Grantor vs Non-Grantor Trust: Who Pays the Tax When the Trust Sells

How it works, in plain English

A trust is either invisible for income tax or it is its own taxpayer. The grantor trust rules in IRC 671 to 679 decide which. If the person who created or funded the trust keeps certain powers or benefits, the trust is a grantor trust and that person is treated as owning its assets for income tax. Every sale, interest payment and dividend lands on the grantor's Form 1040. If none of those powers or benefits exists, the trust is a non-grantor trust: it gets its own tax ID, files Form 1041 and pays tax on income it keeps.

The test is about powers, not labels. The main triggers are:

• Revocation (IRC 676). You can take the assets back. Every revocable living trust is a grantor trust while you are alive.
• Income for you or your spouse (IRC 677). Trust income may be paid to you or your spouse, or used to pay premiums on your life.
• Administrative powers (IRC 675). For example, the power to swap trust assets for others of equal value in a non-fiduciary capacity, or to borrow without adequate interest or security. The swap power is the usual tool for making an irrevocable trust a grantor trust on purpose.
• Control of who benefits (IRC 674) and reversionary interests over 5% (IRC 673).
• Beneficiary as owner (IRC 678) and foreign trusts with U.S. beneficiaries (IRC 679).

Grantor status is separate from estate tax: a trust can be a grantor trust and still sit outside your estate. That gap is the intentionally defective grantor trust, or IDGT.

When a grantor trust sells

The grantor pays. A sale by your revocable trust is reported exactly as if you sold, including the Section 121 home exclusion, installment reporting and NIIT at your own $250,000 or $200,000 threshold. A sale by an irrevocable grantor trust works the same way: you pay the tax even though the cash stays in the trust. For estate planning that is often the point, because each dollar of tax you pay shrinks your estate without being treated as a gift (Rev. Rul. 2004-64). A discretionary power to reimburse you for that tax does not by itself pull the assets into your estate.

Sales to your own grantor trust are ignored. Under Rev. Rul. 85-13 (discussed in Rev. Rul. 2007-13), you and your grantor trust are one taxpayer, so selling an asset to it for a note is not a sale: no gain, no interest income, no interest deduction. That is the engine of the installment sale to an IDGT. It moves future growth to heirs, but it does not avoid tax on a later sale to an outside buyer; the trust's sale is still your sale.

No step-up for the trust's assets. Rev. Rul. 2023-2 holds that assets in an irrevocable grantor trust that are not in your estate get no basis step-up at your death. A revocable trust's assets are in your estate and do get one. See holding for the step-up.

When a non-grantor trust sells

The trust pays at compressed rates. For 2026, Rev. Proc. 2025-32 (Table 5) sets the trust brackets at 10% to $3,300, 24% to $11,700, 35% to $16,000 and 37% above $16,000. Long-term gain is taxed at 0% to $3,300, 15% to $16,250 and 20% above. The 3.8% NIIT applies to undistributed net investment income over $16,000 (IRC 1411(a)(2)). A married couple does not reach the 20% capital gain rate until $613,700 of taxable income or the NIIT until $250,000 of MAGI. The gap is large on a modest sale and narrows on a multimillion-dollar one.

Distributions and DNI. A non-grantor trust deducts what it distributes, up to distributable net income (DNI), and the beneficiaries report it on their K-1s (IRC 661 and 662). Capital gains are usually excluded from DNI and taxed to the trust, unless the trust document and local law allocate gains to income, the trustee consistently treats gains as distributed, or the gains are actually distributed or used to set the distribution (Treas. Reg. 1.643(a)-3(b)). Trustees can elect to treat distributions made in the first 65 days of the next year as made in the sale year (IRC 663(b)).

Traps. If you contribute appreciated property to a non-grantor trust and it sells within two years, the built-in gain is taxed at your rates, not the trust's (IRC 644). And multiple trusts with substantially the same grantor and beneficiaries and a principal purpose of avoiding tax are treated as one trust (IRC 643(f)), so splitting a sale across several trusts to stack low brackets does not work.

Worked example (engine-computed)

Assumptions (labeled, not a quote): a married couple filing jointly, $150,000 of other ordinary income, 2026 tables, a trust that sells company stock with a $2,000,000 long-term gain for cash. The trust is a grantor trust (revocable or an IDGT), so the couple reports the sale.

If the same trust were a non-grantor trust (the engine does not model Form 1041, so this part is qualitative): virtually all of the gain would be taxed at 20% plus 3.8% NIIT, because the trust passes both thresholds at about $16,000. Federal tax would be in the same range as the couple's, somewhat higher because the trust has almost no room in the 15% bracket. The bigger swing is state tax. A non-grantor trust administered in a state without an income tax, with no trustee or beneficiary in a taxing state, may owe no state tax on gain from stock. That is the idea behind incomplete gift non-grantor trusts, and it is why California and New York changed their laws (see below). For a California building, none of this helps: real property gain is taxed by the state where the property sits.

State trust residency and incomplete gift non-grantor trusts

Each state decides when a non-grantor trust is its resident. Common tests are where the grantor lived when the trust became irrevocable, where the trustee lives, where the trust is administered, and where beneficiaries live. California taxes a trust's income based on the residence of its fiduciaries and its noncontingent beneficiaries (Cal. Rev. and Tax. Code 17742). The U.S. Supreme Court held in North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust (2019) that a state cannot tax a trust just because a beneficiary lives there when that beneficiary has no right to demand distributions.

Incomplete gift non-grantor trusts (NING, DING and similar) were built to be non-grantor trusts in a no-tax state while keeping the gift incomplete for gift tax. New York (2014) and California (Rev. and Tax. Code 17082, effective for tax years beginning in 2023) now tax those trusts' income to the resident grantor as if they were grantor trusts. Since 2021 the IRS has declined to issue new private letter rulings on them. If you are thinking about moving rather than using a trust, see changing state residency before a sale.

Toggling grantor status

Many irrevocable trusts are drafted so grantor status can be turned off, for example by releasing a swap power, or turned on by giving someone a power that triggers Sections 674 or 675. Families use it to shift the tax bill: the grantor pays while that suits the estate plan, then the trust pays later. Turning it off has consequences. When grantor status ends, the grantor is treated as transferring the trust's assets to a new taxpayer, and if the trust's liabilities exceed basis, gain can result (Treas. Reg. 1.1001-2(c), Example 5; Madorin v. Commissioner, 84 T.C. 667 (1985)). The income tax result when status ends with an IDGT note still outstanding is not settled by published guidance. Do it with counsel, well ahead of the deal.

IRS stance, costs, and how it compares with a Section 453 installment sale

Grantor and non-grantor trusts are mainstream and not listed transactions. The exam risks are drafting errors that flip status, undervalued sales to grantor trusts, and state residency claims. Costs are attorney drafting (often several thousand to tens of thousands of dollars), an independent trustee where needed, annual Form 1041 preparation for a non-grantor trust, and appraisals for gifts or sales to the trust.

A trust decides who pays and which state taxes; an installment sale decides when. They combine: a grantor trust or a non-grantor trust can sell on an installment note and report gain as payments arrive, though a non-grantor trust hits its top rates so fast that spreading helps it less, and the trust takes on buyer credit risk like any seller. Learn the basics of installment sale tax and seller financing taxes, or run your numbers. Get the full Big Sale Tax Analysis to model the sale on the right return next to the other paths.

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