Several years ago, I sat with the children of a former client, a successful Manhattan business owner. He had done what he thought was right—he created a will establishing a testamentary trust to hold assets for his grandchildren’s education. He wanted to protect the funds and ensure they were used for tuition. His intentions were perfect. The execution, however, created a significant tax problem.
The family was shocked to learn that the trust, holding millions in income-producing assets, was paying federal income tax at the highest marginal rate on nearly all its earnings. This wasn’t a mistake. It is how the tax code is written for trusts. The very tool meant to preserve wealth was actively diminishing it.
This situation is not uncommon. A testamentary trust, created within a Last Will and Testament, can be an essential instrument for generational stewardship. But without deliberate tax planning, it can become a highly inefficient vehicle for transferring wealth.
Why a Trust Pays Its Own Taxes
During your lifetime, a revocable living trust is typically a “grantor trust.” For tax purposes, it is invisible. All income and deductions flow directly onto your personal tax return. The trust is not a separate taxpayer.
A testamentary trust is different. It does not exist until you pass away and your will is admitted to probate in Surrogate’s Court—a process governed by New York’s Surrogate’s Court Procedure Act (SCPA) Article 14. Once the court validates the will and the trust is funded, it becomes its own legal and taxable entity. It is an irrevocable trust with its own Taxpayer Identification Number.
From that moment, the trust must file its own annual income tax return, Form 1041. Any income the trust earns and does not distribute to its beneficiaries is taxed at the trust level. This is where the problem begins.
The Compressed Bracket Trap
The core issue is not just that the trust pays tax, but how it pays tax. Individuals and married couples have wide tax brackets, allowing them to earn significant income before reaching the top marginal rate.
Trusts are the opposite. They operate under “compressed” tax brackets. For 2024, a trust hits the highest federal income tax rate of 37% once its undistributed income exceeds just $15,450. A single individual, by contrast, does not hit that rate until their income is over half a million dollars.
Consider my late client’s trust. It held a portfolio generating $100,000 in dividends and interest annually. The trustee, following the will’s instructions, was holding the funds until the grandchildren reached college age. Because the income was not being distributed, the trust was responsible for the tax. Nearly all of that $100,000 was taxed at the highest possible rate—a far greater burden than if the assets had been managed differently.
This tax structure can undermine the very purpose of the trust, slowing the growth of assets you set aside for your family.
Prudent Planning for Trust Taxation
Anticipating these tax issues is a critical part of our work. The goal is not to avoid taxes, but to manage them intelligently so the trust can fulfill its purpose. We align the legal structure with tax efficiency.
One primary tool is the strategic distribution of income. When a trust distributes income to a beneficiary, the trust generally receives a deduction for that amount. The income is then reported on the beneficiary’s personal tax return and taxed at their individual rate, which is almost always lower than the trust’s rate. The income is moved from the trust’s compressed tax environment into the beneficiary’s more favorable one.
This is why the language used to draft a trust is so critical. We focus on giving the trustee—the person or institution managing the trust—the right discretion. A well-drafted trust gives the trustee flexibility to distribute income when it is prudent from a tax perspective, even if the primary goal is long-term growth. The trustee’s fiduciary duty includes wise asset management, and tax management is a major component of that duty.
For some families, other structures may be more appropriate from the start. But for those who use a testamentary trust, building in tax-aware provisions is a necessity for responsible stewardship.
A will is the final set of instructions for the care of your family. If your estate plan relies on a testamentary trust, its tax structure deserves careful examination. We can review your existing will to analyze the discretion granted to your trustee and discuss the potential tax impact on your beneficiaries.
