Who Really Pays Tax on a Complex Trust? Avoid this Mistake + FAQs

In a complex trust, either the trust itself or its beneficiaries (and sometimes the grantor) will pay the income tax, depending on how the trust is structured and how its income is distributed.

A complex trust is an irrevocable trust that can accumulate income (unlike a simple trust, which must distribute all income annually). This flexibility means the tax liability can fall on different parties.

Below we break down who pays the tax on a complex trust under various scenarios, explore federal vs. state rules, and provide detailed guidance on complex trust taxation.

We’ll also cover all 50 states’ trust tax rules, key tax entities and concepts (IRS, fiduciaries, beneficiaries, grantors, Form 1041, Schedule K-1, DNI, UPIA, Uniform Trust Code, etc.), and answer frequently asked questions.

What Is a Complex Trust (and How Is It Taxed)?

A complex trust is any trust that is not a simple trust. In practical terms, a complex trust may retain income, distribute principal, or make charitable contributions. By contrast, a simple trust is required to distribute all its income to beneficiaries each year and cannot pay out principal or donate to charity.

Because a complex trust can accumulate income, it may itself owe income tax on undistributed earnings. If the complex trust distributes income to beneficiaries, those beneficiaries will pay tax on the distributed income.

Complex trusts are common estate planning tools, and understanding their tax treatment is crucial for trustees (fiduciaries) and beneficiaries.

Example: Suppose a complex trust earns $10,000 of interest in a year. The trustee might distribute $6,000 to the beneficiary and retain $4,000 in the trust. In that case, the beneficiary pays income tax on the $6,000 received, and the trust pays tax (at trust tax rates) on the $4,000 it kept.

This illustrates how “who pays” depends on distributions. In a simple trust (which must distribute all income), the trust would distribute the entire $10,000 and the beneficiary would pay all the tax on it, while the trust itself would pay nothing (aside from possibly capital gains tax, if any).

Key point: Complex trusts can shift the income tax burden between the trust and beneficiaries by controlling distributions. The IRS and state tax authorities have rules (like the Distributable Net Income (DNI) limitation) to ensure income is only taxed once (either to the trust or to the beneficiaries, but not double-taxed).

Grantor Trust vs. Non-Grantor Trust: Who Bears the Tax?

Not all trusts are taxed the same. A crucial distinction is whether the trust is a grantor trust or a non-grantor trust. A “complex trust” typically refers to a non-grantor trust (a separate tax entity), but it’s important to clarify because if a complex trust is structured as a grantor trust, the tax situation changes entirely.

Grantor Trusts – Tax Liability Falls on the Grantor

A grantor trust is a trust in which the grantor (the person who established the trust, sometimes called the settlor) retains certain powers or interests that cause the trust’s income to be taxable to the grantor personally. In other words, for income tax purposes, the IRS ignores the trust as a separate entity and treats the income as if the grantor earned it directly. All income, deductions, and credits “flow through” to the grantor’s Form 1040.

• If a complex trust is structured to be a grantor trust, the grantor pays all the income tax, regardless of whether the trust distributes the income or not. Even if the trust’s income is paid out to someone else (like a beneficiary), the grantor is still on the hook for the tax bill in a grantor trust scenario.

• Common examples of grantor trusts include certain revocable living trusts (during the grantor’s life), Intentionally Defective Grantor Trusts (IDGTs), Grantor Retained Annuity Trusts (GRATs), certain life insurance trusts, and other irrevocable trusts where the grantor kept specific powers as defined in IRC §§ 671–679. For instance, if the grantor can substitute trust assets or if trust income can pay for life insurance on the grantor, the trust is likely a grantor trust for tax purposes.

Why it matters: In a grantor trust, the question “Who pays tax on trust income?” is simple: the grantor does. The trust does not file a normal income tax return (except perhaps an informational return) and beneficiaries do not pay tax on distributions (because that income was already taxed to the grantor).

This can be advantageous in estate planning: the grantor paying the tax effectively lets the trust grow without being diminished by taxes, which is like an additional gift to the trust beneficiaries (since the grantor’s payment of tax on trust income is not considered an additional gift). The downside is the grantor must have the means to pay that tax and is taking on the liability.

Example: John creates an IDGT (Intentionally Defective Grantor Trust), which is a complex trust deliberately drafted to be a grantor trust. The trust earns $50,000 of income and distributes $40,000 to John’s children. Because it’s a grantor trust, John (the grantor) must report the entire $50,000 on his personal tax return and pay the tax, even though he personally received no distribution.

The trust itself pays no income tax, and the children who got the $40k distribution don’t pay income tax on it (since John is covering it via the grantor trust rules).

Non-Grantor Trusts – Trust or Beneficiaries Pay the Tax

If a trust is not a grantor trust, it is a separate taxpayer. Complex trusts usually fall in this category (non-grantor trusts) unless specific grantor powers apply. In a non-grantor trust:

• The trust files its own tax return and can owe taxes. A complex trust must file a Form 1041 (U.S. Income Tax Return for Estates and Trusts) each year and report its income and deductions. It will calculate how much of its income is taxable to the trust vs. taxable to the beneficiaries based on distributions made.

