Software Pitfalls

February 17, 2023

Dealing with Distributions from Trusts to Beneficiaries

By By William Downs, CPA & John Woodford, CPA

When a trustee makes distributions to beneficiaries, the nature of those can often be a challenge to determine. And our tax preparation software doesn’t automatically get it right. A “simple” trust may be anything but simple when dealing with distributions to beneficiaries.

A simple trust, by definition, is required to distribute all its income to beneficiaries. When the trust has received a variety of types of income, the character of the distributions can be a challenge for the preparer. A complex trust, for which the trustee makes distributions of income to beneficiaries, can face similar challenges.

Questions of Income

An important number to determine is the fiduciary accounting income. Utilizing fiduciary accounting concepts, and with reference to the trust document and the Uniform Principal and Income Act, the return preparer will determine the dollar amount that is to be entered in Schedule B of the federal and California trust tax returns, which can impact the overall limit of taxable and tax-exempt income required to be distributed. 

That number may be more or less than the distributable net income (DNI) determined using income tax rules. And while the accounting income amount is crucially important, your tax preparation software may not properly calculate it. It comes down to making your own calculation of accounting income and entering it as an override in tax software programs.

When preparing a beneficiary K-1 form for a simple trust, net amounts of the various items of income are reported, after subtracting expenses allocated against those items of income.

The first consideration is to determine the portion of expenses to be allocated to tax-exempt income and therefore not deducted against taxable income amounts. IRS instructions say that you may use “any reasonable method” to apportion. Your software will offer suggestions, but it is up to the preparer to determine a fraction that is reasonable. And be aware that your software may use a method that you would consider not reasonable. 

For example, Lacerte fiduciary software has a user setting to allow, or not allow, capital gains to be included in the denominator of the fraction. If you include capital gains in the denominator, that will result in a smaller fraction to apply when assigning expenses to tax-exempt income.

Expenses to be allocated against items of taxable income can be apportioned among categories of taxable income. Perhaps your first choice would be to allocate expenses to offset interest income. 

Next you may wish to allocate to non-qualified dividends, then qualified dividends and passive income. Once again, your software may do what you want, or you may have to tweak the input, or even override the calculation. For example, Lacerte software has a K-1 user option to allocate expenses pro-rata to all items of income, or to use what they call a “tier” allocation. The latter would normally be the better choice if you want to offset interest income first as mentioned above.

Schedule K-1

Tax credits, most commonly foreign taxes withheld on dividend income, can be passed through to beneficiaries on Schedule K-1. For 2021 trust income tax returns, the IRS devised a new addition to the 1041 K-1 form, which was an attempt to provide more detailed information to beneficiaries about foreign source income. And again, you may have to devote more effort to be sure your software is producing the proper amount of foreign income distributed to beneficiaries.

Qualified business income (QBI) amounts (Sec. 199A) also would be reported on expanded Schedule K-1 forms. QBI flowing from REIT investments at a brokerage is one example. That particular source of income would likely be a last item you would allow expenses to offset, which is another reason to use the “tier” method.

If there is passive income, such as from rents, the preparer may want to avoid offsetting that income with expenses when determining the amounts to report on K-1 form.

Other Acts and Effects

The Tax Cuts and Jobs Act eliminated deductions that were subject to the 2 percent of AGI limitation for 2018-25. This can cause a surprising result if the miscellaneous expense is a significant amount. 

The trustee would be faced with an expense that reduces accounting income, but does not reduce taxable income. Under the Uniform Principal and Income Act, miscellaneous expenses, along with other administrative costs, are allocated 50 percent to principal and 50 percent to income of the trust. The 50 percent of miscellaneous expenses that are no longer allowed at all as a deduction on form 1041 are still a reduction of accounting income which is used to limit the deduction for distribution to beneficiaries. This situation can result in ordinary taxable income for the trust on its federal income tax return, even for a simple trust or a complex trust that distributes all its income to beneficiaries.

Surprisingly, the IRS revised old existing regulations to draw a distinction between administrative expenses (such as tax preparation and fiduciary fees) and miscellaneous expenses such as investment advisory fees. This complicated how those fees are displayed on Schedule K-1 for a final return.

California, though, still has in effect the long-time rule that miscellaneous expenses can be deducted, after subtracting the 2 percent of AGI haircut. The fiduciary accounting income calculation doesn’t change; the same number for accounting income appears in Schedule B of Form 541 as appears on Schedule B of Form 1041. But there could be miscellaneous expenses deducted on Form 541 that are not allowed on Form 1041.

There are always some wrinkles to fiduciary tax return preparation to keep us alert.

William Downs, CPA is solo practitioner in Sherman Oaks. John Woodford, CPA is principal at his own firm.

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