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Taxation of Unitrust Payments

Payments from a unitrust may be made in one of three ways:  1) the straight unitrust pays the stated payout percentage regardless of earnings; if earnings are insufficient, payments are made from trust principal. 2) The net income with makeup unitrust pays the lesser of the stated payout percentage or the actual trust earnings. If the trust income does not equal the stated payout percentage in any year and later earns more than the stated payout percentage, the trust can pay the stated payout percentage plus the additional earnings each year in order to make up the earlier deficit. 3) The net income unitrust pays the lesser of the stated percentage or the actual trust earnings. In some cases, you may designate a “triggering event” when a unitrust can flip from net income to straight.

To simplify this, let’s look at the “buckets” from which unitrust payments are made:

  1. Ordinary income (dividend income)
  2. Short-term capital gain
  3. Long-term capital gain
  4. Tax-exempt
  5. Principal

When a unitrust is initially funded, all the buckets are empty except principal. But as the trust realizes gains and earns income, the other buckets start to fill up. When the trust sells an appreciated asset that was used to fund a unitrust, any short- or long-term capital gain immediately goes into the appropriate bucket. As the trust investments earn income (ordinary or tax-exempt) it too goes into the appropriate buckets. During the life of a trust, several assets may be bought and sold by the trust; any gains or losses from the sales also flow to the appropriate buckets.

Tax regulations require that payments to the income beneficiaries be made first from ordinary income, then from short-term capital gain, then from long-term capital gain, then from tax-exempt income, and finally from principal. Payments made to income beneficiaries are taxed at a rate appropriate to the bucket from which they came. Payments from income and short-term capital gain are taxed as ordinary income; those from long-term capital gains are taxed at the reduced capital gain rate; payments from tax-exempt income or principal are not taxable.

Do you have questions about unitrusts? Contact your local Financial Services Representative for more information. [view Directory] or view our Gift Legacy pages for more information about unitrusts.

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