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Income Tax Accounting for Trusts

Allocating Income Between Beneficiaries and the Trust Greatly Affects Taxes 

Estates and nongrantor trusts must file income tax returns. There are many similarities between 1041 trust returns and 1040 Individual Tax Returns. Nevertheless, there are  some important differences. 

FIrst, Trust Income  taxed at either the Trust  or Beneficiary level. This is determined by whether trust reciepts are allocated to principal or  to distributable income, and whether it is distributed to the beneficiaries

Secondly, because the exemption amounts, tax brackets and related thresholdsfor Trusts are not indexed for inflation like the rates for individuals have, Trust Income pays a higher tax rate at lower levels of incomeFurther, the Obama Medicare tax on investment income on the highest tax brackets, estates and trusts pay still more taxes on incomes over $11,200, as opposed to $200,000 or $250,000 for individuals.


Income of estates and nongrantor trusts is taxed at either the entity or the beneficiary level, depending on the answer to the following two questions:

  • Is each income, loss or deduction item part of the trust’s or estate’s distributable income, or is it part of a change in the principal?
  • Is the income, loss or deduction item distributed to the beneficiaries, or does the entity retain it?

Fiduciary accountingt deals with a fund (the trust principal) and income derived from the fund.

Practical Result of Trust Income

Trusts will reach the top marginal tax rate faster than individuals because of the tax schedule (in 2010, the top marginal tax rate for trusts starts at $11,200). Therefore it is beneficial to allocate as much depreciation as possible to the trust.. It is also beneficial to distribute the income to the beneficiaries. This can be done by your Estate Tax Attorney specifying the allocation in the trust instrument 

Distribution to Beneficiaries.

To prevent double taxation on their income, estates and trusts are allowed to deduct the lesser of distributable net income (DNI) or the sum of the trust income required to be distributed and other amounts “properly paid or credited or required to be distributed” to the beneficiaries (IRC § 661(a)). This includes distributions that can be made out of either income or trust principal to the extent they are made from trust income. Therefore, the income distibuted to the beneficiaries is usually taxed at a lower rate than the Trust.

Tax Free Income

Because the tax rates of estates and trusts are likely higher than the tax rates of the individual beneficiaries, it is best to retain the tax-exempt income in the Trust and distribute taxable income to the Beneficiaries..