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beneficiaries may be taxed on an amount that is different from
the amount distributed to them from the trust. A trust ordinarily
is a separate taxable entity. Trust income is taxed either entirely
to the beneficiary, entirely to the trust, or partially to the
beneficiary and partially to the trust. The trust’s tax is figured
on Form 1041. Items that the beneficiary picks up from the trust
are shown on Schedule K-1 to that form.
What a trust beneficiary receives from the trust
is based on what’s called “fiduciary accounting
income” (FAI). You can think of FAI as “trust law”
income. To arrive at FAI, the trustee classifies the trust’s
annual receipts and expenditures as either income or principal.
This classification is made in accordance with the terms of
the governing instrument or applicable state law.
How a beneficiary is taxed on trust law income
depends upon what’s technically known as “distributable
net income” (DNI). You can think of DNI as “tax
law” income. Beneficiaries are taxed on distributions
received from a trust but only to the extent of DNI.
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FAI and DNI may or may not be the same in any
given year. The most common difference results from how the
trustee’s commissions (fees) are treated for trust accounting
or tax purposes. Under most state laws, trustee commissions
are chargeable one-half to income and one-half to principal.
But for federal income tax purposes, they are generally deductible
in full. So if the entire amount is deducted, but one-half
is not charged to income for trust accounting purposes, DNI
will be less than FAI. As a result, the trust beneficiaries
will be taxed on less than what they actually receive from
the trust.
These are just some of the many complicated
rules that govern the taxation of trusts and their beneficiaries.
Other rules on how trust beneficiaries are taxed on trust
distributions include the allocation of DNI among classes
of beneficiaries.
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