Insights

Distributing All the Income No Longer Clears the Trust's Tax Bill

By Terry L. (T. L.) Turnipseed, J.D., LL.M., CTFA · October 30, 2026

The Joint Committee's reading of the new itemized deduction limitation would reach a trust's distribution deduction, producing a combined federal rate near 39 percent on income that was fully distributed. Nongrantor trust planning needs a fresh look.

For as long as most practitioners have been practicing, a nongrantor trust that distributed all of its distributable net income could stop worrying about the trust's own income tax. The distribution deduction wiped out the trust's taxable income and the beneficiaries picked up the income on their returns. The Joint Committee on Taxation's explanation of the 2025 tax law suggests that assumption now needs a fresh look.

The new section 68

The 2025 law replaced the old, suspended Pease limitation with a new limitation on itemized deductions. For tax years beginning after 2025, a taxpayer in the 37 percent bracket loses two thirty sevenths of the lesser of total itemized deductions or the amount by which taxable income, computed without itemized deductions, exceeds the threshold for the 37 percent bracket.¹ The practical effect is to cap the tax benefit of an itemized deduction at 35 percent rather than 37 percent. The former subsection that excluded estates and trusts from section 68 was repealed, so the limitation now applies to fiduciary returns, and a trust reaches the 37 percent bracket at a little over $16,000 of taxable income.²

The footnote that matters

The Joint Committee's Blue Book takes the position that a trust's distribution deduction under sections 651 and 661 is an itemized deduction for this purpose, because section 63(d) defines itemized deductions as everything not excluded by section 62 or the standard deduction, and the distribution deduction is not on that list.³ The Blue Book acknowledges that the existing regulations say the distribution deduction is not an itemized deduction under section 63(d), but reads that regulation as interpreting only section 67(e).⁴ Robert Keebler was among the first to flag the point, and commentators have since pressed the competing arguments.

The arithmetic

Take a top bracket trust with top bracket beneficiaries:

• $100 of trust income
• $100 distributed as distributable net income
• Two thirty sevenths of the deduction disallowed, about $5.41
• Trust tax at 37 percent on the disallowed amount, about $2
• Beneficiary tax at 37 percent on the full $100 distributed, $37
• Combined federal tax, about $39

That is an effective federal rate near 39 percent on income that was fully distributed, before the net investment income tax and before state tax. The old line, "we distributed all the income, so the trust tax problem is solved," no longer holds if the Joint Committee's reading prevails.

Why the reading is contested

The conduit principle of Subchapter J taxes trust income once, either to the trust or to the beneficiary. Limiting the distribution deduction while the beneficiary still includes the full distribution taxes part of the income twice. Critics also note that section 641(b) computes a trust's taxable income as an individual's "except as otherwise provided in this part," that section 642(c) allows the charitable deduction "without limitation," and that applying the haircut to the section 691(c) deduction for estate tax on income in respect of a decedent undercuts that section's purpose. The limitation also creates a circular computation, since distributable net income depends on taxable income, which now depends on the limitation. Guidance from Treasury would resolve this. Until it comes, fiduciaries have to plan for both outcomes.

What trustees and advisors should review now

• Trust versus beneficiary bracket planning, and whether accumulating or distributing is the better result given the haircut.
• Distribution timing and character, since capital gains and qualified dividends are reduced as though taxed at 37 percent.
• Grantor versus nongrantor status. A grantor trust has no distribution deduction to lose; a nongrantor trust may need a new cost benefit analysis.
• State income tax exposure, which is now a larger share of the total cost and which a South Dakota situs can address for retained income.
• Charitable, asset protection and dynasty trust structures that rely on nongrantor status for other reasons.
• Fiduciary documentation of the decisions made while the law is unsettled.

The takeaway

Trust income tax planning has become more important, more technical and more valuable. Advisors whose clients use nongrantor trusts should be revisiting those structures now rather than discovering the haircut on the 2026 return.

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