What Is The Difference Between A Grantor Trust And A Non-Grantor Trust?

Non-Grantor Trusts Pay Their Own Income Taxes

A non-grantor trust is its own taxpayer.  If it does not make distributions, it pays income tax on all of its income items – formally referred to as distributable net income or “DNI” (interest, dividends, rents and royalties) as well as on its capital gains.  However, if a trust distributes DNI to its beneficiary, it gets an income tax deduction for that amount and the beneficiary receives a Form K-1 from the trust and pays tax on the DNI the beneficiary received.  This makes sense – the tax on DNI falls on the taxpayer (either the trust or the beneficiary) who has the money in hand.  Also, since DNI does not include capital gains, whether capital gains are distributed or not the non-grantor trust typically pays income tax on capital gains.

For example, assume a non-grantor trust with $10,000 earns $100 of interest income and $10 of capital gain during the year.  Before year-end, the trust distributes $90 to its beneficiary.  As the interest income is $100 of DNI, the $90 distributed provides the trust with a $90 deduction.  The beneficiary picks up the income tax on the $90 and the trust pays $10 on the income items it did not distribute and the $10 of capital gain.  If the trust had distributed $110 to the beneficiary, all $100 of the DNI would be treated as having been paid out to the beneficiary.  The beneficiary would pay tax on $100 of DNI; the extra $10 the beneficiary received would be non-taxable.

A trust that is required to pay “all its income” to the trust beneficiary each year is treated as distributing all the DNI to that beneficiary whether or not the trust actually pays the income to the beneficiary.  Because of this rule, the trust pays no income tax on income items and the beneficiary must pay the tax on those items.  Once example of this type of trust is a qualified terminable interest property (“QTIP”) trust.