Dear Tax Talk,

I am the trustee of a complex trust set up for my son by his great uncle when my son was a year old. My uncle died in 1999. The will states that I may pay portions of net income and/or principal for educational purposes. It also states that when my son turns 22, I am to distribute half of the trust account to him, at age 24 to distribute half of remaining balance, and then at 26 to distribute the balance of the trust.

The only income is from dividends, interest and any stock gains or losses. I am not paying myself a trustee fee, so expenses are taxes, lawyer fees, etc. For the years through 2007, the distributable net income, or DNI, was not distributed and the trust paid the taxes.

Do all these years of nondistributed DNI now become part of the principal? In 2008, my son turned 22, and half of the trust amount was distributed to him. For 2008 tax purposes, does that amount include the 2008 DNI, or is the distributed amount considered all principal? Is there a way for the trust to still pay the taxes on the DNI for 2008, or do I have to pass that on to him?

On the K-1, do I show the full amount distributed, and if so, where? Also, some funds were distributed for college expenses — do these amounts also show up as being distributed to him on the K-1? Are the only forms to be filed the 1041 and the K-1?

— Mike

Dear Mike,

A trust is a separate legal entity for income tax purposes, and thus must file its own tax forms. A trust that is required to distribute all its income currently is considered a simple trust; otherwise the trust is a complex trust.

A trust figures its income and deductions much in the same way that an individual figures his or her income for tax purposes with one major difference. A trust is allowed a deduction for income distributed to beneficiaries. The income distribution deduction is figured by completing Schedule B of Form 1041. The beneficiary, not the trust, pays the income tax on the taxable amount of the distributions.

Generally, if an amount is distributed from a trust, that amount is considered to come out of current-year income first, then from accumulated capital or principal. Accumulated capital would be the original contribution, or contributions, to the trust plus all subsequent accumulations (i.e., income in excess of distributions).

Current income is figured under the state law applicable to trusts and the trust’s governing document. Generally, the only distinction in accounting income under local law and regular net income would be the treatment of capital gains. If you have capital gains, you need to determine if they’re taxable to the trust or the beneficiary.

In 2008, when you distributed half of the trust to your son, all the 2008 income will be taxed to him, and accordingly you will need to complete a Schedule K-1 for him. He in turn will include the K-1 amounts on his individual return. It is hoped he saved some money for taxes. The trust must claim the distribution deduction and pass the tax burden on to the beneficiary.

The full amount distributed is shown on Schedule B and is not required to be shown on the Schedule K-1. All amounts distributed to your son or for his benefit are taxable to him to the extent of the trust’s income distribution deduction. If you don’t have capital gains or alternative minimum tax differences, the two pages of form 1041 and the schedule K-1 would be a complete tax return.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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