Distributable Net Income Application

Course: Estate Planning
Lesson 9: Income Taxation of Trusts and Estates

Student Question:

Hi Bruce

When a Trust has an income accumulation year, must the Trust pay taxes on that accumulation of DNI in the year of accumulation?

If so, why do that – why would a Trust hold income at the confiscatory Trust income tax rates?

If not, how many years can a Trust hold DNI without paying income taxes prior to distribution to the beneficiary/beneficiaries?

Instructor Response:

That’s a most insightful question.  It appears confusing because the statute itself is confusing.

First, I’ll share a little perspective.  Once upon a time the irrevocable trust income tax rates were lower than individual income tax rates; trustees took advantage of that opportunity by having the trust accumulate income and pay the relatively low trust income tax on accumulated income. A 1997 law reduced the type of trusts subject to the throwback rules to only foreign trusts and a limited number of domestic trusts.  In addition, now that the trust and estate income tax rate is 37% as taxable income nears $13,000, there is little to no opportunity to use irrevocable trusts to reduce income taxes. As a general rule there is no income tax advantage to an irrevocable trust accumulating income.

However, a trustee with discretionary authority to withhold income distributions may have powerful non-tax reasons (think personal reasons) to do so.  An irrevocable trust must generally pay income tax on any accumulated accounting income and/or net capital gains in the year of the accumulation. As you might expect, throw-back rules tend to be a very low priority on the CFP Board exam.