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Tax News You Can Use

Trust Income Tax and the Mysterious DNI Deduction

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Tax News You Can Use | For Professional Advisors

 

Jane G. Ditelberg

Jane G. Ditelberg

Director of Tax Planning, The Northern Trust Institute

The income tax treatment of trusts is often misunderstood. Unlike C corporations, income of a domestic irrevocable non-grantor trust1 is not all taxed at the trust level, but unlike partnerships or S corporations, all the items of income and deduction do not pass through directly to the beneficiary’s return either. Rather, for trusts the tax code divides items of income and deduction between the trust and the beneficiary. The beneficiary pays tax on items allocated to the beneficiary in the process described below, while the trust pays tax on the income allocated to the trust. If there are multiple beneficiaries, the trust return divides the income and deductions among them.

In this discussion, “trust” refers only to domestic irrevocable non-grantor trusts.

Which trustees must file tax returns?

The trustee2 of a trust must file a federal income tax return if the trust has more than $600 in income or has a foreign person as a beneficiary. Items of income and deductions are determined under rules that are much the same as those for individuals. For example, a trust that owns rental real estate will have income from rent offset by deductions for real estate taxes and maintenance expenses. However, although the trust reports all taxable income received by the trust on this return, the trust may not be the taxpayer that pays tax on all that income.

Simple vs. complex trusts

The tax code divides trusts into two categories to determine how to calculate the tax. A “simple” trust is one that requires the trustee to distribute all income, as long as there were no distributions of principal and no amounts distributed to or permanently set aside for charity. While a trust that requires the trustee to distribute all income and prohibits distributions of principal will always be a simple trust, for other trusts the status is determined on an annual basis depending on whether the trustee made principal distributions that year. For simple trusts, all items constituting income will be allocated to the beneficiary who will owe the tax.

Trusts that are not simple trusts are “complex” trusts. This includes trusts that distribute less than all the income AND those that make principal distributions, whether or not the trustee distributes the income. To determine whether the trustee has distributed income or principal, the Internal Revenue Code relies on state law and the terms of the trust’s governing instrument. Trusts that meet state law and tax law rules to be a unitrust (define income as a percentage rather than by source) define the percentage as “income” and so are not complex trusts simply because they are unitrusts. For complex trusts, the share allocated to the beneficiary depends on income sources and amounts distributed. The beneficiary pays tax on the income allocated to them, and the trust pays tax on the rest.

What is “income”?

One confusing factor is the difference between “income” for trust accounting purposes and “income” for tax purposes, including the tax code’s concept of “distributable net income.” This distinction is key to understanding the effect of trust distributions on the calculation of tax. From here on, we will refer to TAI (for trust accounting income), TI (for taxable income) and DNI (for distributable net income).

Calculating trust accounting income

Let’s start with TAI. A trust may have receipts from various sources, like dividends, interest, royalties, or rents, as well as the proceeds from the sale of an asset, distributions from an estate, or gift contributions. The trustee must divide these amounts between “income” and “principal” which often benefit different beneficiaries. Typically, a distribution from an estate or a new gift constitutes principal, while interest and dividends constitute income. Similarly, the trustee must allocate amounts paid out, including distributions to beneficiaries as well as expenses, such as trustee fees, legal fees, and taxes, between income and principal.

The governing instrument and applicable state law (the law that governs the administration of the trust) determine which items are income and which are principal for purposes of computing TAI. State statutes set the default rules, while also permitting the governing instrument to vary those rules. For example, a trust may provide that the trustee should pay their fees all from income rather than dividing them between income and principal, a common provision included in trust instruments when the trust’s principal is illiquid.

Trusts frequently define the beneficiaries’ interests by reference to income and principal. When they do this, they are referring to TAI. Some beneficiaries may only receive income, some only principal, and some both but under different circumstances. For these reasons, TAI is important not just for tax purposes but also for determining each beneficiary’s beneficial interest.

Example:

Receipts and Disbursements of Trust A:

From a cash perspective, Trust A received $127,000 and disbursed $69,000 and therefore has $58,000 in cash on hand at the end of the year. But how much of that cash represents income distributable to the beneficiary entitled to the net trust accounting income? In this case neither $127,000 nor $58,000 represents TAI.

To calculate TAI, we split the items between income and principal:

Here, there is $23,500 of income cash on hand at the end of the period, and this amount constitutes the TAI.

Computing taxable income

What is the difference between TAI and TI? The tax code governs TI. It provides that dividends are taxable income, tax-exempt interest is not taxable,3 and the portion of real estate taxes, legal fees, and trustee fees allocated to taxable (rather than tax exempt) income are deductible in full. Here, the computation looks like this:

This results in TI of $18,000. If Trust A were an individual, this would be the net income.

