Distributable Net Income: The Cap on a Trust's Distribution Deduction, and Why Capital Gains Usually Stay in Corpus

Distributable net income is not the amount a trust can distribute. It is a tax figure built from the trust's taxable income, and it caps two things: the trust's deduction for what it pays out, and what the beneficiaries must report. In the trust worked below, the beneficiary receives US$57,000 and reports US$54,000, US$9,000 of it tax exempt, while the trust pays tax on a US$15,000 gain it kept.

Three measures of income run through one Form 1041, and none follows GAAP or IFRS: one is set by the trust deed and local law, two by the Internal Revenue Code. A common TCP trap is carrying an item from one measure into another.

A trust is a taxpayer only for what it keeps

A grantor transfers property, the corpus, to a trustee, who holds it for the beneficiaries named in the governing instrument. The trust is a separate entity for federal tax: the trustee files Form 1041 for a domestic trust with any taxable income, gross income of US$600 or more, or a nonresident alien beneficiary, and pays the trust's tax (Section 641(b)).

The IRS instructions say a trust is "sometimes referred to" as a pass-through entity: unlike a partnership, it is taxed on what it keeps, because it deducts what it distributes. Distributable net income (DNI) caps that deduction (Sections 651(b) and 661(a)) and the beneficiaries' inclusion (Sections 652(a) and 662(a)), and it fixes character: absent a specific allocation in the deed, each class of income reaches the beneficiary in proportion to its share of DNI (Sections 652(b) and 662(b)).

Simple, complex and grantor trusts, and where a revocable trust fits

Type	Test	Exemption, Section 642(b)	Who is taxed
Simple trust	Must distribute all income currently, nothing for charity, no corpus distributed this year	US$300	Beneficiaries on required income, paid or not, up to DNI; the trust on the rest
Complex trust	Any other trust	US$100 (US$300 if all income must be distributed)	Beneficiaries on distributions up to DNI; the trust on the rest
Grantor trust, including a revocable trust	The grantor keeps powers such as the power to revoke (Section 676)	None: ignored for income tax	The grantor, on every item of the owned portion (Section 671)
Decedent's estate	From death to final distribution	US$600	As for a complex trust

Status is tested each year. A trust that must distribute all its income, with nothing for charity, is complex only in a year in which it actually distributes corpus, such as its final year (Reg. 1.651(a)-3), and keeps the US$300 exemption even then.

A grantor trust is valid under state law but ignored by the income tax, because the grantor has not given up "complete dominion and control"; the IRS treats a revocable living trust as one. After the grantor dies, Section 645 lets the trustee and the executor elect to treat a trust the decedent could revoke as part of the estate.

Three measures of income: trust accounting income, DNI and taxable income

Trust accounting income is "income" under Section 643(b): what the governing instrument and local law say the income beneficiary is owed, on the traditional split in Reg. 1.643(b)-1 (dividends, interest and rents to income, sale proceeds to principal). DNI is taxable income under Section 643(a) with no distribution deduction, no exemption, capital gains allocated to corpus removed, and tax-exempt interest added back net of its expenses. Taxable income, after the deduction and the exemption, is the only one taxed to the trust.

Item	Accounting income	DNI	Taxable income
Dividends, taxable interest, rents	In	In	In
Capital gain allocated to corpus	Out	Out, unless an exception applies	In
Tax-exempt interest	In	In, net of allocable expenses	Out
Trustee's fee charged to corpus	Not deducted	Deducted	Deducted, less the share allocable to tax-exempt interest

The fee row decides many questions. Reg. 1.643(d)-2 deducts expenses charged entirely to corpus in reaching DNI, so a fee can cut DNI without cutting what the beneficiary is owed.

Income or corpus: where capital gains and tax-exempt interest land

Section 643(a)(3) keeps capital gains out of DNI to the extent they are allocated to corpus and are neither distributed nor set aside for charity. Reg. 1.643(a)-3 makes exclusion the ordinary result and lists the ways in, under the instrument and local law or a reasonable and impartial exercise of the fiduciary's discretion.

The gain is	Reg. 1.643(a)-3	The regulation's example
Allocated to income	(b)(1)	The deed says so (Example 4)
Allocated to corpus, consistently treated as distributed	(b)(2)	Discretionary payouts regularly treated as paid first from gains (Example 2)
Allocated to corpus, actually distributed or used to fix the payout	(b)(3)	The trust terminates and distributes everything (Example 7)
Paid or set aside for charity	(c)	A Section 642(c) deduction

A discretionary choice binds later years. Capital losses are netted against gains at the trust level, and an unused loss reaches the beneficiaries only as a carryover on termination (Section 642(h)).

Tax-exempt interest moves the other way. Section 643(a)(5) puts it in DNI, net of the expenses Section 265 disallows, including a reasonable share of indirect costs such as the trustee's commission (Reg. 1.652(b)-3). But the trust cannot deduct DNI it never included in gross income (Sections 651(b) and 661(c)), so Schedule B line 12 strips the exempt share out of the deduction, and the beneficiary reports it as exempt (Schedule K-1, box 14, code A).