• Income the trust retains is taxed to the trust. Any income that a complex trust does not distribute to beneficiaries by the end of the year (or within a limited grace period in the next year) will be taxed to the trust itself. The trust pays federal income tax (and possibly state tax) on that retained income.

• Income distributed to beneficiaries is generally taxed to those beneficiaries. A complex trust can deduct the income it distributes to beneficiaries (up to a certain limit, explained by Distributable Net Income below). The beneficiaries then report that income on their own tax returns (via Schedule K-1 from the trust) and pay the tax instead of the trust.

In summary, for a non-grantor complex trust, the trust pays tax on undistributed income, and beneficiaries pay tax on distributed income. There is no grantor involvement in paying tax, because by definition the grantor is not taxed in a non-grantor trust (except possibly for gift or estate tax considerations, which are separate from income tax).

Simple trust vs. complex trust recap: A simple trust (non-grantor) must distribute all income, so it typically ends up with the beneficiaries paying all the income tax (since the trust deducts 100% of income distributed). A complex trust has the option to retain income; when it does, it picks up the tax on that portion. If it distributes some or all of the income, that portion shifts to the beneficiaries’ tax returns.

Complex trusts can also distribute principal (corpus) to beneficiaries. Principal distributions are not considered taxable income to the beneficiary (since that money was usually already subject to tax when earned in a prior year or is the initial funded amount).

Thus, beneficiaries generally do not pay tax on principal distributions or on distributions in excess of the trust’s income.

Example: The Smith Family Trust (a complex, non-grantor trust) earns $20,000 of dividends and $5,000 of capital gains this year. The trustee distributes $15,000 to the trust’s beneficiary, Alice, and retains the rest to reinvest. The trust will take a deduction for the $15,000 distributed to Alice, so that portion of income will be taxable to Alice.

The remaining $10,000 of income ($5,000 dividends + $5,000 capital gain that were not distributed) will be taxed to the trust itself. Alice will receive a Form K-1 showing $15,000 of taxable income from the trust, which she’ll report on her 1040. The trust will pay its own tax on the $10,000 retained (likely at high trust tax rates, as we’ll discuss).

Had this been a simple trust, the trustee would have been required to distribute the full $25,000 of income to Alice, making her responsible for taxes on the full amount (and the trust would pay $0).

Finally, note that charitable trusts (like a Charitable Remainder Trust) have their own special tax rules. For example, a Charitable Remainder Trust (CRT) is generally tax-exempt at the trust level (it doesn’t pay income tax on retained income), but when it makes distributions to the non-charitable beneficiary, those distributions carry out taxable income to that beneficiary in a specific tiered order (ordinary income first, then capital gains, etc.).

A CRT is beyond the scope of this article but worth mentioning as an exception: a CRT can accumulate income without paying tax currently, then beneficiaries pay when distributions occur, according to special rules.

Federal Tax Rules for Complex Trusts

Federal taxation of complex trusts is governed by Subchapter J of the Internal Revenue Code. The IRS treats a trust as a separate taxpayer, but with some unique provisions that differ from individuals. Here are the key federal tax principles for complex trusts:

• Trust Tax Rates: Trusts have a highly compressed tax bracket schedule. For 2025, a trust’s top federal income tax rate (37%) kicks in at roughly around $14,000 of taxable income (this threshold adjusts with inflation). By comparison, an individual filer doesn’t hit 37% until hundreds of thousands of dollars of income. This means if a complex trust retains significant income, it can reach the highest tax rate very quickly. Trusts also face the 20% top capital gains rate and the 3.8% Net Investment Income Tax on relatively low amounts of income. Bottom line: from a pure tax rate perspective, beneficiaries often have lower rates than a trust (especially if the beneficiaries have modest income), which is one reason trustees often distribute income rather than accumulate it – to take advantage of lower individual brackets.

• Personal Exemption: Unlike individuals who get a standard deduction, trusts get a small personal exemption. A complex trust gets an annual $100 exemption (a very small reduction in taxable income), while a simple trust gets a $300 exemption. (An estate gets $600.) This is minor, but it’s one more reason trusts end up paying tax on nearly all their income if retained.

• Form 1041 Filing: A complex trust must file IRS Form 1041 each year if it has gross income of $600 or more, or any taxable income, or if it has a beneficiary who is a nonresident alien. Form 1041 is the “U.S. Income Tax Return for Estates and Trusts.” The trustee (or the fiduciary or tax preparer) completes this form, reporting all the trust’s income (interest, dividends, rents, capital gains, etc.), and deductions (trustee fees, state taxes, attorney/accountant fees, etc.). One critical deduction is the “Income Distribution Deduction”, which we discuss next. The Form 1041 is generally due by April 15 (just like individual returns), with an option to extend.

