Income Taxation of Trusts and Estates
The taxable income of an estate or trust is reduced by the distribution deduction for
amounts distributed, and the beneficiary reports these amounts as gross income.
The estate or
trust pays tax only on amounts retained, less the personal exemption. p. C:14-4.
The opportunity for income tax savings from using trusts is limited because of the
compressed rate schedules and because of the reduced tax rate on dividends, a common type of
income for trusts.
Non-tax reasons for creating trusts still exist, however, including providing for
expert management, assuring that assets are preserved, and reducing probate costs.
Section 641(b) provides that taxable income of estates and trusts is computed in the same
manner as for individuals unless Part I of Subchapter J provides a rule to the contrary. Among the
major differences are a smaller personal exemption deduction and a much more compressed rate
schedule for fiduciaries.
Also, fiduciaries receive a distribution deduction and have no ceiling on
deductible charitable contributions.
Often the trustee cannot distribute principal, or can do so only in limited circumstances.
Many trust instruments mandate that all of the income and/or nothing but income (meaning
income in the accounting, not tax, context) be distributed annually.
Thus, the categorization of a
receipt, gain, expenditure, or loss item as principal or income often affects the dollar amount that
the beneficiary can receive.
pp. C:14-4 and C:14-5.
Under the Uniform Act (1962 version), common examples of principal include the gain
(plus return of capital) upon the disposition of an asset owned by the fiduciary.
examples of income include dividends, interest, and rents.
pp. C:14-5 and C:14-6 and Topic
Review C:14-1 (p. C:14-7).
In general, state law controls; however, if provisions in a trust instrument provide for a
different allocation, the provisions in the trust instrument prevail over state law.
Irene will not receive a distribution equal to the amount of the gain.
Uniform Act, the gain is not classified as income for fiduciary accounting purposes, and Irene is
entitled to receive only income.
pp. C:14-5 and C:14-6.
The gain is retained by the trust for ultimate distribution to Beth, and the trust pays the tax
on the gain.
The tax is imposed in the year of the sale.
pp. C:14-5 and C:14-6.