What is Distributable Net Income for Trusts and Estates?

What is Distributable Net Income (DNI)

Trusts come in all different shapes and sizes. And, when it comes to trusts – domestic or foreign — one of the most important aspects of trusts is to determine the income tax implications of income generated from the trust. One of the key terms involving trust income is DNI – which refers to Distributable Net Income. When a trust is determining how much income it will be taxed on for the year, it is able to deduct the DNI, which can reduce or eliminate the trust tax liability (the amount of DNI deduction may be limited based in part on how much DNI is generated vs the amount actually distributed). Let’s take an introductory look at how the calculation works.

(a) Distributable Net Income

• • • • “For purposes of this part, the term “distributable net income” means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications—”

What does (a) mean?

From a baseline perspective, distributable net income refers to the taxable income of an estate or trust with respect to a taxable year at issue but is subject to various modifications with impact whether the income can be deducted and if so whether retains its same category of income (example, Capital Gains).

(1) Deduction for distributions

• • • • “No deduction shall be taken under sections 651 and 661 (relating to additional deductions).”

What does (a) (1) mean?

It means that the trust cannot take double-dipping deductions in accordance with the other sections, such as Section 651 — which refers to the deduction for trusts distributing current income only.

(2) Deduction for personal exemption

• • • “No deduction shall be taken under section 642(b) (relating to deduction for personal exemptions).”

What does (a) (2) mean?

It means that the trust and estate deductions for personal exemptions such as the estate deduction or simple trust deduction do not apply to DNI.

(3) Capital gains and losses

• • • “Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c). Losses from the sale or exchange of capital assets shall be excluded, except to the extent such losses are taken into account in determining the amount of gains from the sale or exchange of capital assets which are paid, credited, or required to be distributed to any beneficiary during the taxable year. The exclusion under section 1202 shall not be taken into account.”

What does (a) (3) mean?

It means that when there are gains within the trust income category of capital gains they shall not be included when the gains are allocated to corpus and are not paid, credited, or otherwise required to be distributed to the beneficiary in the taxable year – or otherwise set aside under Section 642(c) – which refers to Deduction for amounts paid or permanently set aside for a charitable purpose.

(4) Extraordinary dividends and taxable stock dividends

• • • “For purposes only of subpart B (relating to trusts which distribute current income only), there shall be excluded those items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.”

What does (a) (4) mean?

Section 4 limits extraordinary dividends and taxable stock dividends exclusion for Subpart B (trusts which distribute current income) only. For reference purposes, extraordinary dividends refer to dividends that have significant value above the person’s basis in stock generating the dividends.

(5) Tax-exempt interest

• • • “There shall be included any tax-exempt interest to which section 103 applies, reduced by any amounts which would be deductible in respect of disbursements allocable to such interest but for the provisions of section 265 (relating to disallowance of certain deductions).”

What does (a) (5)mean?

It means that DNI includes the tax-exempt interest of which certain subsections apply but is otherwise reduced for other provisions such as section 265 which limits certain deductions.

(6) Income of foreign trust

• • • In the case of a foreign trust—

      • (A) There shall be included the amounts of gross income from sources without the United States, reduced by any amounts which would be deductible in respect of disbursements allocable to such income but for the provisions of section 265(a)(1) (relating to disallowance of certain deductions).

      • (B) Gross income from sources within the United States shall be determined without regard to section 894 (relating to income exempt under treaty).

      • (C) Paragraph (3) shall not apply to a foreign trust. In the case of such a trust, there shall be included gains from the sale or exchange of capital assets, reduced by losses from such sales or exchanges to the extent such losses do not exceed gains from such sales or exchanges.

What does (a) (6) mean?

In general, the IRS is not a big fan of foreign trusts. Therefore, there are additional limitation rules involving DNI and foreign trusts. For example, there are some limitations involving income being exempt under a treaty; in addition paragraph 3 provides that capital gains are applied in excess of losses. 26 CFR 1.643-6 provides a good example of how it is applied.

(7)Abusive transactions

• • • The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this part, including regulations to prevent avoidance of such purposes. If the estate or trust is allowed a deduction under section 642(c), the amount of the modifications specified in paragraphs (5) and (6) shall be reduced to the extent that the amount of income which is paid, permanently set aside, or to be used for the purposes specified in section 642(c) is deemed to consist of items specified in those paragraphs. For this purpose, such amount shall (in the absence of specific provisions in the governing instrument) be deemed to consist of the same proportion of each class of items of income of the estate or trust as the total of each class bears to the total of all classes.

What does (a) (7) mean?

This is a common type of provision in which additional modifications may apply to the DNI calculation.

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