Trust taxation is complicated, and helping clients understand the intricacies of undistributed net income (UNI) can be especially challenging. We’ll explore how UNI is calculated, the tax implications for trusts and beneficiaries, and unravel the complexities of throwback rules. Understanding these concepts can equip advisors to navigate the landscape of trust taxation, providing insights that can aid in estate planning and wealth accumulation strategies.

Distributed vs. undistributed net income

First, it’s important to distinguish between distributed vs. undistributed net income in trusts.

Distributed net income (DNI)

DNI is the portion of a trust's income distributed to the beneficiaries and is taxable at their personal tax rates. Distributions can include cash payments, property transfers, or any other form of income that the trust passes to its beneficiaries. When DNI is distributed, the trust generally does not incur income tax on that amount.

Undistributed net income (UNI)

On the other hand, UNI is the income that the trust earns but doesn't distribute to the beneficiaries. Instead, it is retained within the trust. The trust is subject to income tax on the undistributed income. The taxation of UNI is often a concern for both trustees and beneficiaries, as it can impact the overall tax liability of the trust.

How is undistributed net income calculated?

Several factors contribute to the calculation of UNI, including:

• Establishing taxable income: The trust’s taxable income can include revenue earned, such as interest, dividends, capital gains, and rental income.
• Distributions to beneficiaries: Subtract any distributions made to beneficiaries during the tax year.
• Add deductions: Add any deductions related to beneficiary distributions, including administrative expenses or charitable deductions. 
• Consider tax-exempt income: Include any tax-exempt income earned by the trust. Tax-exempt income in a trust can include interest earned from municipal bonds or dividends from tax-exempt organizations.

The formula for calculating Undistributed Net Income (UNI) is generally represented as:

UNI = Taxable income − distributions to beneficiaries + deductions + tax-exempt income

It's important to note that trust taxation is complex, and the specific rules and regulations can vary depending on the type of trust, its terms, and where the trust is domiciled. 

Additionally, tax laws are subject to change, so consulting with a trust attorney and accountant is essential. 

Tax implications for undistributed net income

While there are many rules and regulations governing trust taxation, IRC Sections 661(a) and 665(a) are essential for advisors and clients to understand as they outline the treatment of income for estates and trusts. 

Specifically, they allow the fiduciary (the entity responsible for managing the estate or trust) to take a deduction for any income required to be distributed to beneficiaries. The deduction effectively shifts the tax liability on that income from the trust to the beneficiaries, potentially leading to lower overall tax obligations and provides a way to avoid double taxation.

Taxation at the trust level

• Undistributed net income is generally subject to income tax at the trust level. The trust is responsible for paying taxes on its income, even if it doesn't distribute that income to beneficiaries.
• Trusts have their own tax rate structure, which can result in higher tax rates than those for individual taxpayers. Trust tax rates can escalate quickly, potentially leading to a higher tax burden.

Taxation at the beneficiary level

It is important to distinguish whether the distributions come from the trust principal or trust income. If it comes from the principal, the IRS assumes that taxes have already been paid and, therefore, that portion is not taxable to the beneficiary. On the other hand, distributions from trust income are taxable to the beneficiary unless the trust has already paid the income tax. 

It is important to remember that distributing income to beneficiaries may result in tax savings if they are in lower tax brackets than the trust. This is usually the case since trusts are in the highest tax bracket, even with relatively little income. In 2024, for example, a trust is at a 37% tax bracket with just $15,200 of income.  

By comparison, an individual taxpayer would have to make over $609,350 to be in the same 37% bracket. This strategic distribution planning can help optimize the overall tax outcome for both the trust and beneficiaries.

Throwback rules

Throwback rules refer to a set of tax provisions that apply to some trusts, particularly foreign trusts and tax-exempt trusts, to prevent the deferral of income taxes.

The basic concept behind throwback rules is that when a trust with accumulated income makes a distribution to beneficiaries, the distribution is subject to tax, and the tax calculation may take into account the entire history of income accumulation in the trust, not just the current year.

Here are some key things to keep in mind:

• Interest and penalties: If the distribution includes income accumulating in the trust for an extended period, interest and penalties may apply, further increasing the overall tax liability.
• Applicability to foreign trusts: Throwback rules are often associated with foreign trusts. The rules aim to prevent the deferral of U.S. taxes on income earned in foreign trusts. Clients who want to establish a foreign trust should carefully consider the risks and increased scrutiny from the IRS.

Next steps

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