Basic Concepts of Fiduciary Income Tax

Many individuals and even lawyers are under the impression that distributions of an estate are subject to income tax. This is a misconception.

Under the fiduciary income tax rules, there is a concept similar to estate income which is called d.n.i. or distributable net income. For example, if an estate has $100,000 and $6,000 of income, and assuming there are three beneficiaries, distributions of the entire estate would only be income to the beneficiaries to the extent of d.n.i.. Suppose that the distribution of $100,000 resulted in d.n.i. of $6,000, the distributions would result in taxable income of $2,000 to each beneficiary.

If the estate does not end within one year, capital gains are also distributed to the estate. Since the estate reaches maximum income at a much lower rate than an individual, accumulation of
estate income only results in a reduction of principal. Therefore, income from an estate should be distributed mandatorily.

Any distributions of income are deductions to the estate. That is, d.n.i. not only is a measuring rod of taxable income, but also determines the distributions to the estate.

If the estate terminates within one year, capital gains pass through as d.n.i.. However, if there are capital gains and the estate is not distributed within one year, the capital gains are distributed to the estate.

Income tax to the distributees can be deferred by the estate electing a fiscal year. That is, income is taxable to the beneficiary in the taxable year of the beneficiary.

Not all items are subject to estate income tax. For example, life insurance is received by the beneficiary tax-free. However, certain items of life insurance are taxable, such as pre-paid premiums and post-mortem dividends.

The computation of d.n.i. is more complicated than the scope of this article, but it does approximate estate income. The form for preparing estate income is a 1041 and the amount of estate income taxable to the beneficiary is reflected on a Form K-1.

Also, the character of the income to the estate carries through to the beneficiary. For example, if one half of the estate income is dividends and one half is bank income, the distributions carry through, pro rata.

As stressed in many of my articles, it is necessary to retain other professionals in handling an estate. Therefore, an accountant should be retained to prepare estate income tax returns.

With respect to the income taxation of trusts, the rules are similar and the form is the same.

Disclaimer: This article does not constitute legal advice and each person may have unique facts for which legal consultation may be necessary.

© January 2012, Post 182