Footnotes · CE course notes · Form 1041 · Three Incomes

Three Incomes

At the desk

Accounting income	A state-law number (the principal and income act as modified by the document). Fixes what the income beneficiary gets, whether the trust is simple, Tier I, the 65-day cap, depreciation apportionment. Schedule B line 8.
Taxable income	Computed like an individual’s with the Subchapter J changes: no standard deduction, the §642(b) exemption, the distribution deduction, §642(c), §67(e).
DNI	§643(a). Taxable income before the distribution deduction and exemption, capital gains out, tax-exempt interest in, §199A back. The ceiling on the deduction and on what beneficiaries report, and the source of its character. Schedule B lines 1–7.
Order of authority for accounting income	Document → trustee discretion where granted → the Act → anything unallocated is principal (UPIA §103).
Colorado act	C.R.S. 15-1-401 et seq. (UPIA 2000 with 2008 amendments) check — confirm whether Colorado has since enacted the 2018 Uniform Fiduciary Income and Principal Act.

Accounting income: a state-law number

Fiduciary accounting income decides what an income beneficiary is entitled to and whether a trust is simple. It is set by the legislature of the state whose law governs the trust, as modified by the document. Not FASB, not the AICPA, not the IRS. The trustor can define income and principal any way he wants; the Act fills the gaps.
It is essentially a cash-basis number. Payments are classified by due date, not receipt: a bond coupon due July 1 is entirely income of a trust funded June 15 (UPIA §302). A testamentary trust’s income interest begins at the decedent’s death even though the estate holds the asset for a year (§301).
For a complex trust it goes on Schedule B line 8; for a simple trust it is the line 9 amount required to be distributed.
Why the preparer cares: it caps the simple-trust deduction, fixes Tier I, caps the 65-day election, drives the depreciation apportionment — and a trustee who pays the wrong “income” to a surviving spouse in a second-marriage bypass trust has a liability problem the preparer helped create.

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Receipts under the Act

Entities (§401): cash from a corporation, partnership, LLC, mutual fund or REIT is income; property distributions and mutual-fund capital-gain distributions are principal; a distribution of more than 20% of the entity’s assets is a partial liquidation and is principal. A trust’s share of partnership taxable income is irrelevant to accounting income; only cash received counts.
Sales: proceeds and gains are principal (§404). Rent is income; deposits are principal until earned (§405). Bonds: interest is income with no amortization of premium or discount; redemption and sale proceeds are principal unless the bond was bought within a year of maturity (§406). Life insurance proceeds are principal (§407).
Retirement accounts and deferred compensation (§409): the part the payer characterizes as interest or dividends is income; otherwise 10% of a required distribution is income and 90% is principal, and a withdrawal that was not required is 100% principal. Exception: a marital-deduction (QTIP or general-power) trust must determine the IRA’s internal income and distribute it to the spouse (Rev. Rul. 2006-26). The course cites “§407” for this rule; it is §409.
Minerals: royalties, bonuses and working-interest payments are 10% income / 90% principal (§411). Timber: income to the extent cutting does not exceed growth, principal beyond (§412). Liquidating assets (patents, copyrights, lottery rights): 10/90 (§410). Derivatives and options: principal (§414). The trustee may ignore any 10/90 allocation whose effect on net income is under 10% (§408).
Distributions from another trust follow their character in that trust (§402); a business the trustee runs can keep its own books and distribute net cash as income (§403); assets received from the settlor or decedent are principal (§404).

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Disbursements under the Act

Trustee, investment-advisory and custodial fees: half to income, half to principal (§§501(1), 502(a)(1)). Same for accountings and judicial proceedings that affect both interests.
Income: ordinary repairs, interest, recurring property taxes, recurring insurance premiums (§501(3)).
Principal: debt principal, estate and inheritance taxes, environmental costs, acceptance and termination fees, title insurance, costs of a proceeding to construe the trust (§502).
Income taxes follow the receipt that generated them (§505). A depreciation reserve is optional and never for a residence a beneficiary occupies (§503). The trustee’s power to adjust between income and principal (§104) exists so total-return investing can coexist with an income beneficiary; it must be documented.

Example 4.1 — the partnership that distributed nothing

A trust holds a 25% partnership interest. The K-1 shows $40,000 of taxable income; the partnership distributed $6,000 in cash. Accounting income from the partnership is $6,000. The trust’s DNI includes $40,000. A simple trust distributes $6,000 to the income beneficiary and pays tax on the other $34,000 at trust rates.

