Nongrantor Trusts
A nongrantor trust is a trust that pays its own income tax. It is a separate taxpayer with its own return, its own identification number, and its own rate schedule. Most of the time, estate planners work hard to avoid that status, because a trust reaches the highest federal bracket on a few thousand dollars of retained income. But there are situations where a trust that is its own taxpayer is exactly what the plan needs: when the beneficiaries are in lower brackets than the person who funded it, when the trust must qualify for deductions or exclusions of its own, when the grantor no longer wants to carry the tax, or after the grantor has died and the trust has no choice.
Understanding how a nongrantor trust is taxed, and how income can be moved out of it to beneficiaries, is what separates a trust that quietly loses a large share of its earnings to tax from one that is administered well.
Milvidskiy Law Group P.C. drafts nongrantor trusts where they are the right tool, converts grantor trusts to nongrantor status when circumstances call for it, and advises trustees on the distribution and reporting decisions that determine how much tax a trust actually pays.
Key Takeaways:
- A nongrantor trust is taxed on the income it keeps and deducts the income it distributes, which is then taxed to the beneficiaries. For 2026 a trust pays the top 37% federal rate on retained ordinary income above $16,000, so distribution decisions drive the tax result.
- Nongrantor status is chosen when beneficiaries are in lower brackets than the grantor, when the trust needs its own deductions or exclusions, or when the grantor should not or cannot bear the tax. It is also the automatic status of every trust after the grantor’s death.
- State income tax on nongrantor trusts depends on the residence of the grantor, the trustee, and the beneficiaries, and each of New York, New Jersey, and Connecticut applies different rules. The choice of trustee can be a tax decision.
How a Nongrantor Trust Is Taxed
Retained income versus distributed income
A nongrantor trust computes its taxable income much as an individual does, then deducts the amount it distributes to beneficiaries, up to a figure called distributable net income. The beneficiaries report what they receive, in the same character it had inside the trust: ordinary income, qualified dividends, or capital gain. The trust pays tax only on what it keeps. A trust that distributes all of its income each year pays little or no tax itself; a trust that accumulates income pays at the trust rate schedule.
Compressed brackets
The trust rate schedule is compressed. According to the Internal Revenue Service’s inflation adjustments for 2026, a trust’s retained ordinary income is taxed at 10% up to $3,300, then at 24% and 35% in narrow bands, and at 37% above $16,000. An individual reaches the 37% rate only at several hundred thousand dollars of income. A trust that accumulates $100,000 of interest therefore pays far more tax than a beneficiary in a middle bracket would pay on the same income. Capital gains and qualified dividends have their own preferential rates inside a trust, also on compressed thresholds, and the net investment income tax applies at the same low level.
Capital gains and the distribution deduction
Capital gains are generally taxed to the trust rather than carried out to beneficiaries unless the trust instrument or consistent trustee practice treats gains as distributable. That drafting choice matters for a trust expected to sell appreciated assets, and it is one of the items we address when a nongrantor trust is created.
Timing elections
Trustees have a short window after the end of the tax year in which distributions can be treated as made in the prior year, which allows the tax picture to be finalized before the distribution decision is locked in. Trustees who know the rule can move income to beneficiaries in lower brackets after seeing the year’s results; trustees who do not know it pay trust rates.
When a Nongrantor Trust Is the Right Choice
- Beneficiaries in lower brackets. A trust for children or grandchildren whose own incomes are modest can distribute income to them, where it is taxed at their rates, rather than to a grantor in the top bracket. Where distributions are not wanted, a beneficiary deemed owner trust shifts the income tax to the beneficiary without distributions.
- The grantor should not pay. After a sale of a business or a large liquidity event, a grantor trust’s income tax can run to hundreds of thousands of dollars a year. Releasing grantor status shifts that burden to the trust and its beneficiaries.
- Deductions and exclusions that belong to the trust. Certain tax benefits are computed per taxpayer. A nongrantor trust can claim its own charitable deduction for amounts paid from gross income to charity, and, in some planning, separate trusts each qualify for exclusions or deduction limits that a single taxpayer could use only once. This planning has drawn attention from the Internal Revenue Service and is done, when it is done, with care.
- State income tax planning. A nongrantor trust with a trustee and assets outside the grantor’s home state may be taxed differently, or not at all, by that state, depending on its rules. New York has enacted rules that limit the technique for New York residents, and the analysis is specific to each state.
- Asset protection and control. Nongrantor status does not itself protect assets, but many long-term trusts for beneficiaries are nongrantor trusts because the grantor’s involvement has ended and the trustee manages distributions for the beneficiaries’ benefit.
How Trusts Become Nongrantor Trusts
Some trusts are nongrantor from the start, because the grantor retains no power that would cause grantor treatment. Others begin as grantor trusts and convert when the grantor releases the power that created that status, a form of trust modification that should be timed around any outstanding note from a sale to the trust and any pending gain. Every trust becomes a nongrantor trust at the grantor’s death; the revocable living trust that reported on your Social Security number during life becomes a separate taxpayer the day after. Our grantor trusts page explains the other side of that line.
State Income Tax on Trusts
The three states in which our attorneys practice tax nongrantor trusts on different theories. New York generally treats a trust created by a New York resident as a resident trust, but exempts it from New York tax on its undistributed income when no trustee is domiciled in New York, no trust assets are located in New York, and the trust has no New York source income; distributions to New York beneficiaries are then taxed to them. New Jersey similarly bases the trust’s residence on the grantor and relaxes taxation where the trust has no New Jersey trustee, assets, or source income. Connecticut taxes resident trusts with a modification based on the residence of the beneficiaries. The details change, and the interaction among the three states for a family with a trustee in one state and beneficiaries in another is worked through with your CPA before the trust is funded or the trustee is chosen.
