How is an LLC Owned by a Trust Taxed?

Placing a Limited Liability Company (LLC) inside a trust is a powerful strategy combining the asset protection of an LLC with the estate planning benefits of a trust. However, for tax and accounting professionals, this arrangement raises an immediate question: how is the income taxed? The answer isn't about the LLC itself, but hinges entirely on the type of trust that holds the LLC membership interest. This article will guide you through the two primary scenarios—LLCs owned by revocable trusts and irrevocable trusts—to clarify who files what form and who ultimately pays the tax.

First, A Quick Refresher on the Key Players

Before diving into the tax specifics, let's clarify the roles of the LLC and the trust. An LLC is a business structure authorized by state statute that protects its owners (members) from personal liability for the business's debts. By default, the IRS doesn't have a specific tax classification for LLCs; instead, it treats them as "pass-through" entities. A single-member LLC is taxed like a sole proprietorship (a "disregarded entity"), while a multi-member LLC is taxed like a partnership.

A trust, on the other hand, is a legal arrangement where one person (the grantor or settlor) gives a third party (the trustee) the right to hold assets on behalf of a beneficiary. Trusts are primarily used for estate planning, asset management, and probate avoidance. Their tax treatment is determined by whether the grantor retains control.

The Deciding Factor: Is the Trust Revocable or Irrevocable?

The entire tax situation for an LLC held by a trust comes down to one question: can the grantor change or dissolve the trust? If the answer is yes, it's a revocable trust. If the answer is no, it's an irrevocable trust. Each one creates a completely different tax-reporting reality.

Scenario 1: The LLC is Owned by a Revocable Trust

A revocable trust, often called a "living trust," is one where the grantor maintains complete control over the assets during their lifetime. They can change the beneficiaries, modify the terms, or terminate the trust entirely. Because the grantor hasn't truly given up control, the IRS considers a revocable trust a "grantor trust."

For tax purposes, a grantor trust is a disregarded entity. It does not file its own income tax return or pay its own taxes. All items of income, deduction, and credit are reported directly on the grantor's personal tax return, as if the trust didn't exist.

When a grantor trust owns an LLC, you simply look through both entities to the individual owner. Here’s how that plays out.

Case Study: Single-Member LLC Owned by a Revocable Trust

Imagine Sarah, a consultant, establishes the "Sarah Miller Revocable Trust" and transfers 100% of her LLC, "Miller Consulting LLC," into it. The trust is now the sole member of the LLC.

• Since the trust is a grantor trust, the IRS disregards it.
• Since the LLC is a single-member entity, the IRS also disregards it.

The result is a chain of two disregarded entities. For tax filing, it's exactly the same as if Sarah owned the LLC directly. Miller Consulting LLC’s income and expenses are reported on a Schedule C (Profit or Loss from Business), which gets filed with Sarah’s personal Form 1040. The trust is transparent for tax purposes.

Case Study: Multi-Member LLC Where a Revocable Trust is a Partner

Now, let's say Sarah's LLC is a partnership with her colleague, David. Sarah owns 60% of the LLC through her revocable trust, and David owns 40% individually. The LLC files a Form 1065, U.S. Return of Partnership Income.

• Two K-1s are issued. One K-1 for 40% of the income/loss goes directly to David.
• The other K-1 for 60% of the income/loss is issued to the "Sarah Miller Revocable Trust." This trust, in turn, is a disregarded entity.

On her personal Form 1040, Sarah will report the income passed through on the trust's K-1 via Schedule E (Supplemental Income and Loss). Again, the trust acts as a pass-through, and the grantor pays the taxes personally.

Scenario 2: The LLC is Owned by an Irrevocable Trust

Life becomes much more complicated when an LLC is owned by an irrevocable trust. With this type of trust, the grantor has permanently given up control and ownership of the assets. They cannot amend or dissolve the trust without a court order, which is rarely granted. Because the grantor has relinquished control, the IRS views the irrevocable trust as a separate, distinct taxpayer.

An irrevocable trust must obtain its own Employer Identification Number (EIN) and files its own annual income tax return using Form 1041 (U.S. Income Tax Return for Estates and Trusts). Now, let’s see what happens to the LLC’s income.

The Trust as the Taxpayer

Let's say Mark creates an irrevocable trust for the benefit of his children and transfers his solely-owned LLC into it. The trust is now the single member of the LLC.

First, the LLC's income passes through to its owner—the irrevocable trust. Because it’s a single-member LLC, its income and expenses are compiled, and the net profit or loss flows to the trust’s Form 1041. All this activity is reported under the trust's EIN.

Now the critical question is what happens to that income once it's on the trust's tax return. There are two paths it can take.

Path A: The Trust Distributes the Income
The trust instrument may require or allow the trustee to distribute income to the beneficiaries. When it does, the trust gets a tax deduction for its "Distributable Net Income" (DNI). The beneficiaries then receive a Schedule K-1 from the trust detailing their share of the income. They report this income on their personal Form 1040s and pay tax at their individual rates. In this case, the trust acts as a conduit, passing both the income and the tax liability to the beneficiaries.

Path B: The Trust Retains the Income
If the trust accumulates the income instead of distributing it, the trust itself is responsible for paying the tax. This is a significant planning concern because of how fiercely trust tax brackets are structured.

Beware the Compressed Trust Tax Brackets

An individual taxpayer doesn't hit the top marginal tax rate until their income exceeds several hundred thousand dollars. In stark contrast, a trust hits the highest tax rate incredibly quickly.

For example, in 2024, a trust or estate will reach the top 37% tax bracket with taxable income over just $15,200. This is known as "bracket compression." If an LLC owned by an irrevocable trust generates $50,000 in taxable income and retains it, a substantial portion of that income will be taxed at the highest marginal rate. This can lead to a much higher tax bill than if the income had been distributed to beneficiaries who are in lower tax brackets.

Key Planning Considerations and Common Pitfalls

Setting up this structure correctly requires attention to detail. Here are a few things to keep in mind.

• Proper Asset Titling: Simply stating in a trust document that it owns the LLC is not enough. The LLC's operating agreement must be amended, and membership certificates must be officially re-issued in the name of the trust. This formal funding process is frequently overlooked.
• S Corporation Eligibility: If an LLC elects to be taxed as an S Corp, be very careful. Generally, irrevocable trusts are not eligible S Corp shareholders. The primary exceptions are special trusts like an Electing Small Business Trust (ESBT) or a Qualified Subchapter S Trust (QSST), each with its own set of strict rules and election procedures.
• What Happens at Death: The tax treatment of a revocable trust changes dramatically upon the grantor's death. At that point, the trust automatically becomes irrevocable. The entity's disregarded status vanishes, it will need to obtain an EIN, and it will begin filing its own Form 1041. This transition requires careful post-mortem tax planning.

Final Thoughts

To determine how an LLC owned by a trust is taxed, you must first identify the trust as either revocable (disregarded entity) or irrevocable (separate taxpayer). From there, the income flows from the LLC to the owner of record, and tax liability is either passed to the individual grantor or handled by the trust itself and/or its beneficiaries.

The rules for pass-through entities, grantor trusts, and complex irrevocable trusts often sit at a difficult intersection of federal tax law and state-specific fiduciary duties. Getting a quick, definitive, and citation-backed answer is key to providing advice. When your client has a question about ESBT eligibility or the nuances of Distributable Net Income, you need solutions right away. We built Feather AI to give practitioners instant, audit-ready answers from authoritative sources like the Internal Revenue Code and Treasury Regulations, helping you advise your clients confidently.