Trust and estate income is taxed at an extremely high marginal rate. Income not distributed during the year is taxed to the trust or estate. Distributions to trust beneficiaries during the year or within 65 days after the end of the year generate a distribution deduction to the trust or estate.

Such distributions are included in the income of the recipient beneficiary at his or her marginal tax rate. The effect of the distribution deduction is to shift income tax liability from the trust or estate to the recipient beneficiaries. Since trusts and estates are in a much higher tax bracket, distribution of income to beneficiaries is desirable.

The trustee or the personal representative must be ever vigilant against accumulating income in the estate or trust and thereby paying unnecessary income tax.

The following chart compares the tax rate of married couples filing jointly to that of trusts and estates:

As you can see, the tax rate is substantially higher for 1041 income. An estate or trust reaches the maximum tax rate of 39.6% with only $8900 of taxable income, while a married couple filing jointly doesn’t reach the maximum tax rate until they have $297,350 of taxable income.

As noted, trusts and estates are permitted a distribution deduction for distributions to beneficiaries during the tax year or within 65 days of the end of the year. The 65-day rule allows the trustee or personal representatives time to assess trust or estate income tax liability for the year and to make distributions to shift income tax liability to the beneficiaries.

For calendar year trusts and estates, the 65-day period coincides with the deadline for issuance of 1099s. Taxpayers, including trusts and estate, must receive forms 1099 by January 31st. The 65-day rule allows trustees and personal representatives time between January 31 (when they receive trust and estate 1099s) and March 5th (the deadline for making distributions) to assess their tax liability and to make trust or estate distributions that will achieve the optimal application of the marginal tax rates between the entity and the beneficiary.

Distributions within the 65-day period relate back to the previous tax year. The trust or estate is allowed to deduct distributions in the 65 day period as if made during the previous tax year. Likewise, beneficiaries must report the distribution as if received on the last day of the trust or estate’s immediately preceding tax year.

Distributions generate a deduction only to the extent of the trust or estate’s distributable net income (“DNI”). Basically, DNI is the trust or estate’s taxable income for the year. Distributions in excess of DNI are not deductible to the trust or estate and are not taxable to beneficiaries.

Distributions are first considered distributions of DNI and qualify for a distribution deduction. Specific bequests such as “$10,000 to my cousin Vinny” are not considered taxable distributions. The tax Code recognizes that the decedent probably did not want cousin Vinny to pay income tax on the remembrance left to him by the decedent.

Form K-1 is an attachment to Form 1041. A separate K-1 is prepared for each beneficiary to reflect his or her share of trust or estate income and loss. Beneficiaries must wait to prepare their 1040 until they have received their K-1. The K-1 will not only indicate the amount of income and loss to be included on their personal return, but also the character (i.e., capital versus ordinary, long term versus short term).

The following is an example of page one of Form K-1: