Trust 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 trustâ€™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 whatâ€™s called â€œfiduciary accounting incomeâ€ (FAI). You can think of FAI as â€œtrust lawâ€ income. To arrive at FAI, the trustee classifies the trustâ€™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 whatâ€™s technically known as â€œdistributable net incomeâ€ (DNI). You can think of DNI as â€œtax lawâ€ income. Beneficiaries are taxed on distributions received from a trust but only to the extent of DNI.
FAI and DNI may or may not be the same in any given year. The most common difference results from how the trusteeâ€™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.