• Schedule K-1 to Beneficiaries: If the complex trust distributes income to beneficiaries, the trust issues each beneficiary a Schedule K-1 (Form 1041). The K-1 shows the amount and character of income that the beneficiary must include on their own tax return.

• For example, if the trust had $5,000 of qualified dividends and it distributed half of all its income to the beneficiary, the K-1 would report $2,500 of qualified dividends to that beneficiary (which the beneficiary would then report on their 1040, enjoying the favorable qualified dividend tax rate on that portion).

• The K-1 essentially allocates the trust’s income (up to the amount distributed) among the beneficiaries. Beneficiaries use the K-1 to know how much income from the trust to report, and in what categories (ordinary income, qualified dividends, capital gains, tax-exempt interest, etc.).

• Trust Deductions and Credits: Complex trusts can deduct certain expenses the same way individuals can (e.g. investment advisory fees, state income taxes paid, charitable contributions if permitted by the trust terms, etc.), though some deductions were limited by the Tax Cuts and Jobs Act (2017) – for example, miscellaneous itemized deductions (like some investment fees) are suspended through 2025 for individuals, but trusts have some special treatment under regulations for certain deductions necessary for trust administration. Trusts can also have credits (like foreign tax credits) that might flow out to beneficiaries or be used by the trust.

Now, the most important concept in trust taxation is Distributable Net Income (DNI).

Distributable Net Income (DNI) – The Key to Trust Taxation

Distributable Net Income (DNI) is a tax concept unique to trusts and estates. In simple terms, DNI sets the maximum amount of income that can be taxed to beneficiaries and correspondingly deducted by the trust. It acts as a cap on the income distribution deduction and prevents double taxation or untaxed income. Here’s how it works:

• Definition: DNI is the trust’s taxable income, adjusted by excluding capital gains (typically) and excluding any extraordinary dividends or tax-exempt income portions that are allocated to principal. It’s essentially the total pool of income that can be thought of as “available for distribution” for tax purposes. Think of DNI as the pie that can be sliced between trust and beneficiaries for tax allocation.

• Why exclude capital gains? Generally, capital gains are allocated to principal under trust law and thus are not part of DNI (which is usually equivalent to trust accounting income). Unless the trust instrument or state law (e.g., a unitrust provision or Uniform Principal and Income Act (UPIA) allocation) says otherwise, capital gains stay with the trust. That means if a trust sells an asset and realizes a capital gain, it usually pays the tax on that gain itself (because capital gains are not ordinarily counted in DNI to pass out).

• However, some complex trusts are drafted or authorized to treat capital gains as part of income (for example, to distribute them or to include in a unitrust payout). If so, those gains could be included in DNI and passed out to beneficiaries on the K-1. The trust’s governing document and applicable state law (often based on UPIA) guide the trustee on what counts as “income” versus “principal” for fiduciary accounting purposes, which in turn affects DNI.

• How DNI works: Suppose a complex trust has $30,000 of interest and dividends and $10,000 of capital gains in a year. By default, its DNI would be $30,000 (excluding the $10,000 capital gain which is allocated to corpus). If the trustee distributes $40,000 to the beneficiary, the distribution deduction is limited to $30,000 (the DNI).

• The beneficiary will be taxed on $30,000 of that distribution (the portion representing DNI), and the extra $10,000 the beneficiary received is treated as a tax-free return of principal (from a tax perspective). The trust would then pay tax on the $10,000 capital gain that was not included in DNI.

• In effect, DNI ensures that the IRS collects tax on the trust’s income one way or the other: either from the trust (if retained) or the beneficiary (if distributed), but not both and not neither.

• Income Distribution Deduction: The trust claims a deduction on Form 1041 for the amount of income distributed to beneficiaries, capped at DNI. This is how the trust “transfers” the tax liability to the beneficiaries. The beneficiaries then pick up that income (via K-1) so that amount doesn’t escape taxation.

• If a trust distributes more than its DNI (for example, dipping into principal), the amount above DNI is not deductible to the trust (and thus the trust effectively will still pay any tax associated with that portion, though usually there’s no tax on distributing principal itself) and that portion above DNI is not taxable to the beneficiary (because it’s considered a non-taxable distribution of corpus).

• Tax-Exempt Income: If a trust earns tax-exempt income (say, interest from municipal bonds), that income is part of DNI for purposes of determining how much gets allocated to beneficiaries, but the tax-exempt character carries out. For example, if a trust has $5,000 of muni bond interest and it distributes it, the beneficiary’s K-1 will show $5,000 of tax-exempt interest (which the beneficiary reports but doesn’t pay tax on, aside from it possibly affecting things like AMT or certain tax credit calculations).

• The trust can’t take a deduction for distributing tax-exempt income (since it wasn’t taxable to begin with), but it does include it in DNI to properly allocate between trust and beneficiary. The upshot: tax-exempt income stays tax-exempt, whether retained or distributed, but who reports it still depends on distributions.

