8100 / How are the payments from a charitable remainder trust to a beneficiary taxed?

Amounts distributed to noncharitable beneficiaries retain the character (ordinary income, capital gain, and other income such as tax-exempt income) they had when received by the trust (even if the trust is not taxed on the income). However, the income of the trust is deemed to be distributed in the following order:

First, distributions are treated as made out of the ordinary income of the trust to the extent it has ordinary income for the tax year plus its ordinary income not distributed for prior years. Ordinary income not distributed is carried over as such until the next year.¹

Second, distributions in excess of ordinary income are considered to be distributions of net capital gain, to the extent of the trust’s net capital gain not previously distributed.² (See Q 702 for a detailed explanation of the calculation of capital gains and losses.)

Third, if distributions exceed both accumulated ordinary income and accumulated net capital gain, the excess is treated as other income, including tax-exempt income, to the extent the trust has other income for the tax year and undistributed other income for prior years.³

Finally, to the extent distributions for the year exceed the above amounts, the distribution is deemed a non-taxable return of trust corpus.⁴

Example: Jerry establishes a charitable remainder trust with low basis stock that today is worth $100,000. He elects a 7 percent payout. Jerry’s $7,000 payment will be taxed under four different categories depending on the investment performance of the trust over the year. This year, Jerry’s payment consists of $3,000 of ordinary income, $2,000 of capital gain, $1,000 of tax-exempt income and $1,000 of tax-free return of principal.

If there are two or more recipients, each is treated as receiving a pro rata portion of each category of income included in the distribution.⁵

The amount of the distribution is includable in income by the recipient for the tax year in which the amount is required to be distributed, even though the amount is not distributed until after the close of the trust’s tax year. If the recipient and the trust have different tax years, the amount is includable in the tax year of the recipient in which the trust’s tax year (in which the amount is required to be distributed) ends.⁶ However, if the trust’s distributable net income is less than the percentage payout designated in the trust instrument (as may occur by design in the early years of a net income with makeup unitrust – see Q 8079), each beneficiary takes into account only his proportionate share of distributable net income.⁷

Amounts received are taxed under these rules, even if the trust itself paid tax on any of its income.⁸ (See Q 8103 regarding taxation of a charitable trust.) A charitable remainder trust must pay a 100 percent excise tax on its unrelated business taxable income (UBTI). The excise tax is allocated to corpus and does not reduce the taxable income of the trust. The UBTI is considered income of the trust for purposes of determining the character of the distribution to a beneficiary. Trust income is allocated among the trust income categories regardless of whether the income is UBTI.⁹

The IRS privately ruled that amounts treated as consent dividends may be included in a trust’s income for purposes of IRC Section 664(b)(1), but do not constitute trust income for purposes of IRC Section 664(d)(3)(A).¹⁰ The IRS determined that where income received by a charitable remainder trust from its ownership of a limited partnership interest constituted rental activity income, such income would be treated as income from a rental activity in the hands of the unitrust beneficiaries.¹¹