Can an Irrevocable Trust Distribute Capital Gains?

An irrevocable trust is a legal entity that holds assets for beneficiaries, and once assets are transferred to it, the transfer is permanent. When the trust sells an asset for more than its purchase price, it generates a capital gain. By default, the trust itself must pay taxes on these gains. However, specific rules allow these gains to be distributed to beneficiaries, which can lead to a more favorable tax outcome.

Default Tax Treatment of Trust Capital Gains

For tax purposes, a distinction is made between a trust’s income and its principal. Items like interest and dividends are considered income, while capital gains from the sale of assets are allocated to the principal. Consequently, the trust itself is responsible for paying the associated taxes on those gains.

This can lead to a significant tax liability due to the compressed nature of federal tax brackets for trusts. For the 2025 tax year, a trust’s income is taxed at higher rates more quickly than an individual’s income. The highest federal tax rate of 37% applies to a trust’s ordinary income over $15,650, and the top 20% long-term capital gains rate applies to gains exceeding $15,900.

In contrast, a single individual does not reach the 37% bracket until income exceeds $626,350, and the 20% capital gains rate does not apply until income is over $533,400. This disparity creates an incentive for trustees to distribute capital gains to beneficiaries, shifting the taxable event to someone with potentially lower individual income tax rates.

Conditions Permitting Capital Gains Distribution

The ability to distribute capital gains from an irrevocable trust to a beneficiary depends on specific authorizations. Without this authority, gains remain in the trust’s principal and are taxed at the trust’s high rates. The authority can be found in the trust document or provided by state law.

The Governing Trust Document

If the trust agreement defines capital gains as part of the trust’s “income,” it provides clear authority for the trustee to distribute those gains. Alternatively, the trust may grant the trustee discretionary power to make distributions from the trust’s principal. This authority allows the trustee to pass the value of capital gains to the beneficiaries.

State Law (Principal and Income Act)

When a trust document is silent, state law may provide a solution. Most states have adopted a version of the Uniform Principal and Income Act (UPAIA), which gives trustees certain powers. A provision of the UPAIA is the “power to adjust,” which allows a trustee to reclassify receipts from principal to income, permitting a portion of capital gains to be distributed.

Another option under the UPAIA is to convert the trust into a “total return unitrust.” In this structure, the beneficiary receives a fixed percentage of the trust’s assets each year, regardless of whether the return is generated from income or capital appreciation. This conversion allows for the distribution of value derived from capital gains, as the payout is based on the total value of the trust’s assets.

Inclusion in Distributable Net Income (DNI)

The tax mechanism that allows tax liability for capital gains to pass from the trust to a beneficiary is called Distributable Net Income (DNI). DNI is a calculation on the trust’s tax return that determines the maximum amount of a distribution that is taxable to the beneficiaries. Under the Internal Revenue Code, capital gains are excluded from the DNI calculation unless they are allocated to income under the terms of the trust or local law, or are paid to the beneficiary during the tax year.

The Distribution and Tax Reporting Process

Once the trustee has the authority to distribute capital gains, a specific procedural and reporting sequence must be followed. This process involves the physical distribution of funds and the preparation of tax forms to shift the tax liability from the trust to the beneficiary.

Trustee’s Action

The process begins with the trustee’s decision to make a distribution that includes capital gains, consistent with the powers granted by the trust document or state law. The trustee then physically transfers the funds from the trust to the beneficiary. This action is documented to reflect the distribution.

The 65-Day Rule

The “65-day rule” allows a trustee to make a distribution within the first 65 days after the close of the trust’s tax year and elect to treat it as if it were made on the last day of the preceding year. This gives the trustee time to calculate the trust’s income and capital gains for the prior year and make a precise distribution to optimize the tax outcome. The election is made on the trust’s tax return, Form 1041.

Form 1041 (Trust Tax Return)

The trust reports its income, deductions, and gains on IRS Form 1041, the U.S. Income Tax Return for Estates and Trusts. When capital gains are distributed, the trust reports the full gain and then takes an “income distribution deduction.” This deduction, limited by the trust’s DNI, reduces the trust’s taxable income so that it pays no tax on the distributed gains.

Schedule K-1 (Beneficiary’s Share)

After calculating the income distribution deduction, the trust must prepare a Schedule K-1 for each beneficiary who received a distribution. This form details the specific amounts and character of the income being passed to the beneficiary. The trust sends a copy of the K-1 to the beneficiary, who needs it to prepare their personal tax return.

Tax Consequences for the Beneficiary

The beneficiary receives the distributed funds and the corresponding Schedule K-1. The information on this tax form dictates how the beneficiary must report the distribution on their own tax return, determining the final tax paid on the capital gains.

Reporting the Income

The beneficiary is required to report the income shown on their Schedule K-1 on their personal tax return, Form 1040. The amounts from the K-1 are transferred to the appropriate lines on the beneficiary’s return. For example, long-term capital gains are carried over to Schedule D, which ensures the income is taxed at the individual level.

Character of Income

A principle of trust taxation is that distributed income retains its character. If the trust realized and distributed a long-term capital gain, the beneficiary receives it as a long-term capital gain. This is an advantage because long-term capital gains are taxed at preferential rates. The Schedule K-1 separates different income types to ensure the character is preserved.

Applicable Tax Rates

By receiving the capital gain, the beneficiary pays tax on it at their individual capital gains tax rates. For 2025, these rates are 0%, 15%, or 20%, depending on the beneficiary’s total taxable income. Since individual tax brackets are wider than trust tax brackets, the beneficiary’s tax rate is often lower than the rate the trust would have paid. The benefit is shifting the tax burden from the highly taxed trust to a lower-taxed beneficiary.