Tax treatment of liquidating trusts
Capital gains that are allocated to trust principal are subtracted from taxable income because the gains are not distributed to the beneficiaries.
For the same reason, capital losses that are allocated to trust principal are added back, because the losses decrease taxable income, but do not decrease the income that is available for distribution to the beneficiaries.
A trust is considered by tax law to be a modified conduit, because usually only some of the income and deductions pass through to the beneficiaries.
The trust itself often retains some income, especially capital gains, which is usually allocated to the trust corpus.
However, a trust does not usually itemize deductions, and a trust also has a personal exemption, which is 0 for trusts that are required to distribute all their income annually to beneficiaries and 0 for all other trusts.
Generally, trust income is defined as income that is earned from investments, including tax-free income, but does not include capital gains on trust assets.
The trust can deduct the taxable portion of the distributions but not the tax-free portion nor any expenses that must be allocated to the tax-free portion of income.
Trust property consists of principal (aka corpus), which is the property transferred to the trust by the grantor, and income earned by the trust, usually from investments.
If the trust retains income beyond the end of the calendar year, then it must pay taxes on it.
To calculate this allocation, an intermediate result must first be calculated, called the distributable net income.
The distributable net income () sets a ceiling both on the trust distribution deduction and the amount that is taxable to the trust beneficiaries.
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However, expenses for the production of tax-free income are not deductible and depreciation can be claimed either by the trust or by the income beneficiaries or it can be apportioned to both according to the trust document.