When a trust or estate makes a distribution to a beneficiary, the tax question is not simply "how much was distributed?" The answer depends on distributable net income (DNI) — a calculated figure that determines how much of a distribution carries taxable income to the beneficiary and how much is a tax-free return of principal.

DNI is defined in IRC §643(a) and is the cornerstone of fiduciary income taxation. Trustees, executors, and their advisors who do not understand DNI will produce incorrect Schedule K-1s, misallocate income between the entity and its beneficiaries, and potentially trigger IRS examination.

DNI represents the maximum amount of income that can be taxed to beneficiaries rather than to the trust or estate. It serves two functions:

1. It limits the deduction the trust or estate can take for distributions to beneficiaries; and
2. It limits the amount of income that can be included in the beneficiary's gross income as a result of the distribution.

A distribution in excess of DNI is treated as a tax-free return of corpus — not taxable income to the beneficiary.

DNI is calculated starting with the trust or estate's taxable income and making the following adjustments:

1. Add back the distribution deduction (IRC §651 or §661);
2. Add back the personal exemption ($300 for a simple trust, $100 for a complex trust or estate);
3. Subtract net capital gains allocated to corpus (unless the trust instrument or state law requires them to be distributed, or the trustee exercises discretion to include them);
4. Add tax-exempt income (reduced by allocable expenses); and
5. Make other adjustments required by the regulations.

The result is DNI — the ceiling on both the distribution deduction and the beneficiary's income inclusion.

IRC §662 establishes a two-tier system for allocating DNI among multiple beneficiaries when a complex trust makes distributions.

Tier 1 — Required Distributions Distributions required by the trust instrument (mandatory income distributions) are allocated DNI first. If Tier 1 distributions exceed DNI, each Tier 1 beneficiary receives a proportionate share of DNI.

Tier 2 — Discretionary Distributions Discretionary distributions are allocated the remaining DNI after Tier 1 distributions. If Tier 2 distributions exceed the remaining DNI, each Tier 2 beneficiary receives a proportionate share of the remaining DNI.

This system matters when a trust has both mandatory income beneficiaries and discretionary remainder beneficiaries. The mandatory beneficiaries are protected — they receive their share of DNI before discretionary distributions are considered.

The DNI rules operate differently for simple trusts and complex trusts.

A simple trust is one that:

• Is required to distribute all income currently;
• Makes no distributions of corpus during the year; and
• Makes no charitable contributions.

A simple trust deducts the lesser of the amount required to be distributed or DNI. The beneficiaries include in income the lesser of the amount distributed or DNI. Because a simple trust distributes all income, the trust itself generally pays no income tax (other than on capital gains allocated to corpus).

A complex trust is any trust that is not a simple trust — it may accumulate income, distribute corpus, or make charitable contributions.

A complex trust deducts the lesser of the amount actually distributed or DNI. Beneficiaries include in income the lesser of the amount distributed or DNI, allocated under the two-tier system.

When a complex trust accumulates income (does not distribute it), the trust pays tax on the accumulated income at the compressed trust tax brackets. In 2026, the 37% rate applies to trust income above approximately $15,650.

Capital gains are one of the most frequently mishandled items in fiduciary taxation.

The default rule: Capital gains are allocated to corpus and are not included in DNI. This means capital gains are taxed to the trust at the compressed trust rates — not passed through to beneficiaries.

Exceptions: Capital gains are included in DNI when:

• The trust instrument requires capital gains to be distributed to income beneficiaries;
• State law treats capital gains as income (rare);
• The trustee has discretion to allocate capital gains to income and exercises that discretion consistently; or
• The trust is in its final year (see below).

The trustee's discretion over capital gain allocation is a significant planning lever. A trustee who has discretion and consistently allocates capital gains to income — and distributes them — can shift the tax burden from the trust (at 37%) to beneficiaries who may be in lower brackets.

Caution: The IRS has scrutinized trustee discretion over capital gain allocation. The discretion must be exercised consistently and in accordance with the trust instrument and applicable state law. Rev. Rul. 2004-5 and the regulations under §643 provide guidance on when capital gains may be included in DNI.

When a trust has multiple beneficiaries with substantially separate and independent shares, IRC §663(c) requires that DNI be calculated separately for each share. This prevents income earned in one beneficiary's share from being taxed to another beneficiary.

The separate share rule applies when the trust instrument creates economically distinct shares — for example, a trust that holds separate accounts for each of three children, with income and principal allocated separately to each account.

Under IRC §663(b), a trustee of a complex trust may elect to treat distributions made within the first 65 days of the following tax year as if they were made on the last day of the prior tax year. This election — commonly called the 65-day rule — gives trustees additional flexibility to manage the trust's DNI and tax liability after the year ends but before the return is due.

The election is made on the trust's Form 1041 for the prior year. It is irrevocable once made.

The 65-day rule is particularly useful when the trustee determines after year-end that the trust accumulated more income than anticipated and wants to shift some of that income to beneficiaries in lower brackets.

Each beneficiary who receives a distribution from a trust or estate receives a Schedule K-1 (Form 1041) showing their share of the trust's income, deductions, and credits.

The K-1 must correctly reflect the character of the income — ordinary income, qualified dividends, capital gains, tax-exempt income, and other items retain their character when passed through to beneficiaries. A beneficiary who receives a distribution that includes qualified dividends reports those dividends at the preferential qualified dividend rate, not as ordinary income.

Incorrect K-1s — particularly those that fail to separately state capital gains, tax-exempt income, or foreign tax credits — are a common source of IRS notices and examination.

Review the trust instrument carefully. The trust instrument governs how income and principal are defined, whether capital gains are allocated to income or corpus, and whether the trustee has discretion over distributions. These provisions directly affect DNI and the tax consequences of distributions.

Consider the beneficiaries' tax brackets. If beneficiaries are in lower brackets than the trust's compressed rates, distributing income rather than accumulating it can produce significant tax savings. The 65-day rule provides additional flexibility to make this determination after year-end.

Document discretionary decisions. When a trustee exercises discretion over capital gain allocation or distribution timing, the decision should be documented in trustee minutes or a written resolution. This documentation is important if the IRS questions the allocation.

Coordinate with the accountant early. DNI calculations require information about the trust's income, expenses, and distributions throughout the year. Waiting until tax season to gather this information increases the risk of errors.

DNI is not a technicality — it is the mechanism that determines who pays tax on trust and estate income. Trustees who understand DNI can use distributions strategically to minimize the overall tax burden on the trust and its beneficiaries. Trustees who ignore it produce incorrect K-1s and expose the trust to IRS examination.

If you are administering a trust or estate and have questions about DNI, distributions, or Form 1041 compliance, contact us for a consultation.

Governing authority: IRC §§643, 651, 652, 661, 662, 663; Treas. Reg. §§1.643(a)-0 through 1.643(d)-2; Rev. Rul. 2004-5.

Related: Estate vs. Trust: What the Tax Difference Actually Means · Form 1041 vs. Form 706 · Final-Year Trust Deductions