This blog was updated in February 2022 to reflect the most up to date income tax information for our readers.

There is a collective sigh of relief once tax season is behind us. With that said, it’s always good to plan ahead as there are few surprises more unpleasant than to find out there is a sizable tax that needs to be paid when it is already too late to do anything about it.

With the Affordable Care Act of 2010 and the American Taxpayer Relief Act signed by President Obama in 2013, estates and trusts in the highest tax bracket are now more susceptible to paying higher taxes. Prior to 2013, estates and trusts whose taxable income fell within the highest bracket were taxed a maximum 35%. They were also taxed 15% on long-term capital gains. As of 2022, the highest tax bracket now taxes income at 37%, plus a 2.35% Medicare surtax on all wages in excess of $200,000. Additionally, long-term capital gains at this bracket are no longer taxed at 15% but at 20% plus the 3.8% surtax.

It is important to note that estates and trusts use a concept called distributable net income (DNI). An estate or trust is allowed to pass through dividends and income (i.e. DNI) from the trust to the trust’s beneficiaries. In essence, this pass through of DNI allows the trust to pass along the tax burden of the income to the beneficiaries. Since beneficiaries are taxed based on individual tax rates, they are more likely to be in a lower tax bracket. Thus, this distribution of net income can result in significant tax savings.

Navigating Income Tax Consequences

Unlike dividend and income, capital gains and losses are normally excluded from DNI and are subject to tax at the estate or trust level. There are a few ways, however, that capital gains/losses can be passed along as DNI.

  1. Capital gains may be included in DNI If they are allocated to income. According to tax regulations, allocation in this manner must be made according to the instructions in the governing instrument (e.g., the trust document) or based upon a “reasonable and impartial exercise of discretion by the fiduciary.” Ideally, for this methodology, the trust document or court documents should clearly grant the fiduciary the discretion to allocate capital gains to income. If the governing instrument is silent in this regard, it becomes a bit more ambiguous as to what amount of discretion the fiduciary has. Regardless, if you are considering using this methodology, PIN recommends that you consult with your CPA.
  2. Capital gains may be passed through as DNI if they are treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary. The term “consistent”, however, is not clearly defined in any of the government’s regulations or examples. For new trusts, it is possible to establish a consistent pattern of distribution, but for pre-existing trusts, the government is considerably stricter. For example, if a trustee becomes fiduciary of a pre-existing trust that previously did not distribute capital gains as DNI, is he/she allowed to establish a consistent practice of passing capital gains? Based on IRS responses to this question, this is not allowed. Petitioning the court for an order to do so might suffice. However, it should not be done unless your attorney and accountant agree to the approach
  3. Lastly, if the corpus (i.e., the trust’s principal) is to be utilized by the fiduciary in determining the amount that is distributed, or the corpus is required to be distributed to the beneficiary, the capital gains may be passed through. An example of this is age-mandatory principal distributions or situations when proceeds of a specific asset are to be distributed to a beneficiary. Once again, IRS commentary is a bit vague as to how much discretion a fiduciary has in determining the amount that may be distributed, but it is implied that fiduciary discretionary powers hinge on whether the governing instrument gives the fiduciary discretion to allocate capital gains to DNI.

In all circumstances related to reducing tax consequences, PIN recommends that the fiduciary consult with his/her CPA and lawyer to discuss the best approach to reducing the tax burden on the estate/trust and related beneficiaries.

From reviewing these three ways of passing through capital gains, it is clear that the drafting of the governing instrument is critical. In the creation of the trust, specific provisions should be written to allow the trustee or estate to allocate capital gains to DNI. The trust should also give the fiduciary suitable discretion in the allocation and distribution of income. If the trust is not explicitly written as such, the trustee could run the risk of running afoul of the IRS attempting to distribute capital gains as DNI.

Capital gains may be distributed as DNI if the governing instrument grants the fiduciary such discretion. Without this authority granted by the governing instrument, the fiduciary’s legal grounds for passing along capital gains are more ambiguous. You can access the most up to date tax brackets and federal income tax rates via Nerdwallet.

A trusted financial advisor can help provide detailed insight into tax efficient ways to capture short-term and long-term capital gains. If you’ve found this information to be helpful, but you’re still searching for answers on how best to avoid income tax consequences related to your estate or tax, contact us at any time by clicking the link here.


Jared Ong

Jared Ong oversees portfolio management, trading and technology. He previously worked at the Capital Group as a business systems analyst where he was integral in improving the trade operations group’s equity, fixed income, and foreign exchange trade processes. A graduate from Brigham Young University, Jared holds a Bachelors in Music. In his spare time, he enjoys composing and arranging music.