Specialized Returns and Taxpayers · Trust and estate income tax
Separately stated items (items reported on the K-1)
tax year · reviewed 2026-08-21 · Draft for I. Ohu review
A fiduciary Schedule K-1 answers two questions that have nothing to do with each other: how much of the trust’s income each beneficiary must include, and what kind of income it is. The first is a rationing exercise governed by tiers; the second is a proportion exercise that ignores the tiers entirely.
The rule
Rationing: two tiers. first tier — the income for the year required to be distributed currently to the beneficiary, whether actually distributed or not, and where the amount required to be distributed to all beneficiaries exceeds distributable net income computed without the charitable deduction, each beneficiary includes a proportionate share of that figure insteadTY2026 (IRC § 662(a)(1)), then second tier — all other amounts properly paid, credited or required to be distributed, and where the two tiers together exceed distributable net income, each second-tier beneficiary includes a proportionate share of what is left after the first tierTY2026 (IRC § 662(a)(2)). A simple trust has only the first, under IRC § 652(a).
Character: one proportion. amounts have the same character in the beneficiary’s hands as in the trust’s, treated as consisting of the same proportion of each class of item entering into distributable net income as that class bears to the total — unless the terms of the governing instrument specifically allocate different classes of income to different beneficiariesTY2026 (IRC §§ 652(b) and 662(b)). The exception is narrow — a specific allocation of different classes to different beneficiaries in the terms of the governing instrument, not a trustee’s designation.
Deductions are allocated first. the deductions entering into distributable net income, including the IRC § 642(c) charitable deduction, are allocated among the classes of income under the regulations before the classes are apportioned to beneficiariesTY2026 (IRC § 662(b)).
And the last year is different. on termination of an estate or trust, an IRC § 172 net operating loss carryover, an IRC § 1212 capital loss carryover, and deductions for the final year in excess of gross income are allowed as deductions to the beneficiaries succeeding to the propertyTY2026 (IRC § 642(h)).
Current figures
| Item | Rule | Authority |
|---|---|---|
| First tier | first tier — the income for the year required to be distributed currently to the beneficiary, whether actually distributed or not, and where the amount required to be distributed to all beneficiaries exceeds distributable net income computed without the charitable deduction, each beneficiary includes a proportionate share of that figure insteadTY2026 | IRC § 662(a)(1) |
| Second tier | second tier — all other amounts properly paid, credited or required to be distributed, and where the two tiers together exceed distributable net income, each second-tier beneficiary includes a proportionate share of what is left after the first tierTY2026 | IRC § 662(a)(2) |
| Character | amounts have the same character in the beneficiary’s hands as in the trust’s, treated as consisting of the same proportion of each class of item entering into distributable net income as that class bears to the total — unless the terms of the governing instrument specifically allocate different classes of income to different beneficiariesTY2026 | IRC §§ 652(b), 662(b) |
| Deduction allocation | the deductions entering into distributable net income, including the IRC § 642(c) charitable deduction, are allocated among the classes of income under the regulations before the classes are apportioned to beneficiariesTY2026 | IRC § 662(b) |
| Termination | on termination of an estate or trust, an IRC § 172 net operating loss carryover, an IRC § 1212 capital loss carryover, and deductions for the final year in excess of gross income are allowed as deductions to the beneficiaries succeeding to the propertyTY2026 | IRC § 642(h) |
| Distributable net income | distributable net income is the taxable income of the estate or trust with modifications — no distribution deduction, no personal exemption, capital gains allocated to corpus excluded, tax-exempt interest added back net of allocable expenses, and the IRC § 1202 exclusion disregardedTY2026 | IRC § 643(a) |
| Administration costs | costs paid or incurred in connection with the administration of an estate or trust which would not have been incurred if the property were not so held are allowable in arriving at adjusted gross income, along with the exemption and the distribution deductionsTY2026 | IRC § 67(e) |
How it works in practice
Work the tiers before the classes. Compute distributable net income; identify the income required to be distributed currently and give it to the first-tier beneficiaries; then apply what is left of distributable net income to the second tier. Only when each beneficiary’s amount is fixed do you ask what classes it consists of.
A first-tier beneficiary is taxed on what was required, not on what arrived. IRC § 662(a)(1) includes the income required to be distributed currently “whether distributed or not”. A trustee who fails to distribute does not defer the beneficiary’s tax; the beneficiary reports the income and has a claim against the trustee, which is a matter for trust law rather than for the return.
The two proportionate reductions are different and both are tested. Where the first tier alone exceeds distributable net income, each first-tier beneficiary reports a share of distributable net income computed without the charitable deduction, in the ratio their required distribution bears to the total required. Where the two tiers together exceed distributable net income, second-tier beneficiaries share what remains after the first tier, in the ratio of their other amounts. The first tier is never squeezed by the second.
