When a trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. That form shows what part of the beneficiary's distribution is interest income and principal. This tells beneficiaries what they must claim as taxable income, when filing taxes.
A recent Investopedia article asks “Do Trust Beneficiaries Pay Taxes?” The article explains that a trust is a fiduciary relationship, whereby the trustor or grantor gives another party–the trustee–the right to hold assets for the benefit of a beneficiary. Trusts are established to provide legal protection and to safeguard assets as part of estate planning.
When trust beneficiaries get distributions from the trust's principal balance, they don’t have to pay taxes on the distribution. The IRS assumes this money was already taxed before it was placed into the trust. Once money is placed into the trust, the interest it accumulates is taxable as income—either to the beneficiary or the trust itself. The trust is required to pay taxes on any interest income it holds and doesn’t distribute past year-end. Interest income the trust distributes is taxable to the beneficiary.
The amount distributed to the beneficiary is thought to be from the current-year income first, then from the accumulated principal. This is usually the original contribution plus subsequent ones. It is income in excess of the amount distributed.
Capital gains from this amount may be taxable to either the trust or the beneficiary. The entire amount distributed to and for the benefit of the beneficiary is taxable to that person to the extent of the distribution deduction of the trust.
The two most significant tax forms for trusts are the 1041 and the K-1. Form 1041 is similar to Form 1040. The trust deducts from its own taxable income any interest it distributes to beneficiaries in Form 1041. At the same time, the trust issues a K-1. That form details the distribution, or how much of the distributed money came from principal versus interest.
The K-1 schedule for taxing distributed amounts is generated by the trust and given to the IRS.
The IRS will then send the document to the beneficiary to pay the tax.
The trust then fills out a Form 1041 to determine the income distribution deduction that is accorded to the distributed amount.
Reference: Investopedia (Feb. 8, 2020). “Do Trust Beneficiaries Pay Taxes?”