• 65-Day Rule (IRC §663(b)): Complex trusts have a useful election called the 65-day rule. This allows a trustee to make a distribution to beneficiaries within 65 days after the close of the tax year and treat it as if it were made on the last day of the prior year. In practice, this gives trustees a window (typically until early March) to decide to distribute income out to beneficiaries after seeing the trust’s year-end results, thereby carrying out DNI and reducing the trust’s own tax burden for the prior year. Many trustees use this to fine-tune who pays the tax.

• For example, if a trust’s income for the year turned out higher than expected, the trustee can, in late January or February, distribute more to beneficiaries and elect to apply it to last year, so the trust doesn’t get stuck paying tax at 37% on that income. However, not all states follow the 65-day rule for state tax purposes (Massachusetts, for instance, does not recognize the federal 65-day election for its state trust tax).

In short, DNI is the mechanism that balances taxation between trust and beneficiaries in a complex trust. It ensures the core question – “Who pays the tax?” – is answered fairly and without omission or double tax.

If income stays in the trust (within DNI), the trust pays. If income goes out to beneficiaries, they pay. Anything beyond DNI that goes out is considered principal and carries no tax (since someone already paid when it was earned or contributed).

Taxation of Different Types of Income in a Complex Trust

It’s also important to note that the character of income retains its character as it passes through to beneficiaries (often referred to as the “character passing out with DNI”). For example:

• Ordinary income (like interest, non-qualified dividends, rent) distributed to a beneficiary is taxed as ordinary income to them.

• Qualified dividends and long-term capital gains that are part of a distribution (and included in DNI) will keep their preferential tax rates for the beneficiary (e.g. a qualified dividend distributed will be taxed at the beneficiary’s qualified dividend rate, say 15%, rather than ordinary rates).

• Tax-exempt interest remains tax-exempt to the beneficiary if distributed.

• Capital gains typically are not distributed (as explained, usually taxed to trust), but if they are, then the beneficiary would get them on the K-1 and apply capital gains tax rates.

A complex trust will often allocate different classes of income proportionately to distributions. For example, if half of the trust’s DNI is being distributed, the distribution carries out half of each category of income (half the interest, half the dividends, etc.) unless the trust document or local law allows some ordering or specific source allocation.

Example of Trust Tax Calculation

Let’s illustrate the federal tax calculation in a step-by-step example:

• Trust XYZ (a complex trust, non-grantor) has the following in 2025: $50,000 of taxable interest income, $10,000 of dividend income, and $20,000 of long-term capital gains. It has no deductible expenses aside from the personal exemption.

• The trustee decides to distribute $40,000 to the sole beneficiary, Jane, by the end of 2025.

• DNI calculation: Usually DNI will exclude capital gains. So DNI might be $50,000 + $10,000 = $60,000 (interest + dividends, assuming those are all accounting income; capital gains $20k excluded).

• The trust’s income distribution deduction is limited to the lesser of the actual distribution or DNI. Actual distribution was $40,000; DNI is $60,000; so deduction = $40,000.

• On Form 1041, trust reports $60k ordinary income (interest+dividends) and $20k capital gain. It deducts $40k for the distribution to Jane. So the trust’s taxable income would be: $60k + $20k = $80k gross income, minus $40k distribution deduction, minus $100 exemption = $39,900 taxable (which is mostly the undistributed $20k gains and $19,900 of undistributed ordinary income leftover). The trust pays tax (at trust rates) on $39,900.

• Jane gets a K-1 showing $40,000 of income from the trust. What kind? Since DNI was $60k of ordinary income and the trust distributed $40k (which is 2/3 of the DNI), Jane’s $40k carry-out will consist of 2/3 of each type of ordinary income: that might be roughly $33,333 interest and $6,667 dividends (qualified or not as per what trust had, but let’s say they were qualified dividends – then Jane gets that portion as qualified dividends on her tax return). Jane will include those amounts on her 1040 and pay tax at her rates (which might be lower than trust’s).

• The $20k capital gain stayed with the trust (not in DNI, not distributed). The trust will pay capital gains tax on that (likely 20% federal plus any state).

• If the trustee had distributed all $60k of DNI to Jane, the trust would deduct $60k, and only pay tax on the $20k capital gain (since still not in DNI). Jane would then be taxed on $50k interest and $10k dividend at her rates.

• If the trustee had distributed even the $20k of principal (capital gain) to Jane as well and if the trust’s terms allowed treating it as income, they could have potentially included it in DNI. But typically, distributing principal doesn’t give a deduction or carry out that capital gain (except in states with throwback rules or special elections).

• This example shows how the division of the tax burden is largely in the trustee’s hands through distribution decisions (within the limits of the trust’s terms and fiduciary duty).

Special Considerations

• Throwback Rules: In the past, complex trusts that accumulated income over multiple years and then made a large distribution could trigger a complex set of “throwback tax” calculations to tax the previously undistributed income to the beneficiary (to prevent avoidance of higher brackets by accumulating in trust). The throwback rule for domestic trusts was largely repealed in 1997, so U.S. complex trusts today generally don’t have to worry about throwback for domestic accumulations. However, some states have their own throwback taxes (more on that in the state section) and foreign trusts still have throwback rules for U.S. beneficiaries. States like California, New York, Pennsylvania, and New Jersey, for example, may impose a state throwback tax when a trust that hasn’t been paying state tax distributes previously accumulated income to an in-state beneficiary. So, while not a federal issue for domestic trusts, beneficiaries should be aware of possible state implications if their trust accumulated income in a no-tax state and then pays it out to them in a high-tax state.

• Alternative Minimum Tax (AMT): Trusts, like individuals, can be subject to AMT if they have certain preference items. This is relatively rare now for most trusts after 2018 (because many deductions that triggered AMT were removed), but something to note if the trust has tax-exempt interest (municipal bonds) which could trigger AMT due to private activity bonds, etc.

• Uniform Principal and Income Act (UPIA): Most states have adopted UPIA rules that guide trustees on what counts as income vs. principal for trust accounting purposes. For example, stock dividends, bond interest, rental income are typically income; proceeds from selling an asset at a gain are principal (unless the trust says otherwise). The trustee’s allocations under UPIA can influence DNI indirectly. UPIA also allows some adjustments in favor of fairness to beneficiaries (e.g., allocating some capital gain to income for certain trusts, or treating part of total return as income in a unitrust). Trustees should be mindful that their accounting decisions (governed by trust law like UPIA) can affect the tax outcome (since it affects DNI). The Uniform Trust Code (UTC), which many states have adopted, also provides a standardized set of trust laws but doesn’t directly change tax rules—it does, however, shape fiduciary duties and definitions that can indirectly impact trust administration and, by extension, tax reporting (for instance, decanting a trust or modifying it under UTC provisions could alter who is considered a beneficiary and where, with potential tax ramifications).

• Fiduciary Responsibility: The trustee (or trustees) of a complex trust have a fiduciary duty to handle the trust’s tax filings and payments. The IRS holds the trust’s fiduciary responsible for filing Form 1041 and paying any tax due out of the trust’s assets. Trustees need to be careful to either pay estimated taxes on behalf of the trust during the year (if the trust will owe) or ensure beneficiaries are aware of estimated tax obligations if large distributions are made (to avoid beneficiary underpayment penalties). Often, tax attorneys or CPAs are engaged to prepare trust tax returns and advise on optimal distribution strategies. This is where tax attorneys play a key role: ensuring the trust is in compliance with IRS rules and helping minimize the overall tax burden through smart planning (like timing distributions or selecting trust situs, which we’ll discuss for state taxes).

Now that we’ve covered federal taxation, let’s move to the complicated patchwork of state tax rules for complex trusts.

State Taxation of Trusts: 50 States, 50 Rules

Beyond federal taxes, a complex trust may owe state income taxes. State trust taxation is often complex because each state has its own rules for when a trust is considered a “resident” trust and thus subject to tax on all its income. If a trust is not a resident of a given state, that state typically taxes only the income sourced within its borders (for example, income from real estate located in that state). It’s possible for multiple states to claim a piece of the trust’s income, or conversely, for a trust to arrange its affairs so that no state taxes its income. This section will explain the common factors states use and then provide a comprehensive table of all 50 states’ trust taxation rules.

How States Determine Trust Residency (and Who Gets Taxed)

States generally consider some combination of the following factors to decide if a trust is a resident trust subject to full taxation in that state:

• Residence of the Grantor/Settlor at Trust Creation: Many states say if the trust was created by a resident (either via a will of a resident decedent or an inter vivos trust set up by a living resident), then the trust is a resident trust of that state. This means, for example, if Grandma lived in Pennsylvania and established an irrevocable trust, Pennsylvania might treat that trust as a PA resident trust forever (unless it breaks the link, which we’ll get to). Similarly, if someone dies a resident of Illinois and their will creates a testamentary trust, Illinois treats that trust as an IL resident trust. The logic is the trust’s “origin” was tied to the state. However, courts have sometimes limited this when the trust no longer has any other connection to the state (e.g., all trustees and beneficiaries moved away).

• Location of Trust Administration: Some states focus on where the trust is administered. Administration means where the day-to-day management occurs, often where the trustee is located or where trust records are kept. For example, Colorado taxes a trust if it is administered in Colorado. Iowa law considers the residence of a trust to be where it is administered. If you have a corporate trustee in a particular state handling the trust, that could make the trust a resident of that state.

• Residence of the Trustee (Fiduciary): A number of states look at the residency of the trustee(s). For instance, California taxes a trust if any trustee is a California resident. Arizona similarly treats trusts with Arizona resident fiduciaries as resident trusts. Virginia includes trusts with a Virginia trustee. The idea is the trustee is the legal owner of the trust assets for administration purposes, so their residence ties the trust to that state.

