795 / How is the federal income tax computed for trusts and estates?

Taxable income for trusts and estates is computed by subtracting the following from gross income: allowable deductions; amounts distributable to beneficiaries; and the exemption. Estates are allowed a $600 exemption. For trusts that are required to distribute all their income currently, the exemption is $300; for all other trusts, $100. Certain trusts that benefit disabled persons may continue to use the personal exemptions that were available to individuals for tax years beginning before 2018 and after 2025.¹ A standard deduction is not available.² Rates are determined from a table for estates and trusts.

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Planning Point: The United States Supreme Court ruled in North Carolina Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. June 21, 2019) that the due process clause prevents states from imposing a state-level tax on undistributed trust income based solely on the fact that a trust beneficiary resides in the state.

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For estates of decedents dying after August 5, 1997, an election may be made to treat a qualified revocable trust as part of the decedent’s estate for income tax purposes. The election must be made by both the executor of the estate and the trustee of the qualified revocable trust. A qualified revocable trust is a trust that was treated as a grantor trust during the life of the decedent due to his power to revoke the trust (see Q 797). If such an election is made, the trust will be treated as part of the decedent’s estate for tax years ending after the date of the decedent’s death and before the date that is two years after his death (if no estate tax return is required) or the date that is six months after the final determination of estate tax liability (if an estate tax return is required).³

Generally, income that is accumulated by a trust is taxable to the trust, and income that is distributable to beneficiaries is taxable to the beneficiaries.⁴ A beneficiary who may be claimed as a dependent by another taxpayer may not use a personal exemption (prior to 2018), and his standard deduction may not exceed the greater of (1) $500, as indexed ($1,350 in 2025, $1,300 in 2024, $1,250 in 2023, $1,150 in 2022, $1,100 in 2019-2021); or (2) $250, as indexed ($450 in 2024-2025, $400 in 2022-2023, $350 in 2013-2021) plus earned income.⁵ The amount of trust income which can be offset by the basic standard deduction will be reduced if the beneficiary has other income (see Q 728, Q 752). Also, trust income taxable to a beneficiary under nineteen years of age (24 for certain students) may be taxed at the parents’ marginal tax rate (see Q 679) prior to 2018 (for tax years beginning after in 2018 and 2019, taxpayers had the option of electing to apply trusts and estates tax rates to the unearned income of minors).⁶

A charitable remainder trust is generally not subject to income tax (see Q 8102). However, beneficiaries of a charitable remainder trust are taxable on distributions (see Q 8099). A charitable lead trust is generally taxable as a grantor trust (see Q 797) if an upfront charitable deduction is claimed (see Q 8105). Otherwise, a charitable lead trust is generally taxed as described here. Proposed regulations would treat annuity distributions from charitable lead annuity trusts (CLATs) and unitrust distributions from charitable lead unitrusts (CLUTs) as made proportionately from all categories of trust income. State law or trust provisions providing otherwise would be ignored. The regulations would prevent such a provision from being used, for example, to allocate all taxable income to the charitable distribution with capital gain and tax-exempt income retained by the trust.⁷

Editor’s Note: All miscellaneous itemized deductions subject to the 2 percent floor were suspended for tax years beginning after 2017 and before 2026. However, the IRS finalized regulations in 2020 clarifying that trusts and estates will continue to be permitted to deduct certain expenses. The rules clarify that the following deductions are allowable in figuring adjusted gross income (so are not miscellaneous itemized deductions): (1) costs paid in connection with the administration of the estate or trust which would not have been incurred otherwise, (2) deductions concerning the personal exemption of an estate or non-grantor trust, (3) deductions for trusts distributing current income, and (4) deductions for trusts accumulating income.⁸ Estates, non-grantor trusts and their beneficiaries can rely upon the regulations retroactively, for tax years beginning after December 31, 2017.

