Trust DNI [Distributable Net Income]

[MindfulMoneyManager]

The trust has income and assets. Is it possible for the trust to make a distribution to its beneficiaries from its assets rather than income, DNI?

For example, imagine the trust has $1M in stocks. It also earns $500k in income. Could it distribute the $1M in stocks to its beneficiary but the trust retains the $500k in DNI. Thus the trust pays taxes on the $500k? Or does the $500k of DNI always get transferred to the beneficiary, and now the beneficiary is responsible for the tax liability associated with it?

Would the same hold true for a distributed promissory note?


Before you respond saying “consult a tax attorney,” Yes, this has been done. I know this is complicated and in their avenue. I am simply asking a community of knowledgeable people, many of which are professionals with good judgement and opinions.

[Title clarified - moderator Kendall]

[toddthebod]

If a trust is allowed to distribute more than the DNI, why can't it just pay the beneficiary's tax bill?

[MarkNYC]

Generally, trust distributions to beneficiaries must carry out DNI before carrying out trust principal. There could be some rare exceptions based on the terms of the trust.

[MindfulMoneyManager]

If a trust is allowed to distribute more than the DNI, why can't it just pay the beneficiary's tax bill?

Yes, this is an option.

[HootingSloth]

Just to expand on what MarkNYC said, below is my rough understanding of how this works.

There are two separate frameworks at play here that interact with each other: so-called "trust accounting" principles (which exist outside of tax law) and the tax rules of Subchapter J (which help calculate the taxable income of trusts and their beneficiaries).

Trust accounting requires a trustee to prepare an annual report of the cash receipts and disbursements made throughout the year. In preparing the trust accounting, the trustee is guided by the terms of the document as established by the settlor upon the trust's creation. The settlor may have delineated how the trustee allocates receipts and disbursements between income and principal or may have granted the trustee broad discretionary powers to be the ultimate decision-maker concerning those allocations. Trust accounting is governed by state law and the trust documents, e.g. the Uniform Principal and Income Act, and not by tax law. It may or may not be the case, under the particular trust documents, that the trustee is permitted to make a distribution to a beneficiary out of principal rather than out of "trust accounting income."

DNI is a creature of tax law and not trust accounting principles. The tax law takes the trust accounting and the distributions made as an input in determining the tax liability of the trust and its beneficiaries. As MarkNYC alludes to, distributions are generally treated for tax purposes as "carrying out" DNI, regardless of whether they are distributions of trust accounting income or of principal. Therefore, if a complex trust has $500k of DNI, and, for trust accounting purposes, a distribution of $500k of principal and $0 of trust accounting income is made to the beneficiary, then the beneficiary typically will still be taxed as receiving all $500k of the DNI (and the trust will get a deduction for the full amount of the DNI).

The only exception I know of to the above is for gifts or bequests of specific sums of money or specific property made under the terms of the trust instrument.

[Financeguy]

Just to add, there's another question of why exactly you wouldn't want the DNI distributed to the beneficiary.

Assuming the trust is paying taxes (ie. it's not a grantor trust where the grantor does), it's highly likely that the beneficiary would be in a lower tax bracket than the trust. Trusts and estates kick into maximum tax brackets at de minimis levels of income, whereas for individuals, depending on single or joint filing, you're taking $500K+. If the DNI is paid out to the beneficiary, then the trust will get a deduction for that and the individual will pick up the income (at a likely lower tax bracket) than the trust.

The only somewhat rare exception I can think of where it could make sense not to distribute the DNI tax-wise would be if the trust had a low state tax domicile, the individual was in a high state tax domicile, and the trust managed to thread the needle to avoid being captured in the high tax state.

Of course, check this with qualified tax and legal counsel.

[toddthebod]

The only somewhat rare exception I can think of where it could make sense not to distribute the DNI tax-wise would be if the trust had a low state tax domicile, the individual was in a high state tax domicile, and the trust managed to thread the needle to avoid being captured in the high tax state.

There are all sorts of credits that phase out at different income levels.