Trust Tax Rates 2026: How Trusts Are Taxed and When It Becomes a Problem

Written by Sam Brotman, J.D., LL.M. (Taxation), MBA — Managing Attorney, Brotman Law  ·  Updated May 2026

The Trust Tax Rate Problem in Plain English

Trust income tax rates are compressed into a very small income range. That is the core issue with trust taxation, and it drives most of the planning decisions people make around trusts.

For 2026, the federal income tax brackets for a trust or estate look like this:

For comparison, a single individual reaches the 37% bracket only at $609,350 of taxable income. A married couple filing jointly reaches it at $731,200. A trust hits 37% at $15,650. The entire span from 10% to 37% compresses into roughly $15,000 of income rather than $600,000.

This is not an accident of tax law. Congress has deliberately kept trust brackets compressed for decades, largely because a trust can otherwise be used to shelter income at lower rates indefinitely. The result is that any non-grantor trust accumulating meaningful income will hit the top rate quickly — and the tax planning around trusts is largely about whether that income can be shifted to beneficiaries instead.

How Trust Income Is Taxed: Form 1041 and the DNI Framework

A trust files Form 1041 (U.S. Income Tax Return for Estates and Trusts). On that return, the trust reports all income it received — interest, dividends, rents, royalties, capital gains, and ordinary business income — and then claims a deduction for the portion distributed (or required to be distributed) to beneficiaries. The balance — the income the trust keeps — is taxed at trust rates.

Each beneficiary receives a Schedule K-1 (Form 1041) showing their allocable share of trust income, deductions, and credits. That amount goes onto their personal Form 1040. The character of the income generally carries through: if the trust receives qualified dividends and distributes them, the beneficiary treats them as qualified dividends too.

Distributable Net Income (DNI)

Distributable net income (DNI) under IRC § 643 serves two purposes simultaneously. First, it is the maximum amount the trust can deduct for distributions to beneficiaries. Second, it is the maximum amount of those distributions that is taxable income to the beneficiary. DNI prevents both an unlimited deduction by the trust and unlimited inclusion by the beneficiary from exceeding what the trust actually earned.

The calculation starts with the trust's taxable income and then makes several adjustments — adding back the personal exemption, excluding capital gains allocable to corpus in most cases, and making other modifications. The result is a number that generally corresponds to the trust's ordinary accounting income.

One consequence worth noting: capital gains are typically taxed at the trust level, not passed through to beneficiaries. Under the default rules, capital gains are allocated to principal rather than distributable income, so they stay in the trust and get taxed there — at the compressed trust rates plus the 3.8% NIIT if applicable. This is a common surprise for trustees of trusts with appreciated assets.

The Net Investment Income Tax (NIIT) Stacks on Top

Under IRC § 1411, trusts (other than grantor trusts and certain exempt entities) pay a 3.8% net investment income tax on the lesser of: (1) undistributed net investment income, or (2) the excess of adjusted gross income over the dollar threshold at which the top bracket begins — which for trusts is that same $15,650 figure in 2026.

In practice, a trust with more than $15,650 of retained investment income faces a combined federal rate of 40.8% on that income — the 37% ordinary rate plus 3.8% NIIT. Add California's 13.3% top rate and the effective marginal rate on retained trust income can exceed 50% for California beneficiaries.

Simple Trusts vs. Complex Trusts: The Distribution Requirement Matters

The IRS uses these terms in a specific technical sense under IRC § 651 and § 661.

A simple trust must, under its governing document, distribute all current income to beneficiaries each year. It cannot make charitable contributions and cannot distribute corpus. Because it distributes everything, the trust pays little or no income tax itself — the income passes through to beneficiaries at their individual rates. The trust claims a $300 personal exemption on Form 1041.

A complex trust does not meet the simple trust requirements. It may have discretionary distribution authority, accumulate income, distribute principal, or make charitable contributions. These features give the trustee flexibility — but income the trustee chooses not to distribute is taxed in the trust at trust rates. The complex trust personal exemption is only $100.

The distinction matters most when a trustee has discretion. A trustee of a complex trust who accumulates income thinking they are "protecting" assets may be creating a significant tax cost: that income gets taxed at 37% in the trust rather than at whatever lower rate the beneficiaries would pay individually. In many cases, making the distribution and letting the beneficiary pay tax at their own rate produces a better after-tax outcome.

Grantor Trusts: The Bracket Problem Disappears

A trust is a grantor trust when the grantor retains certain powers or interests specified in the Code. The most common triggers include:

• Retaining a reversionary interest worth more than 5% of the trust corpus (IRC § 673)
• Retaining power to control beneficial enjoyment without a substantial adverse party (IRC § 674)
• Retaining administrative powers such as the ability to borrow without adequate interest (IRC § 675)
• Retaining the power to revoke the trust (IRC § 676) — a revocable living trust is a grantor trust
• Retaining the right to income for the grantor's benefit (IRC § 677)

For estate planning purposes, grantor trust status is often intentional. An Intentionally Defective Grantor Trust (IDGT) is structured so the grantor pays income tax on the trust's earnings — effectively making a tax-free gift to the beneficiaries, since the grantor's payment of the trust's tax bill does not count as an additional gift under Rev. Rul. 2004-64. The trust itself grows tax-free from the beneficiaries' perspective.

The tradeoff: if the grantor's personal income tax rate is lower than the trust bracket rate, grantor trust status is favorable. If the grantor is a high earner whose rate equals the trust's top rate anyway, the benefit is limited.

Grantor Trust Audit Risk

Intentionally structured grantor trusts — particularly those used in conjunction with installment sales, SLATs (Spousal Lifetime Access Trusts), or GRATs (Grantor Retained Annuity Trusts) — receive heightened IRS scrutiny. The IRS has specifically identified abusive grantor trust arrangements in published guidance, and certain structures have been subject to challenge on substance-over-form grounds. If you are using an IDGT as a planning vehicle, the documentation underlying the trustee's powers and the arm's-length nature of any sales to the trust is not a formality — it is the defense if the IRS audits.

