Taxation of Income Distributions from Trusts and Estates
These are complicated tax issues and if you have any questions call me at (856) 665-2121.
Estates and non-grantor trusts must file their federal tax returns as separate legal entities, just like individual taxpayers. Unlike individuals, however, these entities may distribute income to beneficiaries, which can shift tax liability. Beneficiaries, heirs, trustees, executors, and those devising plans to transfer their assets need to understand how different types of distributions are taxed.
Principal vs. Income Distributions
The type of distribution — principal or income — is critical in determining the federal tax implications for the beneficiaries in most cases. However, no distribution from a revocable trust is taxable to the beneficiary. That’s because all taxable income is reported on the tax return of the trust creator (also known as a grantor or settlor). This treatment also applies to irrevocable grantor trusts, such as grantor-retained annuity trusts or intentionally defective grantor trusts.
Distributions from an estate generally aren’t taxable to heirs. Instead, they’re subject to the estate tax if the estate is large enough to trigger it. For 2025, the federal lifetime gift and estate tax exemption is $13.99 million ($27.98 million for a married couple).
Note: In 2026, the unified federal exemption is scheduled to fall to the pre-2018 level with a cumulative inflation adjustment for 2018 through 2025. If that happens, the exemption is estimated to be roughly $8 million for 2026. However, Congress is expected to extend the current exemption (or possibly make it permanent) as part of a comprehensive future tax bill. An update to my Blog will be posted when Congress takes action. RJC
Irrevocable Non-Grantor Trusts
Regarding distributions from irrevocable non-grantor trusts, the recipient’s tax liability generally turns on the distribution’s origin. It depends on whether the distribution comes from the trust’s principal (meaning the assets originally contributed to the trust and any subsequent deposits) or the income that the principal has generated (for example, dividends, interest, or rental income). Distributions from the principal aren’t taxable to the recipient because the trust creator presumably already paid taxes on the principal.
Distributions from income are taxable for the recipients, usually at ordinary income tax rates. Tax-exempt income is an exception, though. Distributed income retains the character it had when the trust earned it. Thus, tax-exempt income for the trust is also tax-exempt upon distribution.
The IRS treats trust distributions as coming from current-year income. If a distribution exceeds the current-year income, the excess is attributed to the principal and, therefore, not taxable for the recipient.
Example: A beneficiary could receive a distribution combining principal and income.
If a beneficiary receives a $20,000 distribution and if the trust had no current-year income, the distribution would be treated as a nontaxable principal distribution. If the trust earned $10,000 in dividend income, the distribution would be split equally between income (taxable) and principal (nontaxable).But what if the trust had $10,000 in dividend income and a $10,000 capital gain? The distribution would still be split between income and principal. That’s because capital gains are generally added to the principal rather than treated as income for trust accounting purposes (see below for more information on capital gains).
Fortunately, the beneficiary needn’t figure this out. The trust will issue a Schedule K-1 that indicates the character of amounts distributed and the amount the beneficiary should claim as taxable income.
The Role of DNI – here we go for fun tax information- RJC
The IRS defines distributed net income (DNI) as the income available for distribution from a decedent’s estate or trust. DNI limits the deduction an estate or trust can claim for amounts distributed to beneficiaries. Specifically, an estate or trust can deduct the lesser of:
a.The trust income that’s required to be distributed plus other amounts “properly paid or credited or required to be distributed,” or
b.DNI.
Note:DNI is also the maximum taxable amount to be distributed to a trust’s beneficiaries. Any excess distribution is tax-free to the beneficiaries. RJC
Calculate DNI
To compute DNI:
a. start with the estate or trust’s taxable income before the distribution deduction.
B.add the values of the applicable tax exemption and any tax-exempt interest and subtract net capital gains. Trusts are allowed $100 or $300 exemptions, and estates can claim $600 exemptions.
C. Capital Gains
For estates and trusts, gains on assets held for 12 months or less are taxed as ordinary income. Long-term assets held for over 12 months are subject to the applicable long-term capital gains tax rate (15% or 20%).
Note and Issue: Simple trusts, which are required to distribute all income every year and can’t distribute principal, pay the taxes on capital gains added to the principal. RJC
Suppose a trust is permitted to allocate capital gains to income or distribute capital gains (in which case they’re included in DNI). In that situation, the beneficiaries typically will pay taxes on the gains. Trust beneficiaries may also incur capital gains tax on distributed assets that appreciate after being transferred to the trust (for example, shares of stock or real estate) if those assets are subsequently sold.
Minimizing Tax Obligations
Income tax rates for trusts and estates are the same as for individual taxpayers, but the taxable income brackets are narrower. As a result, trusts and estates reach the highest rate with a much smaller amount of taxable income than individuals do. For 2025, the 37% top marginal tax rate for single filers begins after $626,350 of ordinary income. A trust or estate is subject to that rate after reaching only $15,650 of income for 2025.
The same goes for long-term capital gains rates. For 2025, the top 20% rate doesn’t kick in for single filers until their taxable income exceeds $533,400. That rate applies to trusts and estates with adjusted capital gains above $15,900 for 2025.
That means many beneficiaries will be taxed at lower rates than the trust. Distributing income or capital gains to such beneficiaries can help minimize the trust’s overall tax bill. Not only will the distribution be taxed at a lower rate, but the trust may also be able to deduct the distribution. This approach is especially wise for trusts that generate significant income.
Proceed with Caution
The taxation of distributions can be complicated — even without addressing any state tax laws that might apply. If you have gotten this far and you have any questions call me at (856) 665-2121.
-RJC
5/31/2025
