Trusts are a powerful part of an estate plan, offering long-term control over assets and potential tax benefits. However, they also come with complex tax obligations that trustees must understand. Knowing when a trust is required to file a tax return—and how to minimize income taxes, especially for beneficiaries—can make a big difference in preserving wealth and avoiding costly mistakes.

When Does an Irrevocable Trust Need to File a Tax Return?

Most trusts must file IRS Form 1041 annually if they:

• Earn over $600 in income during the year,
• Have any taxable income, or
• Have a non-resident alien as a beneficiary.

Who Pays the Tax?

It depends on whether income is kept in the trust or distributed to beneficiaries:

• Retained income: The trust pays tax, which can quickly reach the highest 37% federal bracket at just $15,200 of income (as of 2024).
• Distributed income: Tax is paid by the beneficiaries, often at lower rates.

Strategies to Reduce Trust Taxes

1. Distribute Income to Beneficiaries

Trusts can take a deduction for the income they distribute, shifting the tax responsibility to the beneficiaries—often saving money if the beneficiaries are in lower tax brackets.

2. Use a Grantor Trust

A grantor trust is one where the person who created the trust (the grantor) is still responsible for the tax on the income, even if the money stays in the trust. While this may not reduce the total tax bill, it keeps the trust from paying high trust tax rates.

3. Invest in Tax-Efficient Assets

Trustees can choose investments that generate tax-free income (like municipal bonds) or focus on long-term capital gains, which may be taxed at lower rates.

4. Use the 65-Day Rule

Trusts can use a 65-day rule: Distributions made within 65 days of year-end can be treated as if they were made during the previous tax year. This gives trustees flexibility to shift income and reduce tax burdens based on year-end financials.

How to Avoid High Tax Burdens for Beneficiaries

When both grantors are deceased, splitting a trust into subtrusts—especially accumulation trusts—can help manage inherited assets like IRAs. By structuring these subtrusts as BDOTs (Beneficiary Deemed Owner Trusts), income can be taxed at the beneficiaries' lower personal tax rates rather than the trust's high rates.

This setup preserves important estate planning benefits—like creditor protection—while minimizing income taxes.

However, there might be a planning reason not to have this type of subtrust. It can give a beneficiary the right to withdraw all of the trust's income, which might not be ideal for beneficiaries who cannot be trusted to have that kind of access, such as those with reckless money habits or who are mentally handicapped. There are still ways to restrict access to the principal, depending on how the trust is drafted. As with any planning strategy, the unique situation of the grantor and their beneficiaries is taken into account during the estate planning process.

Talk to a Professional

Tax rules for trusts are complex, and the stakes can be high. Trustees should always work with an experienced estate or tax professional to ensure compliance and optimize tax outcomes.

^{Sources:
https://accountinginsights.org/do-irrevocable-trusts-file-tax-returns-what-trustees-need-to-know/
https://greenleaftrust.com/missives/how-to-deal-with-the-taxation-of-irrevocable-trusts/}