The income distribution deduction, worked from trust income to the beneficiary's K-1

A trust deed requires all income to be paid to A currently, allocates capital gains to corpus, charges the trustee's fee half to income and half to corpus, and provides nothing for charity. In the year the trust receives US$30,000 of qualified dividends, US$20,000 of taxable interest and US$10,000 of tax-exempt municipal bond interest, sells shares at a US$15,000 long-term gain, and pays a US$6,000 fee.

Accounting income is the 60,000 of dividends and interest less the income half of the fee: US$57,000, all owed to A; the gain stays in corpus. One sixth of the fee (10,000 of 60,000), US$1,000, is allocated to tax-exempt interest and disallowed, so the trust deducts US$5,000 and its adjusted total income on Form 1041 line 17 is US$60,000.

Schedule B line	Entry	US$
1	Adjusted total income	60,000
2	Adjusted tax-exempt interest, 10,000 less 1,000	9,000
6	The gain on page 1, line 4, as a negative	(15,000)
7	Distributable net income	54,000
9 and 11	Income required to be distributed; total distributions	57,000
12	Tax-exempt income in line 11 (DNI is not above line 11, so line 2)	9,000
13	Line 11 less line 12	48,000
14	Line 7 less line 2	45,000
15	Income distribution deduction, the smaller of 13 and 14	45,000

Lines 3 to 5 and 10 are zero, and a simple trust skips line 8. Taxable income is 60,000 less 45,000 and the US$300 exemption: US$14,700, the corpus gain less the exemption.

A's required income exceeds DNI, so A's share is capped at 54,000 (Section 652(a)). The trustee may set the remaining US$5,000 of fee against any taxable class (Reg. 1.652(b)-3(b)) and chooses interest, so A's K-1 shows 15,000 in box 1, 30,000 of qualified dividends in boxes 2a and 2b, and 9,000 in box 14, code A. The 3,000 gap between cash and DNI is the corpus half of the fee: it cut DNI but not A's entitlement, so A receives it tax free.

The same trust as a complex trust

Change one fact: the trustee may accumulate, and pays A 36,000. Line 8 shows accounting income of 57,000 and line 10 the 36,000; because DNI exceeds the distribution, line 12 is 9,000 times 36,000/54,000, or 6,000.

US$	Simple, pays 57,000	Complex, pays 36,000
Income distribution deduction	45,000	30,000
Exemption	300	100
Trust taxable income	14,700	29,900
A's taxable income from the trust	45,000	30,000
A's tax-exempt interest	9,000	6,000

A receives two-thirds of each class: 20,000 of dividends, 10,000 of interest, 6,000 exempt. Where required (first-tier) and other (second-tier) distributions exceed DNI, the first tier absorbs it first (Section 662(a)); a specific bequest paid in three instalments or fewer carries none (Section 663(a)(1)). Payments in the 65 days after the year end may be elected into the year (Section 663(b)), up to the greater of accounting income and DNI less amounts already paid (Reg. 1.663(b)-1): here 21,000.

How TCP asks it

This is TCP Area II, Entity Tax Compliance, 30 to 40% of the section, Group D, Trusts. Topic 1, Types of trusts, is Remembering and Understanding: simple, complex, grantor and revocable trusts, the trust as a pass-through entity, the roles of grantor, trustee and beneficiaries, and corpus. Topic 2, Income and deductions, is Application: identify the allocation of items between income and corpus, and calculate a trust's accounting income, distributable net income and taxable income, including the income distribution deduction. The highest skill is Application, and no other 2026 Blueprint section tests trusts. The Blueprint does not test amounts "indexed to inflation"; the Section 642(b) exemptions of US$600, US$300 and US$100 are not indexed.

The scenario says	What it changes
Gains go to corpus and none is distributed	The gain stays out of DNI and is taxed to the trust
The fee is charged to corpus	Accounting income is unchanged; DNI falls, cutting the beneficiary's share when all income is paid out
A simple trust distributes corpus this year	Complex for the year; the exemption stays US$300

Where to practise this

Prepito's TCP course covers Area II, trusts included, with practice questions and simulations, and the free TCP practice questions show the format. Read the CPA TCP study guide for the whole section, C corporation vs S corporation vs partnership for how partnerships and S corporations pass income through, and the basis of gifted and inherited property for what an estate's assets carry to the heirs. See also the CPA programme.

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Sources: IRS, Instructions for Form 1041 (2025), Form 1041 and Schedule K-1 (Form 1041); 26 U.S.C. 641, 642, 643, 651, 652, 661, 662, 663, 671 and 676; Treasury Regulations 1.643(a)-3, 1.643(b)-1, 1.643(d)-2, 1.651(a)-3, 1.652(b)-3 and 1.663(b)-1; AICPA, CPA Exam Blueprints. Line numbers follow the 2025 Form 1041 and the Blueprint is revised; confirm both for your testing window.