Trust accounting income
By Richard C. Wilson, founder of the Family Office Club
Key takeaway
Trust accounting income is the income determined under a trust’s governing instrument and applicable local law, a measure distinct from taxable income and distributable net income. Distributable net income is the entity’s taxable income with statutory modifications. Trust terms that depart fundamentally from traditional principles of income and principal will generally not be recognized.
How it works
Ordinary dividends, interest and rents are generally allocated to income, and proceeds from the sale or exchange of trust assets are generally allocated to principal. These are general allocation principles under the Treasury regulation defining income, subject to the governing instrument and applicable local law.
An allocation to income of all or part of the gains from the sale or exchange of trust assets will generally be respected if it follows the terms of the governing instrument and applicable local law. It will also generally be respected if it follows a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law.
Certain extraordinary dividends and taxable stock dividends are not considered income under §643(b). The exclusion applies only when the fiduciary, acting in good faith, determines that they are allocable to corpus under the governing instrument and applicable local law, and it does not apply indiscriminately to ordinary dividends.
Federal tax law respects an allocation between income and principal under applicable local law that provides a reasonable apportionment of the trust’s total return between the income and remainder beneficiaries. Total return includes ordinary and tax exempt income, capital gains and appreciation.
The regulation’s example is a state statute defining income as a unitrust amount of no less than 3% and no more than 5% of the fair market value of the trust assets, determined annually or averaged over multiple years. That example does not itself authorize a trustee to adopt that formula, and the figure is not indexed.
A state statute that permits the trustee to adjust between income and principal to fulfill the duty of impartiality is generally a reasonable apportionment of total return. The regulation describes statutes under which the trustee invests under the state prudent investor standard, the trust describes distributions by referring to income, and the ordinary statutory allocation rules leave the trustee unable to administer the trust impartially.
State statutory authority and its requirements must be satisfied, because the regulation does not independently confer an adjustment power.
Allocations under methods prescribed by state statutes for apportioning total return are respected whether the trust requires income to be distributed or may accumulate it. They are respected regardless of which permitted method is actually used, provided the trust complies with all requirements of the state statute for switching methods.
A switch between methods authorized by state statute is neither a §1001 recognition event nor a taxable gift from the grantor or any beneficiary, provided the trust complies with all requirements of the state statute for switching methods. A switch to a method not specifically authorized by statute but valid under state law, including a judicial decision or a binding nonjudicial settlement, may be a recognition event and may produce taxable gifts, depending on the facts and circumstances.
Where it shows up: required distributions
The fiduciary figures accounting income under the will or trust instrument and applicable local law before preparing Form 1041, to determine the amount, if any, of income that is required to be distributed. The income distribution deduction is based, in part, on that amount.
Income required to be distributed currently is income that the governing instrument and applicable local law require to be distributed in the year it is received. The fiduciary must be under a duty to distribute it currently, even if the actual distribution is not made until after the close of the trust’s tax year.
Required distributions and their tax treatment are separate calculations. First tier distributions are deductible by the estate or trust to the extent of distributable net income, and the beneficiary includes such amounts in income to the extent of the beneficiary’s proportionate share of distributable net income.
A trust may qualify as a simple trust if the trust instrument requires that all income be distributed currently and does not provide that any amounts are to be paid, permanently set aside or used for charitable purposes. The trust must also not distribute amounts allocated to corpus, and qualifying as a simple trust does not make accounting income equal taxable income.
Where it differs from distributable net income and taxable income
| Measure | How it is defined |
|---|---|
| Trust accounting income | The amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. |
| Distributable net income | The taxable income of the estate or trust computed with statutory modifications, which include tax exempt interest to which §103 applies, reduced by disbursements allocable to that interest that would be deductible but for §265. |
Allocating capital gains to principal is relevant to distributable net income but does not, by itself, establish that the gains are excluded from it. Under §643(a)(3), gains from the sale or exchange of capital assets are excluded only to the extent they are allocated to corpus and are not paid, credited or required to be distributed to a beneficiary during the taxable year, and not paid, permanently set aside or to be used for §642(c) purposes.
Section 643(a)(3) does not apply to a foreign trust, so accounting classification and distributable net income treatment must be considered separately.
Capital gains enter distributable net income to the extent they are allocated to income, allocated to corpus but treated consistently on the trust’s books, records and tax returns as part of a distribution to a beneficiary, or allocated to corpus but actually distributed to a beneficiary or used by the fiduciary to determine the amount distributed or required to be distributed. The treatment must follow the governing instrument and applicable local law, or a reasonable and impartial exercise of discretion under a power granted by applicable local law or the governing instrument if not prohibited by applicable local law.
