Take-Away: The income tax deduction afforded to estates and trusts to escape the compressed income tax brackets these entities face is governed by the concept of distributable net income (DNI.) The estate or trust cannot claim this income tax deduction for more than the DNI that is available to the entity. Normally, capital gains are not included in DNI.

Background: The income of a trust or an estate is calculated like an individual, with a couple of exceptions. [IRC 641(b).] The income is either taxed to the estate or trust, (for ease, referred to simply as the entity) or to the beneficiary. If income from the entity is distributed then the entity will receive a distribution income tax deduction that is limited to distributable net income (DNI) and the beneficiary will report that income on his or her own Form 1040 income tax return. If no distributions are made, then the entity must report all income and pay the income tax. The tax rates faced by the entity are brutal, with all income above $13,050 taxed at the 37% federal income tax rate. Accordingly, DNI is important for the following reasons:

(a) DNI identifies the amount of the distribution income tax deduction the entity will receive. The entity cannot receive a distribution deduction for more than its DNI.

(b) DNI identifies how much the beneficiary will have to report as income on his/her Form 1040 income tax return. The amount the beneficiary has to report cannot exceed DNI.

(c) DNI identifies the character of the distribution. The distribution retains the same character with the beneficiary as it had at the entity level.

(d) DNI acts as a ceiling on the amount of the distribution income tax deduction to the entity, and as the ceiling on the amount of distribution that the beneficiary must include in his/her taxable income.

Adjustments to DNI: Several adjustments are made to calculate an entity’s DNI. There is a personal exemption of either $300 or $100. Capital gains are taxed at the entity and normally they will not be distributed out to the beneficiary. Added back are net tax-exempt income, less expenses that are allocated to that tax-exempt income. [Under IRC 265 the fiduciary cannot deduct a portion of the fees that are used to earn tax-exempt income.] Thus, when calculating DNI, the fiduciary starts with taxable income and then makes adjustments. It is trust accounting income,  less any deductible expenses, whether allocated to either income or principal.

Summary:  DNI is taxable income, less capital gains, plus tax-exempt income. As a general rule, DNI will not include capital gains or losses which are taxed at the entity level.

Example #1: A trust has income of $25,000 reflecting $15,000 of dividends and $10,000 interest income. The trust has incurred trustee fees of $5,000. The trust’s income is: $25,000 less $5,000 trustee fees, less $100 tax exemption, or $19,900. DNI is $19,100 + $100 = $20,000.

Example #2: A trust has long term capital gains of $30,000, interest income of $10,000, $15,000 of dividend income, and trustee fees of $5,000. Thus, its taxable income is $49,900 [$30,000 of gain + $10,000 of interest + $15,000 of gain, less $5,000 in fees, less $100 standard deduction = $49,900.] The trust’s DNI is then $49,900 taxable income, adjusted by deducting the $30,000 capital gains and adding back the $100 personal exemption, resulting in a DNI of $20,000.

Moving Capital Gains into DNI: The goal of many fiduciaries is to try to get capital gains moved into DNI, to get the capital gains out to the beneficiaries and taxed at the beneficiaries’ much lower income tax rates. How DNI is allocated is different for simple trusts [IRC 651 and 652] and complex trusts [IRC 661 and 662] and the numerous rules and elections associated with those two categories.

  • Simple Trusts: A simple trust must distribute all income annually. There can be no distributions to a charity that qualify for a trust’s charitable deduction.[IRC 642(c).] The trust does not permit any distributions of principal. Capital gains are normally subject to tax at the entity level. All else is taxed to the trust beneficiary, i.e. the amount the beneficiary must account for on his/her Form 1040 income tax return. [IRC 652.] When the trustee makes a distribution the trust will receive a distribution income tax deduction for all trust accounting income it distributes, limited to DNI. The amount of the distribution income tax deduction will be reduced by tax-exempt income, as a recipient cannot receive a tax deduction for non-taxable income.

Example: A trust has two beneficiaries: the settlor’s wife is to receive 2/3rd income and son 1/3rd income. The trust has accounting income and DNI of $9,000. The amount of DNI a beneficiary receives under a general rule is equal to the amount of his/her distribution over all distributions. Since the wife received 2/3rds of trust accounting income she will receive 2/3rds of DNI, the son will receive 1/3rd DNI. The trust claims a distribution income tax deduction of the entire $9,000. If the trust had more than one class of income, e.g. $6,000 in dividends and $3,000 interest income, each class of income will be allocated between the two beneficiaries pro rata.

  • Complex Trust: Simply put, a complex trust is not a simple trust. A complex trust has (i) discretionary distributions of trust accounting income, and (ii) any principal distributions. If no distributions are made from the entity, all income is taxed at the entity level. If the entity makes distributions, they will qualify for DNI income tax deduction to the entity and carry out DNI to the beneficiaries, the amount the beneficiary has to account for on his/her Form 1040 income tax return. [IRC 662.]

