Income Taxation of Estates and Trusts
Entity Taxation Basics
Estates and trusts are separate taxpayers. They compute taxable income, then deduct distributions to beneficiaries (the distribution deduction), so income is taxed either to the entity or to the beneficiary, but not both. The key mechanics: distributable net income (DNI) caps the distribution deduction and characterizes distributions; the tier system governs how distributions carry out different classes of income; and the entity gets a personal exemption that is small and phased out.
Grantor Trusts and Special Rules
A grantor trust is ignored for income tax purposes; the grantor reports all income. Know the grantor trust powers that trigger this treatment. Also know the rules for charitable remainder trusts, pooled income funds, and the taxation of accumulated trust income. Traps: assuming all distributions are deductible; ignoring the separate share rule for multiple beneficiaries; and missing the distinction between fiduciary accounting income and taxable income.
Fiduciary Accounting vs. Tax
Fiduciary accounting income determines what must be distributed; taxable income determines what is taxed. These differ, for example, with tax-exempt interest or depreciation. Candidates should be able to trace a distribution from gross income through DNI to the beneficiary's return.
Worked Example
A trust has $50,000 of taxable interest and distributes $30,000 to a beneficiary. DNI is $50,000, so the distribution deduction is $30,000 and the beneficiary reports $30,000; the trust reports the remaining $20,000, less its exemption. If the trust had distributed $60,000, the deduction would be capped at DNI of $50,000.
Rule of Thumb
DNI is the ceiling: no distribution deduction and no beneficiary inclusion can exceed DNI.