiaries, allowing for strategic tax planning.
• No State Income Tax: For Texas residents, the lack of state income tax provides additional savings compared to residents of states with high income taxes.

Disadvantages:

• Compressed Tax Brackets: Trusts pay higher taxes on retained income due to the compressed tax brackets.
• Administrative Complexity: Filing a separate tax return and keeping detailed records can be time-consuming and costly.

For Texas residents, understanding how non-grantor trusts are taxed is essential for effective estate planning. By working with an experienced attorney or tax professional familiar with Texas laws, you can structure the trust to minimize taxes and achieve your financial goals. You can also keep your plans up to date by regularly updating your estate plan.

Non-grantor trusts offer flexibility and control, making them a valuable tool for Texans looking to protect and grow their wealth. With no state income tax to worry about, Texas residents are in an advantageous position to leverage these trusts for long-term financial planning. However, the federal tax implications require careful planning to ensure that the trust serves its intended purpose while minimizing tax burdens.

If you’re a Texas resident considering a non-grantor trust, consult with a qualified professional to explore how it can benefit your unique situation. With the right approach, you can create a trust that aligns with your goals and safeguards your legacy for future generations. Contact Stuart Green Law, PLLC today for help!