How Is Income From a Trust Taxed?

The taxable income of a trust or an estate is generally computed in the same manner as the taxable income of an individual.

The fiduciary must compute the tax on this taxable income and pay it. This tax applies to the taxable income of estates and various types of property held in trust, which includes income accumulated for unborn, unascertained, or contingent persons, as well as income held for future distribution. It also covers income that must be distributed currently to beneficiaries, income collected by a guardian of an infant to be held or distributed as the court directs, income received by estates during administration or settlement, and income that the fiduciary has the discretion to distribute or accumulate. For foreign trusts and foreign estates, they are treated as nonresident alien individuals who are not present in the United States at any time. Specific rules apply to electing small business trusts, where the portion consisting of stock in one or more S corporations is treated as a separate trust, taxed using the highest rate set forth in specific provisions with certain modifications and exclusions.

A grantor is treated as the owner of any portion of a trust—and must therefore include the corresponding items of income, deductions, and credits in their own taxable income—when the trust's income, without the approval or consent of any adverse party, or in the discretion of the grantor, a nonadverse party, or both, may be distributed to the grantor or the grantor's spouse, held or accumulated for future distribution to them, or applied to pay insurance premiums on the life of the grantor or the grantor's spouse.

However, trust income is not considered taxable to the grantor merely because it may be applied or distributed in the discretion of another person, a trustee, or the grantor acting as trustee or co-trustee for the support or maintenance of a beneficiary whom the grantor is legally obligated to support or maintain, except to the extent that the income is actually so applied or distributed. If amounts applied or distributed for support are paid out of corpus or other than the year's income, they are treated as paid or credited amounts that are taxed to the grantor under the rules governing beneficiary distributions.

Beneficiaries generally include in their gross income certain amounts required to be distributed to them currently, as well as other amounts properly paid, credited, or required to be distributed for the taxable year.

If the required current distributions to all beneficiaries exceed the distributable net income of the estate or trust, the amount included in a specific beneficiary's gross income is limited to a proportionate share determined by their distribution ratio. Similarly, if the total of current distributions and all other proper payments, credits, or required distributions exceed distributable net income, specific statutory ratios determine the amount included in the beneficiary's income. The amounts included in a beneficiary's hands retain the same character as they had in the hands of the estate or trust. These distributed amounts are treated as consisting of the same proportion of each class of items entering into distributable net income as the total of each class bears to the total distributable net income, unless the governing instrument specifically allocates different classes of income to different beneficiaries.