Unexpected Surprise for Trusts and Estates from the 2025 One Big Beautiful Bill Tax Act
An irrevocable trust (or an estate) files taxes on IRS Form 1041, U.S. Income Tax Return for Estates and Trusts. While some trusts can be treated as the “alter ego” of a grantor while the grantor is alive, many irrevocable trusts[1] eventually become separate tax-reporting entities. Historically, a trust has served as a “conduit” entity, whereby the earnings of the trust are taxed only once, either by the trustee (if retained in the trust) or by the beneficiary (if the earnings are paid to the beneficiary). A surprising provision of the One Big Beautiful Bill Act (OBBBA) will alter this longstanding concept.
Under the OBBBA,[2] Congress sought to limit income tax deductions for taxpayers in the highest marginal tax bracket by limiting the amount of “itemized deductions” a high-income taxpayer can claim against taxable income. This new rule will apply beginning in 2026. Generally, a taxpayer is entitled to either a standard deduction[3] or deductions referred to in the tax code as “itemized deductions” under Internal Revenue Code (“IRC”) Section 63(d). An itemized deduction is any deduction other than those described in IRC Section 63(b). These deductions include a standard deduction, an individual’s personal exemption, certain qualified business income (IRC 199A) deductions, a $1,000 charitable deduction, certain depreciation deductions, and two deductions new to the OBBBA: the tip deduction and the overtime deduction. Common itemized deductions include certain medical expenses, state and local taxes,[4] some home mortgage interest expenses, and gifts to charity. If the aggregate itemized deductions exceed the standard deduction, then a taxpayer benefits from claiming itemized deductions. Historically, itemized deductions have been more useful for middle- and high-income taxpayers.
Under OBBBA, these itemized deductions will now be subject to a limitation equal to 2/37ths of their amount[5] (approximately 5%) when a taxpayer reaches the highest marginal income tax bracket. These limitations have been known as the “Pease” deductions because they were initially conceived by Congressman Pease (D-Ohio) to limit the tax benefits of deductions for higher-income taxpayers. In the past, the limitation did not apply to trusts and estates. Now, however, IRC Section 68 refers to the limitation as applying “in the case of an individual . . . .” Moreover, under the rules for taxation of trusts and estates, the tax code[6] says that taxation is to occur “in the same manner as in the case of an individual . . . .” Thus, with the new limitations, it appears that the Section 68 Pease limitation will apply to a trust or estate.
Here are the problems with this new clause when applied to an estate or a trust. The first difficulty is that a trust will be included in the highest income tax bracket when income exceeds $16,000. Thus, while the limitation will affect high earners, it will also affect nearly all trusts.
Next, as applied to an estate or trust, it had initially been unclear whether the limitation was intended to apply to trusts and estates serving as a mere conduit of trust income. Under IRC Sections 651 and 661, a trust or estate is entitled to a deduction (called a Distributable Net Income Deduction), and under IRC Sections 652 and 662, a beneficiary is required to include in income the amount of income received from the trust or estate. This merely shifts the tax burden from one taxpayer (the trust) to another taxpayer (the beneficiary), but does not result in any additional tax liability. Under a strict reading of IRC Section 63, it appears that the Section 651/661 Distributable Net Income Deduction is an “itemized deduction” and, thus, subject to this new 2/37th limitation (also being called a “haircut,” since it limits the amount of the deduction).
A third “problem” with the limitation is that it will also apply to a trust attempting to claim a charitable deduction for payment to charity. This deduction is allowed under IRC Section 642(c) for a trust or estate. Once again, because of the limitation on deductions, contributions to charity will be limited, and 5% will remain taxable to the trust.
Immediately after the law was passed, several trust and estate professional groups advised the government of this ambiguity and requested relief. Unfortunately, on May 28, 2026, the Joint Committee on Taxation of the United States Congress released its report explaining the OBBBA (referred to as the “Blue Book”). The Blue Book now states (in Footnote 102) that the limitation is intended to apply to trusts and estates and will be enforced.
Example Suppose a trust has $1,000,000 of income. Under pre-2026 law, the $1,000,000 of income paid to the beneficiary would not be taxed to the trust or estate, but instead would be taxed to the beneficiary by virtue of this “conduit” mechanism built into the tax code. Now, however, approximately 5% is disallowed. The beneficiary would still be obligated to pay income tax on the entire $1,000,000 distributed; however, only about $947,000 can be deducted, leaving about $53,000 taxable to the trust. Since the tax is imposed at the highest income tax bracket, this would result in approximately $20,000 of income tax payable.
In summary, unless there is a legislative change, a longstanding principle of trust and estate taxation—under which a conduit approach was used—has been eliminated, and this new limitation will impose taxes on trusts and estates. In fact, it will create a double tax on 5% of the earnings because of the position taken by the government.
[1] For simplicity, the article will refer to trusts but the concept applies equally to estates of decedents.
[2] One Big Beautiful Bill Act, P.L. 119-21.
[3] For 2026, $16,100 for single taxpayers, $32,200 for married joint taxpayers and $24,150 for head of household taxpayers.
[4] Up to $40,400 (married) or $20,200 (single) in 2026. This is increased by 1% through 2029 and it reverts to a limits of $10,000 in 2030.
[5] The prior law Pease limitation took away 2% of itemized deductions and the newly formulated version, assuming the highest tax bracket is 37%, denies 2/37, as a supposedly easier way to calculate the same result.
[6] IRC Section 641.