Software's Pitfalls: Dealing with Distributions from Trusts to Beneficiaries.

• Author: Downs, William

When a trustee makes distributions to bonrficiarics, the nature of those can often be a challenge to determine. And our tax preparation software doesn't automatically get it right.

A "simple" trust may be anything but simple when dealing with distributions to beneficiaries.

A simple trust, by definition, is required to distribute all its income to beneficiaries. When the trust has received a variety of types of income, the character of the distributions can be a challenge for the preparer. A complex trust, for which the trustee makes distributions of income to beneficiaries, can face similar challenges.

Questions of Income

An important number to determine is the fiduciary accounting income. Utilizing fiduciary accounting concepts, and with reference to the trust document and the Uniform Principal and Income Act, the return preparer will determine the dollar amount that is to be entered in Schedule B of the federal and California trust lax returns, which can impact the overall limit of taxable and tax-exempt income required to be distributed.

That number may be more or less than the distributable net income (DNI) determined using income tax rules. And while the accounting income amount is crucially important, your tax preparation software may not properly calculate it. It comes down to making your own calculation of accounting income and entering it as an override in tax software programs.

When preparing a beneficiary K-1 form for a simple trust, net amounts of the various items of income are reported, after subtracting expenses allocated against those items of income.

The first consideration is to determine the portion of expenses to be allocated to tax-exempt income and therefore not deducted against taxable income amounts. IRS instructions say that you may use "any reasonable method" to apportion. Your software will offer suggestions, but it is up to the preparer to determine a fraction that is reasonable. And be aware that your software may use a method that you would consider not reasonable.

For example, Lacerte fiduciary software has a user setting to allow, or not allow, capital gains to be included in the denominator of the fraction. If you include capital gains in the denominator, that will result in a smaller fraction to apply when assigning expenses to tax-exempt income.

Expenses to be allocated against items of taxable income can be apportioned among categories of taxable income. Perhaps your first choice would be to allocate...