Grandpa Will Pay the Income Tax Every April on a Trust He No Longer Owns. The IRS Will Call It Required. His Estate Lawyer Will Call It a $1.2 Million Tax-Free Gift.

A 72-year-old retired surgeon signed his trust papers early in 2026. He moved $5 million of bonds and dividend stocks into an irrevocable trust for his four grandchildren. He can’t take the money back, and he can’t change who gets it.

Then his CPA told him the part nobody mentioned at the signing. Every April, the trust’s income will show up on his own Form 1040. He owes the tax, and the trust owes nothing.

He was angry at first. His estate lawyer was pleased, because that yearly tax bill is the most efficient gift he will ever make.

A Trust Drafted To Be Defective On Purpose

Estate attorneys call this an intentionally defective grantor trust, or IDGT. The flaw only matters for income tax. Under 26 U.S.C. § 671, when the grantor is treated as the owner of a trust, the trust’s income, deductions and credits go on the grantor’s own return. One common way to set this up is to give him a power, held in a nonfiduciary capacity, “to reacquire the trust corpus by substituting other property of an equivalent value” under § 675(4)(C).

The IRS puts it simply: “Income earned by a grantor trust is taxable to the grantor, not the beneficiary, if the grantor keeps certain control over the trust.”

For gift and estate tax, the transfer is complete. Estates of people who die in 2026 have a basic exclusion amount of $15,000,000, so his $5 million gift goes on Form 709 and uses part of his exemption. No gift tax is due.

The IRS has also said the yearly tax payments are not extra gifts. In Rev. Rul. 2004-64, it ruled that the grantor’s payment “does not constitute a gift by A to Trust’s beneficiaries for federal gift tax purposes” because the grantor is the person legally liable for the tax.

How $92,500 a Year Adds Up to $1.2 Million

Here are the assumptions. The trust earns 5% a year in taxable interest and nonqualified dividends. That is $250,000 of income. He and his wife file jointly, and their other income already tops $768,700, so every dollar of trust income is taxed at the 37% top rate.

• Annual tax he pays on trust income: $92,500
• Years he pays it: 13
• Total tax paid on the trust’s behalf: $1,202,500

That leaves out the separate net investment income tax and any state income tax, and both would push the total higher. Each payment reduces his taxable estate by the amount he pays. Meanwhile the trust keeps all $250,000 of its income every year and compounds it for the grandchildren.

Two Other Paths Cost the Family Six Figures

Path one: a non-grantor trust. Here the trust pays its own tax, and trust brackets are compressed, so it hits the top rate quickly. The same $92,500 a year comes out of the trust. Before any growth, the grandchildren get $1,202,500 less.

Path two: he keeps the cash. Suppose his remaining estate is above the exclusion. The estate tax schedule in 26 U.S.C. § 2001(c) taxes amounts over $1,000,000 at 40%. Left in his estate, that $1,202,500 would cost $481,000 in estate tax. Giving it away directly would take about 63 annual exclusion gifts at the 2026 limit of $19,000 each, or it would use up lifetime exemption.

There is a cost. Under Rev. Rul. 2023-2, assets in a grantor trust that sit outside the grantor’s estate get no step-up in basis when he dies. Low-basis stock in the trust keeps its old basis, and the grandchildren owe capital gains tax on that gain when they sell.

Five Moves To Make Before Next April

1. Read the trust document for the grantor-trust power. Find the substitution clause or similar power, and confirm who holds it and in what capacity.
2. Have the CPA set up grantor-trust reporting. The trust’s income goes on the grantor’s return, so his quarterly estimated payments need to be raised to cover it.
3. File Form 709 for the original funding. This records the use of his exemption, even though no gift tax is owed.
4. Ask about a tax reimbursement clause. When state law allows, an independent trustee can repay him if the tax bills get too heavy, and experts note the 2004 ruling holds that “actual exercise of the trustee’s power to reimburse the grantor is not a gift either”.
5. Plan a basis swap before death. Use the substitution power to pull low-basis assets back into his estate in exchange for cash or high-basis assets of equal value, so the step-up applies where it does the most good.

A CPA and estate tax attorney should run these figures against his actual income, state and trust terms. Most multi-generational transfers go sideways on a stale beneficiary form or an untitled account, which is why we put the full estate checklist in a free guide here.

The number to remember is $92,500 a year. Over 13 Aprils, that tax bill moves $1,202,500 to his grandchildren with no gift tax and no estate tax on it.

Contact [email protected] for any questions or corrections.