Distributable Net Income (DNI): How Schedule B Splits the Tax

Quick Answer

Distributable net income (DNI) is the ceiling on two things at once: the income distribution deduction an estate or trust can take on Form 1041, and the amount of its distributions that beneficiaries must include in their own income. It is figured on Schedule B, line 7. Income that is distributed, up to DNI, is taxed to the beneficiaries; income that stays in the trust is taxed to the trust at its own compressed rates.

An estate or trust is a separate taxpayer, but it is not meant to pay tax twice on the same dollar. When income is passed out to beneficiaries, the entity deducts it and the beneficiaries report it. DNI is the measuring stick that keeps those two sides equal.

Here is how the Form 1041 instructions build DNI on Schedule B, which distributions it covers, and the elections that move income from one year or one side to the other.

What DNI does

The Form 1041 instructions put it in one sentence: the income distribution deduction for amounts paid, credited, or required to be distributed to beneficiaries "is limited to DNI." The same figure, from Schedule B, line 7, also decides how much of what a beneficiary receives is includible in that beneficiary’s gross income.

So DNI works in both directions. The trust cannot deduct more than DNI, and beneficiaries collectively are not taxed on more than DNI. Anything distributed beyond it is not income to them.

How Schedule B builds it

Schedule B starts from the return itself. Line 1 is adjusted total income, generally the amount from line 17 on page 1 of Form 1041. Line 2 adds back adjusted tax-exempt interest, net of the expenses allocable to it. Line 3 deals with capital gains.

Line 3 is where most of the judgment sits. It includes all capital gains, whether or not distributed, that are "attributable to income under the governing instrument or local law." Gains that the trust instrument or state law treats as principal (corpus) stay out of DNI, which is why most trusts pay the tax on their own capital gains. The lines that follow adjust for capital gains and amounts set aside for charity, and arrive at DNI on line 7.

Tax-exempt interest is part of DNI, but the trust gets no deduction for it: for the income distribution deduction, DNI is figured without regard to any tax-exempt interest (Schedule B, line 12).

First-tier and second-tier distributions

Schedule B sorts what goes out into two tiers. Line 9 is income required to be distributed currently, whether or not it was actually paid. The instructions call these "first-tier distributions," and they are deductible to the extent of DNI. Every simple trust completes line 9, as do complex trusts and estates that must distribute income currently.

Line 10 is everything else paid, credited, or required to be distributed, the "second-tier distributions." That includes annuities not paid out of income, mandatory and discretionary distributions of corpus, and distributions of property in kind. Only a decedent’s estate or a complex trust completes line 10. Beneficiaries include second-tier amounts only to the extent of their share of whatever DNI is left after the first tier.

What doesn’t count as a distribution

Lines 9 and 10 leave out amounts deducted on the prior year’s return, amounts paid or set aside for charity, and gifts or bequests of a specific sum of money or specific property. To be treated as a specific gift or bequest, the amount must be paid in three or fewer installments, and an amount that can be paid only from income does not qualify.

Property distributed in kind is valued at the smaller of the trust’s adjusted basis (adjusted for any gain or loss it recognized) or fair market value, unless the fiduciary makes the section 643(e)(3) election, in which case fair market value is used.

The 65-day election and separate shares

The executor of a decedent’s estate or the fiduciary of a complex trust can elect under section 663(b) to treat amounts paid within 65 days after year-end as paid on the last day of the tax year. The election is made by checking the box at Question 6 under Other Information, the return must be filed by its due date including extensions, and once made it is irrevocable.

When one trust or estate has beneficiaries with substantially separate and independent shares, the separate share rule treats each share as its own trust for the purpose of figuring the DNI allocable to it. Deductions and losses that belong to one share are not available to any other.

Frequently asked questions

Is DNI the same as trust accounting income?⌄
No. Accounting income follows the trust instrument and state law and determines what the beneficiaries are entitled to receive. DNI is a tax figure built on Schedule B. Complex trusts report accounting income separately on Schedule B, line 8; estates and simple trusts skip that line.
Why does DNI usually leave out capital gains?⌄
Because Schedule B, line 3, includes only the capital gains attributable to income under the governing instrument or local law. Most instruments and state laws treat gains as principal, so those gains stay with the trust and are taxed there.
Where does the income distribution deduction show up?⌄
It is figured on Schedule B and carried to the front of Form 1041. It is limited to DNI, figured without the tax-exempt interest the trust can never deduct.
Does a simple trust use the 65-day election?⌄
No. The section 663(b) election is available to the fiduciary of a complex trust or the executor of a decedent’s estate. A simple trust already must distribute all its income currently.
Is there a DNI figure for the alternative minimum tax?⌄
Yes. The instructions say to use Schedule I (Form 1041) to compute DNI and the income distribution deduction on a minimum tax basis.

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