When income is defined as a statutory unitrust amount, a discretionary allocation of gains to income must be exercised consistently and cannot exceed the unitrust amount less distributable net income determined without that allocation. Gains that support an allowed §642(c) charitable deduction must be included in distributable net income, and capital losses are first netted at the trust level against gains, except gains used to determine the distribution to a particular beneficiary.
A nongrantor estate or complex trust deducts income required to be distributed currently plus other amounts properly paid, credited or required to be distributed, but never more than distributable net income. No deduction is allowed for the part of distributable net income that is tax exempt income, and the rule applies to an estate or trust not subject to subpart B.
For distributions from an estate or trust described in §661, beneficiaries include amounts required to be distributed currently, whether distributed or not, generally up to the estate’s or trust’s distributable net income. When required current distributions exceed distributable net income, each beneficiary includes a proportionate share.
Common questions
Does trust accounting income mean taxable income?
No. Trust accounting income is determined under the governing instrument and applicable local law, while distributable net income is the entity’s taxable income with statutory modifications. Qualifying as a simple trust does not make accounting income equal taxable income.
Are capital gains included in trust accounting income?
Generally no, because proceeds from the sale or exchange of trust assets are generally allocated to principal. An allocation to income of all or part of the gains will generally be respected if made under the governing instrument and applicable local law, or through a reasonable and impartial exercise of a discretionary power granted by applicable local law or the governing instrument, if not prohibited by applicable local law.
Are capital gains included in distributable net income?
Yes, to the extent capital gains are allocated to income, allocated to corpus but treated consistently on the trust’s books, records and tax returns as part of a distribution to a beneficiary, or allocated to corpus but actually distributed to a beneficiary or used by the fiduciary to determine the amount distributed or required to be distributed. The treatment must follow the governing instrument and applicable local law, or a reasonable and impartial exercise of fiduciary discretion under a power granted by applicable local law or the governing instrument if not prohibited by applicable local law. When income is defined as a statutory unitrust amount, discretionary allocation of gains to income must be consistent and cannot exceed the unitrust amount less distributable net income determined without that allocation. Gains supporting an allowed §642(c) charitable deduction must enter distributable net income. Capital losses are first netted at the trust level against gains, except gains used to determine the amount distributed or required to be distributed to a particular beneficiary.
Does allocating a gain to principal keep it out of distributable net income?
Not by itself. Under §643(a)(3), exclusion applies only to the extent the gains are allocated to corpus and are not paid, credited or required to be distributed to a beneficiary during the taxable year, and not paid, permanently set aside or to be used for §642(c) purposes, and the rule does not apply to a foreign trust.
Are extraordinary dividends always excluded from trust accounting income?
No. Only certain extraordinary dividends and taxable stock dividends are excluded, and only when the fiduciary, acting in good faith, determines that they are allocable to corpus under the governing instrument and applicable local law. The exclusion does not apply indiscriminately to ordinary dividends, which are generally allocated to income.
Does trust accounting income decide what a trust must distribute?
No, not by itself. Accounting income helps determine the amount of income required to be distributed, but the duty to distribute comes from the governing instrument and applicable local law in the year the income is received. The fiduciary must have a current duty to distribute, even if actual payment occurs after the close of the trust’s tax year. First tier distributions are deductible to the extent of distributable net income, and beneficiary inclusion is limited to the beneficiary’s proportionate share of distributable net income.
Can a trust deduct more than distributable net income for distributions?
No. A nongrantor estate or complex trust not subject to subpart B deducts income required to be distributed plus other amounts properly paid, credited or required to be distributed, but never more than distributable net income. No deduction is allowed for the part of distributable net income that is tax exempt income.
Does tax exempt interest count in distributable net income?
Yes, if the interest qualifies under §103, it is included in distributable net income. It is reduced by disbursements allocable to that interest that would be deductible except for §265, which shows why distributable net income is not simply taxable income.
Does a state unitrust formula count as income for federal tax purposes?
Yes, when applicable local law provides a reasonable apportionment of total return between the income and remainder beneficiaries. Total return includes ordinary and tax exempt income, capital gains and appreciation. The regulation’s example is a state statute defining income as a unitrust amount of no less than 3% and no more than 5% of the fair market value of the trust assets, determined annually or averaged over multiple years. That example does not itself authorize a trustee to adopt the formula, and the figure is not indexed.
Is switching how a trust defines income a recognition event or taxable gift?
No, a switch between methods authorized by state statute is neither a §1001 recognition event nor a taxable gift from the grantor or any beneficiary when the trust complies with all statutory requirements for switching. A switch that is valid under state law but not specifically authorized by statute, including one by judicial decision or binding nonjudicial settlement, may be a recognition event and may produce taxable gifts, depending on the facts.