Rules: In keeping with its name, a complex trust has different rules. (i) It follows the pro rata rule explained in the prior example. (ii) It follows a tiered system of allocations. (iii) It follows the separate share rule. (iv) It has  a special rule for specific bequests. (v) It permits special elections for in-kind distributions. (vi) And it permits the 65-day election to make taxable distributions retroactive to the prior calendar year.

Tier System: This rule is complex because it may, or may not, apply to some complex trusts. It affects the allocation of distributions among beneficiaries. If total distributions from the complex trust are greater than DNI the tier system comes into play. If a beneficiary is entitled to trust accounting income and other trust beneficiaries are discretionary distributees, the tier system of allocation applies. Those beneficiaries who are required to receive trust accounting income are known as first tier beneficiaries. Those who receive discretionary distributions are second tier beneficiaries. Either the trust instrument or the state’s version of the Uniform Principal and Income Act will govern this allocation. Under this tier regime of allocation, the first tier beneficiaries are allocated DNI first. If there is any DNI left over, that DNI is only then allocated to the second tier beneficiaries. This ‘all DNI first’ rule can obviously produce a different result than the pro rata rule which was described earlier.

Charitable Distributions: A charitable distribution will ‘gross up’ DNI by the full charitable distribution. However, no charitable deduction is allowed for first tier trust beneficiaries. It is possible that when calculating DNI for a second tier beneficiary the second tier beneficiary may receive the distribution from the trust without any income tax consequence. If all the beneficiaries are second tier beneficiaries, that charitable distribution may leave no DNI for the second tier beneficiaries, i.e. no taxable distribution to them.

Separate Share Rule: This rule provides that beneficiaries cannot dip into the shares of other beneficiaries. Each beneficiary will only be taxed on the DNI of their respective separate share. As a result, the trustee must calculate the DNI of each separate share. In order to avoid the separate share rule a trust must either be set up as a ‘pot trust’ or actually require the division of the trust into separate trusts. The separate share rule is mandatory, not elective, and it applies to both trusts and estates. This rule does not mean that you have multiple trusts, e.g. two tax returns, just that the rule is used to allocate DNI to separate beneficiaries.

65-day Rule: This is for a trust that has not distributed all of its DNI by year end, but the trustee wants to move more taxable income, i.e. DNI, out of the trust and to the beneficiaries at their lower marginal income tax rates. The trustee can make such a distribution within 65 days of the following year, e.g. March 5, and treat that distribution (by an election) as if it was made on the prior December 31. [IRC 663(b).] The election is made by checking a box on the Form 1041. Consequently a distribution from the entity within 65 days of the end of the prior year will carry out DNI to beneficiaries for that prior taxable year.

Specific Bequests: If a specific asset is identified in the trust or the estate, e.g. a car, a piano, an exact sum cash like $10,000, no distribution income tax deduction to the entity is available, and nothing is included in the beneficiary’s taxable income. Specific bequests do not carry out DNI. The asset or the specific amount of money must be ascertainable at the date of the owner’s death. [IRC 663(a)(1).]

In-Kind Distributions: An election can be made by the fiduciary for an in-kind distribution to fund a bequest. If a distribution is made in-kind the amount of DNI that the distribution carries out is generally the lower of cost basis or the fair market value of the property.  If appreciated property is distributed, the fiduciary can elect to recognize gain at the entity level; if so, the amount of DNI that carries out to the beneficiary is the fair market value of the property not the lower cost basis. This election also then increases the tax basis of the asset in the hands of the beneficiary. [IRC 643(e).]

Including Capital Gains in DNI: The Tax Code provides two requirements to meet and three options to include capital gains in DNI. (i) State law permits the fiduciary to allocate to income capital gains, but that allocation and treatment must be consistently applied, e.g. the fiduciary cannot ‘cherry pick’ which years in which to include gains in DNI. (ii) The trust instrument expressly authorizes the fiduciary to treat capital gains as part of DNI. (iii) The trust instrument gives the fiduciary the right under any of three different methods to elect to treat capital gains as part of DNI, so long as that election does not violate local law. While Treasury Regulations provide 14 different examples of the ability to include capital gains in DNI they still leave many unanswered questions. [Regulation 1.643(a)-3(b).]

Conclusion: Distributable net income controls who pays the income tax, and in some cases, if an income tax will even have to be paid if distributions are made from a trust or an estate (if DNI has been fully distributed previously.) As a generalization, capital gains are not included in DNI and thus are taxed to the trust or the estate. If the desire is to have the capital gains carried out as part of DNI when distributions are made to beneficiaries, then a complex trust will have to be adapted in order for the trustee to treat capital gains as part of DNI and thus covered by the trustee’s distribution income tax deduction.