Trust income is usually taxable. Either the trust pays the tax or the trust beneficiary does. Revocable living trusts are an exception: Usually the grantor who created the trust pays any tax on the income.
Trust accounting can get complex, but the basic rule is simple: The trust is an individual taxpayer. The income it receives is taxed according to type: Business income and capital gains are taxed differently, for instance, just as a human taxpayer's income is.
When the trust distributes some of its income to the beneficiaries, the trust can take a deduction. Say the trust brings in $20,000 in net rental income this year and distributes $15,000 evenly to three beneficiaries. The trust writes off the $15,000 so it only has a net $5,000 income. The beneficiaries each report $5,000 in rental income.
A beneficiary pays taxes on his share of trust income as if it were personal income. Rental income is taxed as if he owned the rental property, and capital gains are taxed as if he sold the stock. He doesn't have to guess what sort of income he received: The trustee should send him a K-1 tax form with that information.
With a simple trust — one in which the trustee distributes all the income every year, but none of the principal — that may be all there is to it. A complex trust can retain some of the income and also distribute principal. This can become more complicated.
Beneficiaries only pay tax up to the distributed net income, or DNI, calculated according to an Internal Revenue Service formula. In a complex trust, DNI may be less than the amount of the distribution. Everything distributed above DNI is tax free.
If the trust loses money, the trust takes the loss on the taxes. There's no way to shift the loss to the beneficiaries and give them a tax break. For example, if a trust sells stock at a loss, the trust gets any capital-loss write-off; the beneficiaries do not.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.