• Residence of the Beneficiary/Beneficiaries: Some states consider whether the trust’s beneficiaries are residents. This is more controversial (as we’ll discuss with a Supreme Court case), but states like Georgia, North Carolina, North Dakota, Alabama, and California have in the past asserted that a trust is taxable if a beneficiary is a resident, especially if that beneficiary has a current right to income. California specifically taxes a trust if it has any non-contingent beneficiary who is a California resident (a non-contingent beneficiary means someone who is currently entitled to income or principal or whose interest is not subject to a condition precedent). North Carolina tried to tax trusts based on beneficiary residence alone, which led to a major court case (Kaestner, discussed below).

• Source of Income / Location of Assets: Every state with an income tax will tax income that is sourced within the state, even for nonresident trusts. For example, if a trust (no matter where formed) owns rental real estate in New York, New York will tax the rental income as NY-source income. But beyond that, some states consider the mere presence of in-state assets as a factor for residency. For instance, New York doesn’t explicitly use assets for residency (it uses grantor’s residence), but California will tax any trust (resident or non-resident) on California-source income (so if a trust has a business or property in CA, that portion of income is taxed by CA). Typically, intangible assets (stocks, bonds) are sourced to the state of the trust or beneficiary rather than having a situs, but real estate and business income is sourced to a state.

• Governing Law / Situs Clauses: A few states consider if the trust instrument says it’s governed by that state’s laws or if the trust has its official situs in the state. Delaware for example is often chosen as a trust situs (governing law) but Delaware only taxes a trust in limited circumstances (more on Delaware below). Idaho has a rule that a trust is resident if it meets a combination of factors, including if Idaho law governs the trust.

• Other Factors: Some states have unique tests. For example, Illinois, Maine, and others historically taxed based on the settlor’s residence at creation, but court cases (like Fielding in Minnesota 2018 and Kaestner in North Carolina 2019) have put pressure on states to require more current connections. Missouri only taxes a trust if there’s a Missouri resident beneficiary as of the last day of the year (an interesting rule). Ohio had provisions for trust with Ohio resident beneficiaries. Tennessee used to tax trusts on certain investment income (the Hall tax) but that has been repealed.

When a trust is considered a resident trust in a state, typically that state will tax all of the trust’s income (just as it would for a resident individual), regardless of where the income is from, but often still allow the distribution deduction so that distributed income is taxed to beneficiaries (who may be in another state). If two states both claim a trust as resident, there is potential double taxation on the undistributed income (since each state might want to tax it). In practice, trusts try to avoid being dual-resident, or if they are, sometimes state tax credits or allocations might mitigate it.

When a trust is a nonresident in a state, the state will tax only the income sourced to that state. For example, New York will tax a nonresident trust’s New York rental property income but not its investment portfolio income.

States With No Income Tax: It’s worth noting that a number of states do not impose any income tax on trusts (or individuals). These include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming (none have state income tax), as well as Tennessee (no income tax as of 2021) and New Hampshire (no tax on earned income; NH has a tax on interest/dividends, but not on trust ordinary income or capital gains in general). For this reason, wealthy families often choose to situs a trust in a state like Delaware, South Dakota, Nevada, or Alaska, which have favorable trust laws and no (or minimal) income tax. Delaware is notable: it has a state income tax, but it offers an exemption for “Delaware resident trusts” that have no Delaware resident beneficiaries – effectively a trust in Delaware can accumulate income tax-free for out-of-state beneficiaries.

Next, we provide a state-by-state table summarizing how each of the 50 states treats complex trust income taxation. This includes whether the state taxes trust income and what factors make a trust a resident taxpayer in that state, as well as any special rules about beneficiaries.

50-State Complex Trust Taxation Rules

Below is a comprehensive table of all 50 U.S. states and their approach to taxing trust income (for non-grantor, complex trusts). It lists the key factors that cause a trust to be treated as a resident trust (taxed on all its income) in that state, and notes unique provisions like throwback taxes or exemptions. Keep in mind state laws can change, and specific situations can be nuanced; this table provides the general rule for each state:

Table Key: “Administered in [State]” generally means the trust is managed in that state (often where the trustee is located). “Created by [State] resident” refers to the residency of the trust’s grantor (settlor) at the time of trust creation or at death for testamentary trusts. “Resident beneficiary” indicates the state may consider the trust taxable if a beneficiary is a resident. “No income tax” means the state does not levy an income tax at all.

Observations from the table: Some states rely purely on the settlor’s original residency (e.g., PA, IL, VA), some on the trustee’s location (e.g., AZ, CA, KY), some on administration situs (e.g., CO, IA, IN), and some on beneficiary residence (e.g., GA, CA, AL in part). Many use a combination. A handful of states (notably NV, SD, WY, AK, FL, TX, TN, NH) impose no or minimal tax, which is why many trusts are moved or established there. Delaware is unique in taxing trusts only if there are in-state beneficiaries. States like New York have mitigation rules to avoid taxation if the trust has left the state (no NY trustees/assets). States also react to court rulings: after the Kaestner case, states are careful about using beneficiary residence alone; after Fielding, using only settlor’s past residence is shaky if no current ties.

