What's the difference between taxable income and accounting income when administering a trust? Taxable income and accounting income may be different on paper, but they are both important, and it's important to understand how they differ.
Trust accounting income, or TAI, is the income that is available to distribute to the income beneficiary of a trust. The formula for calculating TAI is all income of the trust, less expenses attributable to income.
Ohio, like most states, has adopted the Uniform Principal and Income Act (UPIA). This law allocates income and expenses as follows: operating income and expenses, depreciation of assets, interest, rents, royalties, and dividends are allocated to accounting income. Taxes on accounting income are also allocated to income. Capital gains and losses, capital improvements and extraordinary repairs to trust property, casualty gains and losses and insurance recoveries are allocated to principal. Taxes on trust principal are also allocated to the principal.
Why is it important to know exactly what the trust's accounting income is? Certain trusts (known as simple trusts) are required to distribute all of the trust's income in a given year to the income beneficiary or beneficiaries. (Complex trusts, by contrast, have the flexibility to let all or part of the accounting income accumulate.) The beneficiaries of the the simple trust must not be charitable, and income is taxable to the beneficiaries. Tax-free income is included in trust accounting income.
Trusts, like individuals, have income and expenses. In the case of a trust, however, that income and those expenses must be allocated either to the principal or the income of the trust. Most of the time, the document creating the trust will specify how income and expenses should be allocated. If it does not, state law will dictate the allocation.
Taxable income for a trust includes all income, including capital gains, but does not include tax-free income, such as, for instance, tax-free interest on bonds. Taxable income for trusts is, as a general rule, determined in the same was as for individual taxpayers. Unlike individuals, trusts do not typically itemize deductions.
Trusts also have a personal exemption. This exemption is $300 for simple trusts that distribute all income annually, and $100 for all other trusts. (Unlike the personal exemption for individuals, the personal exemption for trusts was not eliminated by the new Tax Cuts and Jobs Act, or TCJA.)
The TCJA did eliminate some tax deductions that trusts have historically been allowed to claim. These include investment management fees and personal casualty or theft losses, unless those losses resulted from a presidentially-declared disaster.
Trust expenses that remain deductible under the TCJA include depreciation and depletion, state and local taxes on entity-owned businesses, net operating losses from a business, and disaster losses in presidentially-designated areas, among others.
You should be aware of another impact of the TCJA on taxable income for trusts: the 20 percent deduction for pass-through entities also applies to trusts and estates. The computation of this deduction is somewhat complex, involving the allocation of W-2 wages and the unadjusted basis of qualified property between fiduciaries and beneficiaries of the trust.
If you are the fiduciary of a trust, you may want assistance to navigate the complexities of identifying both trust accounting income and taxable income of the trust. Even if you have some familiarity with the trust, the new tax laws may have created some challenges that you will need help with.
You are required to file IRS Form 1041 for any domestic trust that has taxable income for the tax year, or gross income of $600 or more for the tax year, regardless of the amount of taxable income. If any beneficiary of the trust is a non-resident alien, you must also file Form 1041.
The attorney who drafted the trust document should be your first call as far as getting the assistance you need. He or she can advise you of legal changes you should know about and connect you with a trusted accountant or other resources to assist you in carrying out your obligations to the trust and its beneficiaries. If you have other questions about the difference between taxable income and accounting income, we encourage you to contact our law office.
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