Question

Consider the term distributable net income as it is used with respect to the Federal income taxation of trusts and estates. How is this amount computed? Where is it used in computing the parties’ taxable incomes?

Answer 1

Distributable net income (DNI) is used to allocate income between a trust and its beneficiaries. According to U.S. tax code: To prevent double taxation on income, estates and trusts are allowed to deduct the lesser of distributable net income or the sum of the trust income required to be distributed and other amounts “properly paid or credited or required to be distributed” to beneficiaries. An income trust recognizes distributable net income as an amount transferred to unitholders. With an estate trust, it’s the amount to be distributed to a beneficiary. Distributable net income is the maximum amount received by a unitholder or a beneficiary that is taxable; any amount above this figure will be tax-free.

Distributable Net Income = Taxable Income - Capital Gain (or + Capital Loss) + Tax Exemption

Where:

Taxable Income = Interest Income + Dividends + Capital Gains (or - Capital Losses) - Fees - Tax Exemption

Explanation

The calculation of distributable net income, or DNI, is used to allocate income between a trust and its beneficiaries. Distributable net income is the maximum taxable amount received by a beneficiary. Any distribution made to a beneficiary in excess of DNI will be free of income taxes since it will consist of principal.

DNI is viewed by the Internal Revenue Service (IRS) as an estimate of the economic value derived from a distribution to a beneficiary. In practice, DNI provides beneficiaries with a reliable source of income while minimizing income taxes paid by the trust.

Just as individuals, estates and non-grantor trusts must file income tax returns, this income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries.

The Internal Revenue Service (IRS) sees DNI as an estimate of the economic value derived from a distribution to a beneficiary. In practice, DNI provides beneficiaries with a reliable source of income while minimizing income taxes paid by the trust.