Estates and trusts can earn money that gets paid out to beneficiaries. If the trust has instructions that require the payouts, the beneficiaries must pay the taxes. Otherwise, the trust is on the hook for the taxes. Each year, the estate or trust sends the beneficiary a Schedule K-1 that details the distributions to the beneficiary. The beneficiary uses this document to figure out and pay their income taxes.
Complete Form 1041 with the IRS. The 1041 reports earnings kept by the trust or estate and money paid out to beneficiaries. The trust or estate only pays taxes on required nonbeneficiary distributions that aren't retained in the trust. Unless the trust document has alternative instructions for capital gains and losses, they remain in the trust.
Issue a Schedule K-1 to all beneficiaries. If the trust requires the trustee to pay out dividends or gains from stocks to the beneficiaries, it is reported on Schedule K-1. The K-1 is sent to each beneficiary along with the 1041.
Deduct mandated beneficiary income from the income of the trust or estate. Any income paid out to beneficiaries is deductible. The trust attaches Schedule B to Form 1041 to specify these deductions.
Do not deduct discretionary distributions to beneficiaries. If the trustee distributes income to the beneficiaries without instructions from the trust, the trust can’t deduct them. Also, the K-1 doesn’t report the income to the beneficiary because the trust, and not the beneficiary, pays the taxes.
Report K-1 income on the beneficiary for Form 1040. Beneficiaries who receive K-1s must report these distributions as income on IRS Form 1040. The K-1 details different categories of income, including long-term and short-term capital gains, rental real estate income, ordinary business income, interest earnings, and qualified and ordinary dividends. The IRS taxes qualified dividends at a lower rate than ordinary dividends.
Review other information. The K-1 also reports other financial information in addition to gains and losses. K-1s also are an overview of a beneficiary's share of deductions for depletion, depreciation, amortization and "domestic production activities" -- a special deduction for income obtained from domestic manufacturing activities.