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Taxable income

Computed as for an individual with the Subchapter J modifications (§641(b)): no standard deduction (§63(c)(6)(D) sets it at zero); a personal exemption of $600 (estate), $300 (trust required to distribute all income currently) or $100 (any other trust); the distribution deduction under §651 or §661; charitable deductions under §642(c) rather than §170; §67(e) administration costs above the line.
The $300 belongs to a trust required to distribute all its income currently, and it keeps the $300 in a year it also distributes corpus or makes a charitable gift (Reg. §1.642(b)-1); a simple trust that becomes complex for the year does not drop to $100.
The exemption is not prorated in a short first year. It is prorated only when the entity changes its tax year (§443(c)).
Form 1041 is the 1040 rearranged: lines 1–8 income (interest, dividends, business, capital gain, rents and pass-throughs, farm, ordinary gain, other), lines 10–15 deductions (interest, taxes, fiduciary fees, charitable from Schedule A, attorney and accountant fees, other), then the distribution deduction from Schedule B, the exemption, the §199A deduction on its own line updated 2026, and taxable income. Schedule D is the trust-and-estate version; Schedules C, E and F and Form 4797 are the 1040 forms.

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Distributable net income

§643(a): start with taxable income; add back the distribution deduction and the exemption; remove capital gains allocated to corpus (and capital losses, except to the extent they offset gains that are in DNI); no §691(c) deduction; add back §1202 excluded gain; add net tax-exempt interest (less expenses allocated to it); remove extraordinary dividends and taxable stock dividends a simple trust allocates to corpus; add back the §199A deduction updated 2026.
DNI is computed for every trust and estate, not only complex ones. It is the maximum distribution deduction, not the minimum. It is not driven by the state-law income allocation, except that capital gains follow the document and the Reg. §1.643(a)-3 rules.
Capital gains come into DNI only under one of four exceptions (Reg. §1.643(a)-3(b), (e)): (1) allocated to income by the document or state law; (2) allocated to corpus but consistently treated by the trustee as part of distributions; (3) actually distributed, or used to determine the amount distributed; (4) distributed in full or partial liquidation of a beneficiary’s interest — the termination-year case, Examples 7 and 9. The public page lists three; the fourth is the one that matters in the final year.
Short-term capital gain dividends from a mutual fund are ordinary dividends for this purpose and are in DNI; long-term capital gain distributions are capital gains and are out.
DNI fixes character: each dollar distributed is a pro rata slice of every class in DNI (interest, dividends, rents, tax-exempt interest, IRA income). What the document calls income is irrelevant to what the beneficiary reports.

Example 5.1 — Schedule B lines 1–7

Adjusted total income $20,000, which includes a $5,000 long-term capital gain allocated to corpus; tax-exempt interest $3,000 (no allocable expenses); §199A deduction $1,500.

Line 1 adjusted total income $20,000 + $1,500 = $21,500 (the §199A deduction is added back). Line 2 tax-exempt interest $3,000. Line 6 capital gain allocated to corpus ($5,000). DNI (line 7) $19,500.

Study Questions 17 and 21 — Brianna’s trust

Dividends $3,000, interest $2,000, capital gain $1,000 (to corpus), taxable IRA distributions $25,000, no expenses. DNI = $30,000: the gain is out, the IRA income is all in — even though under the Act only $2,500 of the IRA money is accounting income.

The trust distributes $3,000. That is 10% of DNI, so the K-1 carries $300 of dividends, $200 of interest and $2,500 of IRA income (box 5). Never the capital gain. The other $27,000 of DNI is taxed to the trust, $16,000 of it at 37%.

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The mismatch, and why it matters

Accounting income can be smaller than DNI (IRA distributions at 10/90; a partnership that distributes less than its taxable income) or larger (expenses charged to principal reduce DNI but not accounting income). A trust required to distribute “income” distributes the state-law number; the beneficiary is taxed on the DNI slice that rides with it; the trust is taxed on the rest.
The fix is in the document (define IRA distributions as income; give the trustee discretion over principal; a conduit provision) or in the trustee’s hands (distribute principal; the 65-day election after the 1099-R arrives). The preparer’s job is to show the trustee the two numbers side by side before March 6.
added 2026 An IRA distribution retained in the trust is taxed at 37% above $16,000 but is not net investment income (§1411(c)(5)), so there is no 3.8% on top. See Tax Computation.

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Study questions 2, 12, 17, 21

SQ 2. Who sets accounting income? The state legislature, through the principal and income act, as modified by the document.
SQ 12. A deferred-compensation payment with no part characterized as interest or dividends: 10% income, 90% principal if required; a full payout or a voluntary IRA withdrawal is 100% principal; a phantom-stock “dividend” is 100% income.
SQ 17/21. Brianna’s trust above: DNI $30,000; a $3,000 distribution carries $300 / $200 / $2,500.

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Private reference, not client advice. Notes taken from two continuing-education courses: Form 1041: A Practical Guide (Hadges & Zollars, Thomson Reuters Checkpoint Learning, 10 hours, written on 2019 law) and Taxation of Trusts, Estates, and Decedents (DeScherer & Rodda, CeriFi, 2025 printing on 2024 law). Figures and rules brought current to 2026 in October 2026 (P.L. 119-21, Rev. Proc. 2025-32, T.D. 9918). Items tagged check are to be confirmed against primary sources before they are relied on.