Deductions available to an estate or trust are generally subject to the 2 percent floor on miscellaneous itemized deductions (prior to 2018 and before 2026).⁹ However, deductions for costs incurred in connection with the administration of an estate or trust that would not have been incurred if the property were not held by the estate or trust are fully deductible from gross income.¹⁰

Deductions excepted from the 2 percent floor include only those costs that would not have been incurred if held by an individual (those costs that would be uncommon for a hypothetical investor). Investment advisory fees incurred by a trust were subject to the 2 percent floor.¹¹ Final regulations have been issued on the proper treatment of costs incurred by trusts and estates. The regulations provide that if a cost is unique to a trust or estate, it is not subject to the 2 percent floor, but if the cost is not unique to a trust or estate, it is subject to the 2 percent floor.¹² For taxable years beginning before 2009, taxpayers can deduct the full amount of bundled fiduciary fees without regard to the 2 percent floor.¹³ For taxable years beginning after December 31, 2014, bundled fiduciary fees must be allocated between fully deductible expenses and those subject to the 2 percent floor.¹⁴ Any reasonable method may be used to allocate a bundled fee.

For distributions in taxable years beginning after August 5, 1997, the throwback rule for accumulation distributions from trusts in IRC Sections 665-667 has been eliminated for domestic trusts, except for domestic trusts that were once foreign trusts, and except in the case of trusts created before March 1, 1984, which would be aggregated with other trusts under the multiple trust rules.¹⁵ Generally, for those trusts subject to the throwback rule, if a trust distributes income which it has accumulated after 1968, all of the income is taxed to the beneficiary upon distribution. The amounts distributed are treated as if they had been distributed in the preceding years in which the income was accumulated, but are includable in the income of the beneficiary for the current year. The “throwback” method of computing the tax in effect averages the tax attributable to the distribution over three of the five preceding taxable years of the beneficiary, excluding the year with the highest and the year with the lowest taxable income.¹⁶

Excess taxes paid by the trust may not be refunded, but the beneficiary may take a credit to offset any taxes (other than the alternative minimum tax) paid by the trust. However, a beneficiary who receives accumulation distributions from more than two trusts may not take such an offset for taxes paid by the third and any additional trusts. But if distributions to a beneficiary from a trust total less than $2,000 for the year, this penalty will not apply to distributions from that trust.¹⁷

Distributions of income accumulated by a trust before the beneficiary is born or before he attains age 21 are not considered accumulation distributions and thus are not generally subject to the throwback rules.¹⁸

The 2020 final regulations also address the treatment of excess deductions under Section 642(h)(2). The regulations preserve the tax character of the three categories of expenses, rather than grouping all non-Section 67(e) expenses together, to allow for such expenses to be separately stated and to facilitate reporting to beneficiaries. Under the regulations, each deduction comprising the Section 642(h)(2) excess deduction retains its separate character: (1) as an amount allowed in arriving at adjusted gross income, (2) as a non-miscellaneous itemized deduction, or (3) as a miscellaneous itemized deduction. The character of these deductions does not change when succeeded to by a beneficiary on termination of the estate or trust. The regulations also require that the fiduciary separately state deductions that may be limited when claimed by the beneficiary as provided in the instructions to Form 1041 and Schedule K-1.

The regulations use the principles under Treasury Regulation Section 1.652(b)-3 to allocate each item of deduction among the classes of income in the year of termination for purposes of determining the character and amount of the excess deductions under Section 642(h)(2). Deductions directly attributable to one class of income are allocated to that income.¹⁹

Any remaining deductions that are not directly attributable to a specific class of income, as well as any deductions that exceed the amount of directly attributable income, may be allocated to any item of income (including capital gains), but a portion must be allocated to tax-exempt income, if any.²⁰ The character and amount of each deduction remaining after application of Treasury Regulation Section 1.652(b)-3 comprises the excess deductions available to the beneficiaries succeeding to the property as provided under Section 642(h)(2).