California Trust Taxation: The FTB's Residency-Based Approach

The California Franchise Tax Board's approach to trust taxation is more aggressive than the federal framework. The key rules:

• Trustee residency: If all trustees are California residents, California taxes 100% of the trust's income. If the trust has both California-resident and non-resident trustees, the tax is apportioned.
• Beneficiary residency: Under the Supreme Court's ruling in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust (2019), a state cannot constitutionally tax trust income solely because a beneficiary resides in that state if the beneficiary has no right to demand the income. California's § 17742 conditions beneficiary-based taxation on the interest being "non-contingent" — meaning the beneficiary has a present, fixed right to receive trust distributions.
• Source income: California-source income (California real property, California business income) is taxable in California regardless of where the trust or trustees are located.

California's top income tax rate is 13.3%, applying to income over $1,000,000. The state does not have a counterpart to the federal NIIT exemption for non-grantor trusts. For a California trust or a trust with California-resident beneficiaries, the combined federal-plus-state marginal rate on retained income can be substantial.

One planning implication that sometimes comes up: moving a trust to a no-income-tax state like Nevada or South Dakota reduces future state tax on accumulated income — but only if the trustees also relocate and the California-resident beneficiaries' connection to the trust income is genuinely severed. The FTB will look at whether the redomestication is substantive. It is not enough to change the governing law on paper if the actual administration remains California-based.

When Trust Income Creates a Real Tax Problem

A few situations where trust taxation crosses from planning inconvenience into actual dispute territory:

Accumulation Trusts and the Throwback Rules

For domestic trusts established after 1969, the throwback rules under IRC §§ 665–667 generally no longer apply — income accumulated in the trust is just taxed at trust rates in the year it is earned, and there is no additional "throwback" tax when it is later distributed. But foreign trusts are a different matter. Under IRC § 668, accumulation distributions from foreign trusts can trigger an interest charge based on the time value of money, on top of the income tax — sometimes dating back decades. If you are administering a foreign trust or receiving distributions from one, the tax calculation is not straightforward.

Qualified Dividends and Capital Gains in Trusts

The preferential rates for qualified dividends and long-term capital gains — 0%, 15%, and 20% — also apply to trusts, but the thresholds are compressed just like the ordinary income brackets. For 2026, a trust reaches the 20% capital gains rate at $15,650 of taxable income. The NIIT applies on top, bringing the effective capital gains rate for a trust to 23.8% at the top. A California trust adds another 13.3% on top of that, for a combined marginal rate on capital gains exceeding 37%.

Excess Deductions on Termination

When a trust terminates, any excess deductions in the final year pass through to the beneficiaries on Schedule K-1. Under regulations finalized in 2020 (T.D. 9918), those excess deductions are miscellaneous itemized deductions — deductible only if they exceed 2% of the beneficiary's adjusted gross income, and suspended under current law through 2025. Starting in 2026, the 2% floor may apply again depending on legislative developments. Trustees administering terminating trusts should make sure the final year accounting addresses this correctly.

Disputes with the IRS and FTB Over Trust Characterization

The IRS and the FTB both have programs focused on trust-based tax shelters and abusive grantor trust arrangements. The disputes we see most often involve:

• Whether a purported grantor trust actually qualifies — specifically, whether the grantor's retained powers are genuine or formalistic
• Whether a family limited partnership or LLC held inside a trust is being valued correctly for estate and gift tax purposes
• Whether trust deductions (administrative expenses, trustee fees, attorney fees) are allocable to tax-exempt income and therefore non-deductible under IRC § 265
• Whether a redomesticated trust has genuinely severed California contacts for FTB purposes

These are legal disputes, not accounting disagreements. The underlying documents — trust agreement, trustee resolutions, correspondence — form the record, and that record matters enormously in how the audit or appeal resolves.

What a Tax Attorney Does That a CPA Typically Doesn't

The Form 1041 itself is a CPA's work — preparing the return, calculating DNI, allocating income to beneficiaries, and issuing K-1s. Most trust administration stays squarely in that lane and never needs an attorney.

The situations that do need an attorney:

• IRS audit of the trust or an underlying estate: An IRS examination of a trust return — or an estate tax audit where the trust's funding date or asset values are at issue — is a legal proceeding with appeal rights. The IRS's conclusions can be appealed to Appeals, and then to Tax Court. Having counsel involved from the beginning of an examination produces better outcomes than bringing in an attorney after the revenue agent has already made findings.
• FTB residency disputes: The FTB's position on trust residency — specifically, whether a beneficiary's California residence requires California taxation of out-of-state trust income — has been in active litigation. The constitutional parameters are not fully settled, and the FTB's administrative positions are sometimes more aggressive than the case law supports.
• Grantor trust restructuring: If a grantor trust is being restructured to remove grantor trust status (or vice versa), the transaction has income tax consequences under Rev. Rul. 77-402 and potentially gift tax consequences. The planning should involve both the attorney and the CPA working from the same set of assumptions.
• Estate administration disputes: Disputes between co-trustees, or between trustees and beneficiaries, over investment decisions, distribution discretion, or trustee fees often have an embedded tax dimension. A trustee who makes a distribution that isn't required under the trust terms, and that triggers an adverse tax result for the trust or a beneficiary, can face personal liability.

If you are looking at a trust with accumulated income taxed at the top rate, a redomestication question, an IRS notice involving a trust return, or a dispute over how trust income is being reported to beneficiaries — those are the situations where a conversation with a tax attorney is worth having before anything else happens.