How can a simple trust beneficiary owe tax without receiving cash?

By Richard C. Wilson

When total required current income for all beneficiaries of a trust described in IRC §651 exceeds DNI, each beneficiary's inclusion before applying the income character rules is calculated as follows:

DNI × the beneficiary's required current income ÷ total required current income for all beneficiaries.

When total required current income does not exceed DNI, each beneficiary's starting amount is their required current income. The rule does not automatically allocate all DNI to beneficiaries.

What does “required to be distributed currently” mean?

Income is required to be distributed currently when the governing instrument and applicable local law require the fiduciary to distribute it in the year the trust receives it. Actual payment after the trust's tax year closes does not by itself remove that duty.

Does the income keep its character?

Yes, simple trust income keeps its character in the beneficiary's hands, including its tax exempt character. Each beneficiary generally receives the same proportion of each income class entering DNI. Deductions entering DNI are allocated among its items under the prescribed regulations.

A different allocation required by the trust instrument replaces the proportional allocation for the affected items only to the extent it has an economic effect independent of its income tax consequences. An allocation required by local law also replaces the proportional allocation for the affected items.

What makes a trust simple?

A trust qualifies as simple only when all three requirements apply:

• The trust instrument requires all income to be distributed currently.
• The instrument does not provide for amounts to be paid, permanently set aside or used for charitable purposes.
• The trust does not distribute amounts allocated to corpus, or principal.

A trust that does not qualify as simple is a complex trust. For accounting income definitions, see the income tax, basis, and trust taxation guide.

How does the required distribution affect the trust's deduction?

Income required to be distributed currently under the governing instrument and applicable local law supports the simple trust's income distribution deduction, subject to DNI, even if no payment occurs. The deduction excludes any DNI item that is not included in the trust's gross income.

What does Schedule K-1 report?

Schedule K-1 reports your share of the trust's income, deductions and credits. The fiduciary must file it, attach each beneficiary's Schedule K-1 to Form 1041 and give each beneficiary their respective copy.

Grantor type trusts do not use Schedule K-1 to report the income, deductions or credits of the grantor or other person treated as owner. For that topic, read the grantor trust income tax and reimbursement guide.

Does a later payment mean the same amount is included again?

No, a later payment does not create another beneficiary income inclusion for an amount deducted on an earlier Form 1041 because it was credited or required to be distributed in that earlier year. The rule applies to that previously deducted amount, rather than to every later payment from the trust.