When the grantor of an intentionally defective grantor trust dies, the trust loses its special income tax status and becomes a separate taxpayer overnight. Income that used to flow to the grantor’s personal return now belongs to the trust itself and gets taxed at the compressed brackets that apply to trusts and estates. The assets inside the trust keep the grantor’s original cost basis rather than receiving the step-up that ordinary inherited property gets, which can create a large capital gains bill whenever those assets are sold. Here is what changes, in what order, and what the successor trustee has to do about it.
The Trust Becomes Its Own Taxpayer
During the grantor’s lifetime, an IDGT is structured so that a specific power, most often the power to swap trust assets for property of equal value, makes the grantor the trust’s owner for income tax purposes.1Office of the Law Revision Counsel. 26 U.S. Code 675 – Administrative Powers The IRS treats the grantor as the taxpayer on all trust income, but the assets sit outside the grantor’s taxable estate. That split is the whole point of the structure.
Death ends it. The power that created the “defect” can no longer be exercised, so the trust stops being a grantor trust. From that moment forward, the IRS treats it as a non-grantor trust with its own tax identity and its own filing obligations. This change happens automatically, not because the trustee files anything or takes any action.
Splitting Income in the Year of Death
The calendar year the grantor dies gets cut in half for tax purposes. Income the trust earned from January 1 through the date of death still goes on the grantor’s final Form 1040, because the trust was still a grantor trust during that stretch. Income earned from the day after death through December 31 belongs to the newly independent trust and goes on its own fiduciary return.
The grantor’s executor files the final 1040. The successor trustee files the trust’s first Form 1041. Coordinating those two filings is one of the first practical headaches after death, and splitting the income wrong can generate IRS notices on both returns.
New EIN and Annual Form 1041 Filings
While the grantor was alive, the trust typically reported under the grantor’s Social Security number. Once the grantor dies, the trust needs its own Employer Identification Number from the IRS.2Internal Revenue Service. When To Get a New EIN The successor trustee can apply online and get the number immediately, then use it to retitle accounts and open new ones under the trust’s new tax identity.
If the trust earns more than $600 in annual gross income, the trustee must file Form 1041 each year.3Internal Revenue Service. File an Estate Tax Income Tax Return The return reports the trust’s income, deductions, gains, losses, and any distributions made to beneficiaries.4Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts The trust may also have to make quarterly estimated tax payments to avoid underpayment penalties.
There is one meaningful relief valve. When the trust distributes income to beneficiaries, it deducts that distribution, and the beneficiaries pick up the income on their own returns. This is the distributable net income mechanism, and it means the trust itself only pays tax on income it keeps. For trusts designed to distribute regularly, that can significantly reduce what actually gets taxed at trust rates.
Why the Compressed Trust Brackets Hurt
The bracket compression for trusts and estates is where this transition really bites. In 2026, a trust hits the top federal rate of 37% on income above just $16,000. An individual doesn’t reach that same rate until income exceeds roughly $609,000.
The 2026 trust brackets:
- 10% on income from $0 to $3,300
- 24% on income from $3,301 to $11,700
- 35% on income from $11,701 to $16,000
- 37% on income above $16,000
While the grantor was alive, trust income was taxed at the grantor’s individual rates, across much wider brackets. After death, any income the trust retains gets squeezed into these narrow ones. That is a strong reason for trustees to consider pushing income out to beneficiaries in lower brackets rather than accumulating it inside the trust, assuming the trust document gives them the discretion to do so.
No Stepped-Up Basis on the Trust’s Assets
This is the consequence most families do not see coming. Normally, when someone dies, assets in their estate get a stepped-up basis: the tax basis resets to fair market value at the date of death, and any unrealized capital gains are wiped out.
IDGT assets do not get this treatment. Because the point of the trust is to keep assets outside the grantor’s taxable estate, those assets are not “acquired from a decedent” under the tax code’s definition.5Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent The IRS confirmed this in Revenue Ruling 2023-2, concluding that assets in an irrevocable grantor trust that are not included in the grantor’s gross estate do not qualify for a basis adjustment at death.
Instead, the trust keeps the grantor’s original cost basis, often called carryover basis. Say the grantor transferred stock purchased for $50,000 into the IDGT, and by the time the grantor dies the stock is worth $500,000. The trust’s basis stays at $50,000. If the trustee later sells at $500,000, the trust realizes a $450,000 capital gain, taxed at the trust’s compressed rates unless the proceeds are distributed to beneficiaries who then report the gain themselves.
The estate tax savings from keeping appreciated assets out of the gross estate often outweigh the lost step-up, especially for large estates, but the trade-off is real and it lands entirely at death.
What Happens to a Promissory Note From an Installment Sale
Many IDGTs are funded through installment sales, where the grantor sells appreciated assets to the trust in exchange for a promissory note. During the grantor’s lifetime, that sale is ignored for income tax purposes because the grantor is treated as dealing with themselves. No gain is recognized, and interest payments are not taxable income.
At death, the note splits along the same estate-versus-income line that defines the whole structure. The outstanding balance is included in the grantor’s gross estate for estate tax purposes because the grantor owned the note personally. But because the original sale was a non-event for income tax purposes, the unpaid balance is generally not treated as income in respect of a decedent, and the note should receive a basis equal to its value as included in the estate.
The trust’s assets keep their carryover basis even though the note that paid for them is now part of the taxable estate. The trust still owes the remaining payments, which now go to the grantor’s estate or to whoever inherits the note. Those payments become real transactions between two separate taxpayers for the first time.
What the Successor Trustee Has to Do First
The person named as successor trustee steps into a role with legal obligations the moment the grantor dies. The trustee owes a fiduciary duty to the beneficiaries and has to follow the trust document precisely. The first few months bring a cluster of tasks:
- Obtain a new EIN for the trust and open or retitle bank and brokerage accounts under the trust’s new tax identity.
- Inventory all trust assets, including real estate, investment accounts, business interests, and personal property, and get date-of-death valuations for tax reporting.
- Notify beneficiaries of the grantor’s death and their interest in the trust. Most states require written notice within a set timeframe, commonly 30 to 60 days.
- Pay trust debts and expenses, including any outstanding obligations, professional fees, and tax liabilities.
- Coordinate with the grantor’s executor on the split-year income tax reporting and any estate tax filings.
Trustees who are not professionals often underestimate how much accounting and tax work the first year involves. Hiring a CPA experienced with fiduciary returns is worth the cost for most successor trustees.
Distribution or Continuation, Depending on the Document
What happens to the assets themselves depends entirely on what the trust document says. Some IDGTs terminate at the grantor’s death and distribute outright to named beneficiaries. Others continue for years or generations, with the trustee making distributions on a schedule or for specific purposes such as education or health care.
If the trust continues, the trustee keeps managing the assets, filing Form 1041 each year, and making distributions according to the trust’s terms. Discretion runs only as far as the document grants it. A trust that says “distribute all income annually” leaves no room to accumulate income; a trust that gives the trustee “sole discretion” leaves substantial flexibility to manage the beneficiaries’ tax situations.
For trusts that terminate, the trustee should not rush to distribute everything before settling the trust’s final tax obligations. Holding back a reasonable reserve for taxes owed on the final Form 1041 is standard practice. Once debts, expenses, and taxes are paid, the remaining assets go to the beneficiaries as the trust document directs, and the trust is formally closed.