Taxation of Estates and Gifts

Distributable Net Income

The distributable net income is the taxable income of the trust (from 26 U.S.C. § 61, including capital gains and excluding tax-exempt interest at first) with some adjustments made. 26 U.S.C. § 643(a).

Subtract the "distributions deduction". 26 U.S.C. § 643(a)(1).
- Distributions Deduction
  To calculate the distributions deduction:
  1. Take the lesser of:
    - All distributions minus the charitable deductions
    - Distributable Net Income
  2. Subtract the net tax-exempt income ( $TEI - Direct TEI Expenses - Allocated Indirect Expenses$ )
  65-Day Rule
  
  26 U.S.C. § 663(b)(1)
  
  If within the first 65 days of any taxable year of an estate or a trust, an amount is properly paid or credited, such amount shall be considered paid or credited on the last day of the preceding taxable year.
  
  You must elect to do so though.
- Basically, how much taxable income you've already distributed
Add back the personal exemption substitute deduction from 26 U.S.C. § 642(b). 26 U.S.C. § 643(a)(2).
- I.e., it's not allowed.
Subtract net capital gains allocated to principal. 26 U.S.C. § 643(a)(3).
Add tax-exempt interest. 26 U.S.C. § 643(a)(5).

Allocating Distributable Net Income

After determining DNI, it must be allocated among the distributions.

First, indirect expenses of the trust must be segregated pro rata between taxable income and tax-exempt income. The differences after subtracting direct expenses and these portions of indirect expenses from classes' gross incomes are the net amount of DNI for the classes (which should add back up to the total DNI). You really only care about the percentages here though.

Second, DNI must be allocated among the distributions according to a tier list:

Required distributions. 26 U.S.C. § 662(a)(1).
All other distributions. 26 U.S.C. § 662(a)(2).

All DNI and charitable deductions are first allocated proportionally among the tier 1 distribution beneficiaries.
If the DNI is greater, what's left over is then likewise allocated among the tier 2 distribution beneficiaries.
If there is still DNI left over, the DNI is allocated to the trust, and it will be taxed for it.

Then each person has income according to the DNI allocated to him, classified as according to the percentages that the income was classified as.