State Tax Planning for Trusts

Given this complexity, estate planners often choose the trust’s governing state (situs) carefully to minimize state income tax. For example, someone in a high-tax state (say, California or New York) might create a complex trust and appoint a trustee in a no-tax state (like Delaware or Nevada) and ensure no beneficiary is in the settlor’s state, thereby attempting to have the trust escape home-state taxation. Often “situs change” or “trust decanting” techniques are used to move an existing trust to a more favorable state.

It’s also common to structure trusts as Incomplete Non-Grantor (ING) trusts in Delaware, Nevada, etc., to purposefully avoid state tax on investment income while the grantor is living (this is an advanced strategy: essentially making a deliberately non-grantor complex trust that the grantor can add assets to without triggering gift tax, used in some states to avoid state income tax on capital gains).

Trustees must also consider state income tax credits: if a trust is resident in one state but earns income taxed in another (e.g., source income), usually the resident state will give a credit for taxes paid to the source state, to prevent double taxation. Beneficiaries similarly can often credit taxes paid by the trust on income they received in their own state returns.

Key Court Cases: We mentioned a few –

• Kaestner (2019) – Supreme Court said NC taxing a trust solely due to in-state beneficiaries with no distribution violates Due Process Clause. This set precedent that states need a tangible connection (assets, trustee, actual distributions) to tax a trust.

• Fielding (Minn. 2018) – MN Supreme Court invalidated taxing trusts based only on grantor’s historical domicile, when everything else moved out of state.

• McNeil (Pa. 2013) – a case where Pennsylvania courts struck down PA taxing a trust that had no PA trustees or assets, even though the settlor was PA resident.

• Blue (Mich. 1990) – Michigan Court of Appeals similarly limited MI’s reach.

The trend is that courts are scrutinizing state trust taxation and often siding with taxpayers when the state’s only tie is the long-ago settlor residency. As a result, many high-tax states have carved out exceptions (NY’s three-factor exemption, NJ’s administrative practice, etc.) to avoid constitutional issues.

Beneficiaries and State Tax: Regardless of trust-level tax, beneficiaries owe state income tax on distributions in their own resident state (just as they pay federal). If a beneficiary lives in a state with income tax, they will report the trust income from K-1 and pay state tax on it. If the trust also paid state tax on the same income (because the trust was resident in another state), often the beneficiary’s state will allow a credit to avoid double taxation (for instance, a beneficiary in NY receiving income from a trust that paid tax in CA might claim a credit on NY return for the CA taxes that are attributable to that income).

In summary, state taxation can dramatically affect “who pays tax” on trust income. In some cases, a trust might pay a state and the beneficiary pays their state as well (different states) – thus the family pays two states on the same income (though hopefully with credits to offset). Or careful structuring can result in no state tax at the trust level (situs in a tax-free state) and then only the beneficiary’s home state taxing when income is distributed. In extreme cases, if neither trust nor beneficiary are in a taxing state (and income isn’t sourced in one), trust income could avoid state tax entirely.

State rules are one reason trustees sometimes choose to retain income despite high federal trust tax rates: If the beneficiary lives in a state like California (13.3% tax) but the trust is sitused in a state with 0% tax, the trust might decide to pay the federal tax at 37% but avoid that 13.3% state hit, effectively saving overall tax for the family (especially if the beneficiary would already be in the top federal bracket themselves, there’s no federal difference, only state). This is a trade-off: the trust’s federal rate is high, but the state savings could be significant. Professional advice from a tax attorney or CPA is crucial in weighing these decisions.

Now that we’ve covered the rules, let’s consider some common scenarios and practical examples, and then discuss the advantages and disadvantages of various approaches to complex trust taxation.

Examples of Complex Trust Tax Scenarios

To solidify who pays the tax in different circumstances, here are several common tax scenarios for complex trusts and how the tax liability is allocated:

These scenarios show how flexible a complex trust can be in allocating tax liability. The trustee’s decisions on distributions (and the trust’s grantor status) directly determine who writes the check to the IRS.

It’s worth emphasizing that the trust and beneficiaries will never both pay tax on the same income. It’s one or the other. The distribution deduction and DNI mechanism ensure that there is no double taxation in scenarios 2 and 3. Either the trust pays (retained portion) or the beneficiary pays (distributed portion). In scenario 1, it’s all trust; in scenario 2, all beneficiary. In scenario 3, split accordingly. Scenario 4 is a different animal – the grantor pays instead of either trust or beneficiary.

Also, note that capital gains are usually retained by the trust (thus taxed to the trust) unless specifically planned otherwise. For example, in scenario 2, even if the trust “distributed all income,” if it had a capital gain, it might still pay tax on that gain unless it actually distributed the proceeds and is allowed to include that in DNI. Many complex trusts strive to keep capital gains taxed at the trust if the beneficiary won’t get a benefit (since either way it’s 15% or 20% capital gains; but if the beneficiary is in a low bracket it could help to distribute, while if the trust is in a state with no tax and beneficiary in high-tax state, trust paying might be better despite the high bracket).

