Estate Taxes & How They Interact With Trusts

Estate taxes can take a significant portion of your assets when you pass away. Trusts are one of the tools used in estate planning to reduce tax exposure, but they also come with their own rules and trade‑offs. In this article, we'll explain how estate taxes work, how trusts can affect them, and some strategies to consider.

1. What Is an Estate Tax?

The estate tax is a tax imposed on the transfer of property when someone dies. The tax is applied to the “gross estate” (all assets owned) after subtracting debts, expenses, and allowed deductions. ([SmartAsset](https://smartasset.com/estate-planning/estate-tax-planning?utm_source=chatgpt.com))

However, the tax only kicks in if the estate exceeds a certain exemption threshold. As of 2025 in the U.S., the federal estate tax exemption is $13.99 million per person. Estates below that amount owe no federal estate tax. ([SmartAsset](https://smartasset.com/estate-planning/estate-tax-planning?utm_source=chatgpt.com))

2. Federal vs. State Estate / Inheritance Taxes

In addition to federal estate tax, some states impose their own estate tax or inheritance tax. Whether state tax applies depends on where the decedent lived or where property is located. ([SmartAsset](https://smartasset.com/estate-planning/estate-tax-planning?utm_source=chatgpt.com))

It’s important to check your state’s rules because some state exemptions are much lower than the federal exemption, and some states have “death taxes” even on smaller estates.

3. How Trusts Can Help Reduce Estate Tax Exposure

Trusts are commonly used in estate planning to reduce taxable value, control distributions, and preserve assets. But they need to be structured correctly. Here’s how they interact with estate tax:

• Irrevocable trusts: Assets transferred into a properly designed irrevocable trust may be removed from your taxable estate, reducing the estate tax burden.
• Grantor vs non‑grantor trusts: Some trusts are treated as part of the grantor’s taxable estate depending on how the trust is drafted. ([Special Needs Alliance](https://www.specialneedsalliance.org/the-voice/a-short-primer-on-trusts-and-trust-taxation-2/?utm_source=chatgpt.com))
• Use of gift and exemption amounts: You can gift assets or fund trusts up to the exemption amounts during life to shrink estate size. ([CLA](https://www.claconnect.com/en/resources/articles/24/gift-tax-exemption-is-set-to-be-halved-explore-estate-planning-strategies?utm_source=chatgpt.com))

4. Step-Up in Basis & Its Importance

A powerful tax benefit at death is the “step-up in basis.” When someone inherits property, its cost basis resets to fair market value at the decedent’s death. That often reduces capital gains tax if the beneficiary sells the asset. ([Wikipedia on Stepped-up Basis](https://en.wikipedia.org/wiki/Stepped-up_basis?utm_source=chatgpt.com))

This benefit is only available if the asset passes through the estate or certain trusts that include the asset in the taxable estate.

5. Trust Taxation & Income Taxes

Trusts also have income tax rules. A trust’s income, gains, and losses may be taxed to the trust itself or passed through to beneficiaries, depending on distributions and trust type. ([Fidelity](https://www.fidelity.com/viewpoints/wealth-management/insights/trusts-and-taxes?utm_source=chatgpt.com))

Federal rules, state laws, and trust provisions all influence how trust income is taxed and how distributions affect beneficiary tax burdens.

6. Common Estate Tax & Trust Planning Strategies

Here are some techniques people use to reduce estate tax exposure:

• Make lifetime gifts using annual gift tax exclusions
• Use irrevocable trusts to remove appreciating assets from the estate
• Set up grantor retained annuity trusts (GRATs) or similar vehicles
• Leverage portability (spousal unused exemption) for married couples
• Consider charitable trusts or wealth replacement strategies
• Revisit plans if laws change—exemption amounts may shrink or sunset

7. Pitfalls & What to Watch Out For

• Trusts drafted poorly may include transfers back into the taxable estate
• Using trusts may reduce flexibility or control over assets
• Tax law changes can reduce or eliminate benefits (e.g. exemption cuts) ([CLA](https://www.claconnect.com/en/resources/articles/24/gift-tax-exemption-is-set-to-be-halved-explore-estate-planning-strategies?utm_source=chatgpt.com))
• State estate taxes or inheritance taxes not addressed by federal planning
• Failure to account for income tax implications on the trust or beneficiaries

Conclusion

Estate taxes can seem daunting, but understanding how they work—and how trusts interact with them—gives you powerful tools for planning. Proper structure, timely decisions, and awareness of legal changes are key. If you’d like help evaluating your estate plan or trust structure in light of taxes, upload your documents and I’ll help you see where your risks or opportunities lie.

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