Character flows in the same proportions to everyone. Each beneficiary’s amount is treated as consisting of the same proportion of each class as that class bears to distributable net income. So a beneficiary receiving a quarter of the total takes a quarter of the interest, a quarter of the dividends and a quarter of the tax-exempt income, and the trustee cannot direct otherwise.
The specific allocation exception has to be in the instrument and has to be specific. The statute displaces the proportionate rule only where “the terms of the governing instrument specifically allocate different classes of income to different beneficiaries”. A general power to distribute, a trustee’s resolution or a note on the accounts is not enough, and the allocation must have economic effect independent of tax.
Allocate the deductions to the classes before apportioning. Distributable net income is a net figure, and the deductions inside it — including the IRC § 642(c) charitable deduction — are allocated among the classes of income under the regulations before the classes are shared out. Indirect expenses are generally allocated proportionately, with a required allocation to tax-exempt income first, and the fiduciary has some discretion over the rest.
The final year reverses direction. During the trust’s life, income flows out to beneficiaries and losses stay in. On termination IRC § 642(h) sends the net operating loss carryover, the capital loss carryover and the excess deductions for the last year out to the beneficiaries succeeding to the property. It is the only year in which a fiduciary Schedule K-1 routinely carries deductions rather than income.
Scenarios
The income that never arrived
The Wingate Trust requires all income to be distributed annually to the settlor’s son. For the year its distributable net income is $58,000, all of it required to be distributed. The trustee, in dispute with the son, distributes nothing.
The son reports $58,000. IRC § 662(a)(1) — and IRC § 652(a) for a simple trust — includes the amount of income required to be distributed currently “whether distributed or not”, and the trust takes a corresponding deduction. The tax follows the requirement, not the cash.
The remedy is not a tax remedy. The son has a claim against the trustee under trust law for the undistributed income, and the trustee may have breached a duty; none of that changes the return. Preparers occasionally try to solve this by not deducting at the trust level and not reporting at the beneficiary level, which is wrong twice and leaves the income taxed nowhere.
Two tiers, one shortfall
The Aldingham Trust has distributable net income of $90,000. Its instrument requires $70,000 of income to be distributed annually to A. The trustee also distributes $60,000 of corpus to B under a discretionary power.
A reports $70,000 in full: the first tier is satisfied before anything is allocated to the second, and $70,000 is within distributable net income. B reports $20,000 — what is left of distributable net income after the first tier — even though B received $60,000 in cash. The balance of $40,000 is a distribution of corpus.
Note what would change if the first tier alone had exceeded distributable net income. Then A would report a proportionate share of distributable net income computed without the charitable deduction, and B would report nothing at all. The tiers ration in order, and the second tier absorbs the shortfall entirely.
The allocation the trustee could not make
The Selby Trust has distributable net income of $100,000: $55,000 of taxable interest, $25,000 of qualified dividends and $20,000 of tax-exempt interest. It distributes $50,000 to each of two beneficiaries. One beneficiary is in the top bracket and the other pays no tax, so the trustee resolves to allocate all the tax-exempt income to the first.
The resolution has no effect. IRC § 662(b) treats each beneficiary’s amount as consisting of the same proportion of each class as that class bears to distributable net income, unless the terms of the governing instrument specifically allocate different classes to different beneficiaries. A trustee’s resolution is not a term of the instrument.
Each beneficiary therefore reports $27,500 of taxable interest, $12,500 of qualified dividends and $10,000 of tax-exempt interest. Had the settlor drafted a specific allocation into the instrument, with economic effect independent of the tax consequences, the answer would differ — which is a drafting point, not an administration one.
Traps
“Whether distributed or not” is the operative phrase. A first-tier beneficiary reports income required to be distributed currently even if the trustee withheld it. Non-payment is a trust law problem, not a timing rule.
The two proportionate reductions use different denominators. The first tier uses distributable net income computed without the charitable deduction; the second tier uses what remains after the first tier. Substituting one for the other is a common computational error.
Only the instrument can allocate classes specifically. IRC §§ 652(b) and 662(b) displace the proportionate rule for a specific allocation in the terms of the governing instrument — not for a trustee’s designation, a resolution, or the account a payment was drawn on.
The final year carries deductions out, not income. IRC § 642(h) passes the net operating loss carryover, the capital loss carryover and the excess deductions to the beneficiaries succeeding to the property, which is the reverse of every other year.
How this has changed
The tier system and the character rules date from 1954 and have not been amended in substance. What has changed is the value of what flows through. The compression of trust brackets after 1986 and the application of the IRC § 1411 surtax to trusts at a very low threshold mean that pushing income out is almost always better than accumulating it, so the K-1 now carries far more of a typical trust’s income than it once did.
The excess deductions rule was thrown into doubt in 2018 and then settled. Because IRC § 67(g), now § 67(h), suspended miscellaneous itemized deductions, it was unclear whether excess deductions passed out under IRC § 642(h)(2) survived in the beneficiaries’ hands. Regulations finalised in 2020 resolved it: the excess deductions retain their character in the beneficiaries’ hands, so amounts attributable to IRC § 67(e) administration costs remain deductible in arriving at adjusted gross income, while amounts that would be miscellaneous itemized deductions are not. The fiduciary must therefore report the excess deductions by category rather than as a single figure.
Nothing in the post-2024 legislation alters IRC §§ 652, 662 or 642(h). Pub. L. 119-21 § 70110 made the suspension of miscellaneous itemized deductions permanent, which makes the categorisation on the final K-1 permanently significant rather than a temporary complication.
Exam focus
Separate the two questions and answer them in order. Amount first, through the tiers; character second, through the proportions.
Know that a first-tier beneficiary includes income required to be distributed currently whether distributed or not, and be ready to say what the beneficiary’s remedy is.
Learn both proportionate reductions with their different denominators, and remember that the first tier is never reduced to accommodate the second.
Know the specific allocation exception precisely — terms of the governing instrument, specifically allocating different classes to different beneficiaries — and that nothing a trustee does can substitute.
Finally, know that IRC § 642(h) passes losses and excess deductions to the beneficiaries on termination, and that the excess deductions must be reported by character.
Check yourself
1. A trust must distribute $40,000 of income annually to A and may distribute corpus to B. Distributable net income is $30,000. The trustee distributes $40,000 to A and $25,000 to B. What does each report?
Answer: A reports $30,000 and B reports nothing. The first tier alone — $40,000 required to be distributed currently — exceeds distributable net income, so under IRC § 662(a)(1) A includes a proportionate share of distributable net income computed without the charitable deduction, and as the sole first-tier beneficiary that is the whole $30,000. Nothing remains for the second tier, so B’s $25,000 is entirely a distribution of corpus carrying no income. The tiers ration in order.
2. A trust’s instrument says the trustee “may allocate different classes of income among the beneficiaries as the trustee thinks fit”. The trustee allocates all the municipal bond interest to one beneficiary. Is that respected?
Answer: No. IRC § 662(b) displaces the proportionate rule only where the terms of the governing instrument specifically allocate different classes of income to different beneficiaries. A power to allocate as the trustee thinks fit is not a specific allocation — it is a delegation of the choice, and the statute requires the instrument itself to make it. The proportionate rule applies and each beneficiary reports a share of every class.
3. An estate terminates with a $60,000 capital loss carryover and $18,000 of deductions in excess of gross income for its final year, of which $11,000 are executor’s commissions and $7,000 are investment advisory fees. What passes to the beneficiaries?
Answer: The $60,000 capital loss carryover under IRC § 642(h)(1), and the excess deductions under § 642(h)(2) — but reported by character. The $11,000 of commissions are IRC § 67(e) costs and remain deductible by the beneficiaries in arriving at adjusted gross income. The $7,000 of investment advisory fees would be miscellaneous itemized deductions, which IRC § 67(h) disallows entirely, so they yield nothing. The fiduciary must break the figure out rather than reporting $18,000 as one number.
4. Why is a beneficiary taxed on income the trustee refused to pay?
Answer: Because IRC § 662(a)(1), and IRC § 652(a) for a simple trust, include the amount of income required to be distributed currently “whether distributed or not”. The statute taxes the entitlement rather than the receipt, which is the necessary counterpart of the trust’s deduction under IRC § 651 or § 661 — the deduction is likewise for amounts required to be distributed, so if the beneficiary were not taxed the income would escape entirely. The beneficiary’s remedy against the trustee is a matter of trust law and does not affect either return.
5. A trust has distributable net income of $80,000 including $16,000 of tax-exempt interest, and distributes $40,000 to its sole beneficiary. What does the beneficiary report?
Answer: $40,000 of distributable net income, of which one fifth — $8,000 — is tax-exempt interest, because IRC § 662(b) treats the amount as consisting of the same proportion of each class as that class bears to distributable net income. So the beneficiary reports $32,000 of taxable items with their several characters preserved and $8,000 of exempt interest. Note the trust’s distribution deduction is correspondingly reduced for the exempt portion, so the exemption is preserved once and not twice.
Change log
- Initial draft. Sets out the two-tier system in IRC § 662(a) with the proportionate reduction that applies where distributions exceed distributable net income, the character rule in IRC §§ 652(b) and 662(b) with the specific allocation exception and the allocation of deductions among classes, and the IRC § 642(h) pass-out of loss carryovers and excess deductions on termination.