Form 1041 Schedule K-1

The professional fees etc may be used to reduce the distributed income.

If the fees were $200, and the only income was $2000 of interest, if you elect to use that 200 to reduce distributed income, the K-1 would report interest income of 1800 and you would never see the "fee" on the K-1. That's the N of DNI.

If you do not so elect, you would report the fee as a fee on the K-1 which the K-1 then passes through to, for example, the bene's 1040 sch A Misc 2% deduction.

The trust owns a % of a partnership. Most of the income is a pro- rata share of the partnership's interest & "qualified" dividend income. There are also G&A expenses from the partnership, in addition to professional fees. Since interest and dividend is taxed at different rates, do you deduct the expenses from interest first, then from dividends -- and report the DNI as qualified dividend income on K-1?

TIA

Allocate in a sensible manner. For example, if the expenses were 3% of the gross income, apply the 3% reduction to interest to ordinary dividends, to qualified dividends, to royalty income, etc etc.

I am guessing that if you can find a cheap trust software package it should be smart enough to do that for you.

The reason I originally thought the expenses would be allocated first to interest income/non-qualified dividends is because if the income/ expense is passed through to the beneficiary by item, the tax calculation on beneficiary's Form 1040 would be : (1) gross qualified dividend is compared to the taxable income (net of std/itemized deductions). (2) qualified dividend (and LTCG) -- up to the amount of taxable income -- is taxed at its special rate (up to 15%). (3) if taxable income exceeds gross qualified dividend, then the excess is calculated at the regular rate.

But, I guess, in a DNI distribution, the allocation of expenses is different.

Does the method of allocation differs for DNI distribution from a non- grantor trust vs. grantor trust?

Yes. A grantor trust does not compute DNI. All items in a grantor trust are reported gross on a grantor letter schedule (not on a K-1) as if there were no trust. Read the Form 1041 instructions.

Richard Di Bernardo, CPA San Francisco

"Since interest and dividend is taxed at different rates, do you deduct the expenses from interest first, then from dividends -- and report the DNI as qualified dividend income on K-1? "

Yes, you could if you want to. And you should.

You must make an allocation of the deductions to tax-exempt income, if any, first.

Since there is no preferential tax treatment for interest, and unless the beneficiary needs investment income to deduct investment interest, DNI = Do Net Interest.

Richard Di Bernardo, CPA