In practice, trustees will often run projections with a CPA to decide how much to distribute near year-end to optimize combined taxes for the trust and beneficiaries.

Pros and Cons of Trust Taxation Strategies

Complex trusts provide leeway in tax planning: the trustee can choose to retain income (trust pays) or distribute income (beneficiary pays), and the estate planner can choose to make a trust a grantor trust (grantor pays) or a non-grantor trust. Each approach has advantages and disadvantages. Below is a pros and cons comparison of three approaches to taxing trust income:

In practice, trustees and planners may use a combination of these strategies over the life of the trust. For example, while the grantor is alive, maintain it as a grantor trust (grantor pays). After the grantor’s death (trust becomes non-grantor), perhaps distribute income to a lower-tax-bracket beneficiary. Or accumulate income for a few years while beneficiaries are in high-earnings years, then distribute in later years when beneficiaries’ own income is lower (thus taxed less). The flexibility of a complex trust allows tailoring the tax strategy to family circumstances and tax law changes.

It’s also common to see provisions where the trust can reimburse the grantor for taxes (known as a tax reimbursement clause) if needed, which provides some relief if the grantor trust tax burden gets too high – but care is needed to avoid including such provisions if asset protection is a concern (in some states, giving the trustee discretion to reimburse can be okay, but an obligation to reimburse could make trust assets reachable by the grantor’s creditors).

State tax planning (situs changes, etc.) is another strategy, as mentioned. The pros/cons table above doesn’t explicitly cover “moving a trust to a no-tax state,” but generally:

• Pro: No state income tax on accumulations (potential huge savings over time).

• Con: Often requires using an out-of-state trustee or trust company, which could mean less familiarity or higher trustee fees; also some states might still attempt to tax based on original settlor domicile, requiring legal navigation.

In summary, there is no one-size-fits-all answer to whether a complex trust should retain income or distribute it – it depends on tax brackets, state laws, the grantor’s intent, beneficiaries’ needs, and asset protection considerations. A Ph.D.-level understanding, as we’ve aimed for here, helps in analyzing all these moving parts.

Before we conclude, let’s address some frequently asked questions in a straightforward yes/no format, as often seen on forums.

Frequently Asked Questions (FAQs) – Complex Trust Taxation

Q: Do beneficiaries of a complex trust have to pay income tax on distributions?
A: Yes. Beneficiaries pay income tax on distributions of the trust’s income (reported to them on Schedule K-1), up to the amount of the trust’s DNI. Distributions of principal are not taxable to them.

Q: Does a complex trust itself pay income taxes?
A: Yes. A complex trust pays income tax on any income it retains (undistributed income). The trust files Form 1041 and pays tax at the trust tax rates on retained taxable income.

Q: Can the same income be taxed to both the trust and the beneficiary?
A: No. Income is taxed either to the trust or to the beneficiary, but not both. If the trust takes a distribution deduction for income paid out, the beneficiary pays; if not distributed, the trust pays.

Q: In a grantor trust, does the trust pay the tax?
A: No. In a grantor trust, the grantor (trust creator) pays all the income tax on the trust’s income. The trust is ignored for income tax purposes, so the trust itself doesn’t pay.

Q: Are trust tax rates higher than individual rates?
A: Yes. Trusts reach the highest federal tax bracket (37%) at a very low income level (around $14,000). Individuals have much larger brackets. Thus, trust-retained income often faces higher marginal rates.

Q: Is a trust distribution considered taxable income for the beneficiary?
A: Yes. If the distribution includes income (interest, dividends, etc.), it’s taxable to the beneficiary. If it’s a distribution of previously taxed income or principal, then no, that portion isn’t taxable.

Q: Can a complex trust avoid state income tax?
A: Yes. By choosing a trust situs in a state with no income tax (and having no resident beneficiaries in high-tax states), a complex trust can lawfully avoid state income taxes on its income.

Q: Does the trustee have to pay trust taxes out of their own pocket?
A: No. The trustee uses trust assets to pay any trust income tax liability. The trustee isn’t personally liable for the tax, provided they properly handle trust funds (unless they distribute all assets and leave taxes unpaid).

Q: Does a trust file a tax return every year, even if it paid all income to beneficiaries?
A: Yes. The trust must file Form 1041 annually if it had any income over $600 or any taxable income. Even if it distributes all income, it files to report income and claim the distribution deduction (and to issue K-1s).

Q: If a beneficiary lives in a different state than the trust, do they pay tax twice?
A: No. The beneficiary pays tax in their own state on the distribution. The trust’s state typically doesn’t tax the distributed portion (it taxes the trust on undistributed income only). If two states tax the same income, usually a credit is available to prevent double taxation.