Administering a Nongrantor Trust Well
Because the tax result depends on the trustee’s decisions, administration is where the money is saved or lost. A well-run nongrantor trust has a distribution policy that considers beneficiaries’ brackets, uses the post-year-end election window, tracks the character of income, treats capital gains consistently with the instrument, claims the deductions available to trusts, files on time in every state where it must, and issues beneficiary statements so that beneficiaries can report correctly. Our trust administration practice and our professional trustee services handle this work for trustees and families.
When a Nongrantor Trust Is Not the Right Choice
A nongrantor trust is the wrong design when the grantor is in a lower bracket than the trust would be and is willing to pay, when the plan depends on sales or swaps between the grantor and the trust, when the trust will accumulate substantial income for young beneficiaries with no one in a low bracket to receive it, or when state rules would tax the trust in a high-tax state regardless of structure. In those cases a grantor trust, or a different distribution design, does better. Our irrevocable trusts and tax planning pages set out the options, and our dynasty trust page addresses the long-term trusts where these decisions recur for generations.
What Our Nongrantor Trust Service Includes
- Analysis with your CPA of grantor versus nongrantor status for each trust, including projected income, beneficiary brackets, and state residence of everyone involved.
- Drafting nongrantor trusts with distribution standards, capital gain treatment, charitable provisions, and trustee selection aligned with the tax plan.
- Planning and executing the conversion of a grantor trust to nongrantor status, including the timing of outstanding notes and gains.
- Advice to trustees on distribution decisions, the post-year-end election, multistate filing, and beneficiary reporting.
- Review of existing trusts to identify avoidable tax from accumulated income or a poorly chosen trustee location.
Schedule a Consultation About Trust Income Tax
If you are a trustee wondering why the trust’s tax bill is so high, or a grantor deciding who should pay the tax on a trust you are creating, the answer usually lies in the choice between grantor and nongrantor status and in how distributions are handled. Our attorneys practice in New York, New Jersey, and Connecticut. Contact Milvidskiy Law Group P.C. to schedule a consultation.
This page is provided for general informational purposes only and does not constitute legal advice. Laws differ by state and change over time. Tax figures are as of the date stated and change annually. For advice about your situation, consult a qualified attorney.
Frequently Asked Questions
What is a nongrantor trust?
A nongrantor trust is a trust treated as its own taxpayer for income tax purposes. It files its own return, pays tax on the income it retains, and deducts the income it distributes to beneficiaries, who then report that income on their own returns. Any trust in which the grantor has kept none of the powers that cause grantor trust treatment is a nongrantor trust, and every trust becomes one at the grantor’s death.
How much tax does a trust pay?
On retained ordinary income, a trust reaches the top federal rate quickly. For 2026, according to the IRS inflation adjustment tables, the 37% rate applies to a trust’s taxable income above $16,000, with 10%, 24%, and 35% brackets below that. Capital gains and qualified dividends have preferential rates inside a trust but on similarly compressed thresholds. Income distributed to beneficiaries is taxed to them instead.
What is distributable net income?
It is the measure of a trust’s income that can be carried out to beneficiaries with a matching deduction to the trust. Distributions up to distributable net income shift the tax to the beneficiaries in the same character the income had inside the trust. Distributions above it are generally a tax-free return of principal.
Are capital gains taxed to the trust or the beneficiaries?
Usually to the trust, because capital gains are generally allocated to principal and are not part of distributable net income unless the trust instrument, state law, or a consistent trustee practice treats them as distributable. A trust expected to sell appreciated assets should be drafted with this in mind so that gains can be carried out when that produces a better result.
Why would anyone choose a nongrantor trust given the high rates?
Because the trust does not have to retain income. A nongrantor trust can distribute income to beneficiaries in lower brackets, claim its own charitable deduction, qualify separately for certain per-taxpayer tax benefits, and, depending on state rules and the location of the trustee, avoid state income tax that the grantor would pay personally. It is also the right choice when the grantor should not bear the tax.
How does a grantor trust become a nongrantor trust?
By the grantor releasing the power that created grantor status, if the trust permits it, or automatically at the grantor’s death. The conversion should be timed carefully, because an outstanding installment note from a sale to the trust can produce taxable gain when the trust stops being disregarded.
Does New York tax a trust created by a New York resident?
New York generally treats a trust created by a New York resident as a resident trust, but it does not tax the trust’s undistributed income if no trustee is domiciled in New York, no trust assets are located in New York, and the trust has no New York source income. Distributions to New York beneficiaries are taxed to them. New York has also enacted rules aimed at certain trusts created to avoid state income tax, so the planning is done carefully with your CPA.
Does the choice of trustee affect the trust's state taxes?
It can. Several states, including New York and New Jersey, look to where the trustee is located in deciding whether to tax a trust’s undistributed income. Naming a trustee in another state, or a professional trustee, can change the result. The rules differ by state and interact when the grantor, trustee, and beneficiaries live in different states.
What is the 65-day election?
It is a federal election that lets a trustee treat distributions made within a short window after the end of the tax year as if they were made in the prior year. It allows the trustee to see the year’s actual income before deciding how much to distribute to beneficiaries, which is one of the most useful tools for keeping a nongrantor trust’s tax low.
Does a nongrantor trust protect assets from creditors?
Not by itself. Creditor protection comes from the trust being irrevocable with a spendthrift provision and an independent trustee, not from its income tax status. Many protective trusts for beneficiaries are nongrantor trusts, but the two features are separate decisions.