What is the deduction for distributable net income?

However, with a trust, simple or complex, we must compute another number. This is the distributable net income or DNI, and this is what generates the deduction to the trust and the income to the beneficiary and ensures that both the trust and the beneficiary do not pay tax on the same income.

For there to be a DNI deduction, there needs to be a distribution to a beneficiary. If we assume Trust A is a simple trust, then the trustee would distribute $23,500 to the beneficiary. Trust A then could deduct the amount distributed, up to the total of DNI, from the TI to determine its tax. In this case, the DNI deduction would cover the entire $18,000 TI, and the trust would have zero taxable income itself. The beneficiary, who received $23,500, would receive a K-1 with $18,000 of DNI. Note that the amount received, and the taxable amount are not the same.

If instead we have a complex trust, we look at the amount the trustee distributed. Because it is often not possible to know the amount of DNI before the end of a calendar year, the tax code gives the trustee the right to elect to treat distributions made in the first 65 days of the following calendar year as distributions of DNI from the first year.4

Suppose the trust were a complex trust and the trustee distributed only $10,000 to the beneficiary, which is less than the TAI. Then, the DNI deduction would be less than the TI so both the trust and the beneficiary would report and pay tax on part of the income. The income taxed to the trust and the income taxed to the beneficiary would consist of pro rata shares of net taxable and net tax-exempt income.

What about capital gains?

In the foregoing examples, none of the receipts were the proceeds of sale of a capital asset. In general, the trust and not the beneficiary pays tax on capital gains except in the year the trust terminates. This is because the proceeds of sale of a capital asset are not part of TAI and so they do not form part of DNI and are therefore not deductible even if the trustee distributes them.

Under some state statutes and the terms of some governing instruments, the trustee may have discretion to allocate some or all the capital gains to income. In other cases, the trust defines income for TAI purposes as including capital gains or as a unitrust (a fixed percentage of the value of the trust each year). When capital gains are allocated to income for TAI purposes, they then become part of the DNI deduction calculation.

Example:

Trust B has $50,000 in taxable dividend income and $100,000 in long-term capital gains from the sale of stock. It also has $10,000 in deductions which are equally allocated between income and principal under the terms of the governing instrument.

If the distribution to the beneficiary is $75,000, and the governing instrument does not re-allocate capital gains to TAI, the maximum DNI deduction will be $45,000 ($50,000 in dividends less $5,000 in deductible expenses allocated to income). The trust will pay tax on the remaining amount.

If instead the trust agreement required the allocation of 50% of the capital gains to income every year for trust accounting purposes, then the DNI would be $92,500 ($50,000 in dividends plus $50,000 in capital gains less two-thirds of the deductions). The trust could deduct the entire $75,000 distributed as a DNI deduction, and the trust would pay tax on the remaining amount. The beneficiary would include the $75,000 on their tax return, and the income would have the same character as dividend or capital gain in the beneficiary’s hands as it did for the trust.

Key Takeaways:

  • For irrevocable non-grantor trusts, the amount distributed to a beneficiary is not automatically all taxable income.
  • A beneficiary will not know what portion of the amount received will be taxable income until the beneficiary receives a form K-1 from the trustee, usually in March of the following calendar year unless extended.
  • Calculating TAI requires understanding the terms of the trust instrument and applicable state law.
  • Taxing the income to the beneficiary often results in lower overall tax because the trust income tax brackets are more compressed. Trust income is taxed at 37% (the highest rate in 2024) if it exceeds $14,450. Individuals do not reach that tax bracket until they have $609,351 for a single taxpayer or $731,201 for a married taxpayer filing jointly. However, don’t forget to take state income taxes into account. The trust and the beneficiary may not be residents of the same state for income tax purposes.
  • Trust beneficiaries, trustees and their tax preparers should coordinate tax planning and related decisions.
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  1. We limit this discussion to domestic irrevocable non-grantor trusts. We’ll cover grantor trusts (including revocable trusts) and foreign trusts, as well as special rules applicable to charitable trusts, in upcoming editions of Tax News You Can Use.
  2. Although we talk about tax imposed on trusts, legally it is trustees who must file returns and pay any tax assessed from the trust’s assets.
  3. If the trust had tax-exempt income, then the deductions would need to be allocated between tax-exempt and taxable income, and the treatment of income as taxable or tax-exempt would carry out to the beneficiary.
  4. For more details on the 65 day rule and the planning opportunities it provides, see our companion piece, found here: https://www.northerntrust.com/united-states/institute/articles/the-65-day-rule-its-impact-on-trust-income-taxes

Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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