Advanced Analysis of Trust Taxation Under Subchapter “J”
Why Passive Income Allocated to Corpus Is
Not Taxable
By Scott McGrath, MFP©, CWM©, CTEP©
In the field of trust taxation, few subjects provoke as much confusion or skepticism as the treatment of passive income in an irrevocable, non-grantor, complex, discretionary, spendthrift trust. Often misunderstood by tax professionals unfamiliar with the intricacies of Subchapter J, this specific structure has sparked debate about when and how passive income is taxed, and under what conditions corpus distributions are reportable or taxable events. At the heart of the analysis lies a simple but powerful distinction: not all income received by a trust is income taxed to the trust or to the beneficiary—especially when that income is lawfully allocated to corpus.
This analysis unpacks, in depth, why passive income that is allocated to corpus is not taxed to the trust or to the beneficiary. This is not a tax loophole, nor is it a form of evasion. It is a result of the statutory construction of Subchapter J of the Internal Revenue Code, long-standing fiduciary accounting practices under state law, binding judicial precedent, and the constitutional boundary set by the Sixteenth Amendment. When these sources are examined together, the outcome is both logical and lawful.
We begin with the statutory architecture. Under IRC §641, a trust is a separate taxable entity, and its income is generally taxed either to the trust itself or passed through to its beneficiaries. The mechanism by which this occurs is governed by Distributable Net Income (DNI), as defined in IRC §643(a). DNI is the measurement that determines both the amount the trust can deduct under §661 and the amount the beneficiary must include under §662. Crucially, DNI is not synonymous with gross income. It is a special tax concept that excludes, among other things, capital gains that are allocated to corpus and not distributed, per IRC §643(a)(3).
Treasury Regulation §1.643(a)-3 further affirms that capital gains are to be excluded from DNI unless expressly allocated to income or actually distributed to beneficiaries. Thus, if the trust instrument and state fiduciary law allow for it, a trustee may allocate capital gains—and other passive income such as interest, dividends, or rents—to corpus. Once allocated, these amounts are no longer “income” for tax purposes. They are retained as principal, and unless they later become part of DNI and are distributed, they never enter the stream of taxable income.
This allocation authority is governed in large part by state law, particularly the Uniform Principal and Income Act (UPIA), adopted in some form by most U.S. jurisdictions. UPIA §401 provides that capital gains are allocated to principal by default. UPIA §104 allows trustees to adjust between income and principal when necessary to administer the trust impartially. And most importantly, UPIA §103 stipulates that the terms of the trust instrument override the default rules of the statute. Therefore, if a trust document expressly directs or permits all passive income to be allocated to corpus, that fiduciary action is legally binding.
Courts have long upheld the sanctity of these fiduciary classifications. In Kenan v. Commissioner , 114 F.2d 217 (2d Cir. 1940), the court ruled that the distribution of appreciated property from corpus was not income to the beneficiary when such distributions were authorized under the trust instrument. The court recognized that unless a distribution carries out DNI, it is not income—even if the underlying asset appreciated in value. This principle, firmly established more than 80 years ago, remains good law.
In Freuler v. Helvering , 291 U.S. 35 (1934), the Supreme Court reinforced the importance of fiduciary discretion in determining how trust receipts are classified. The Court held that absent a clear statutory override, the IRS could not second-guess or recharacterize allocations made in accordance with trust law and the governing instrument. The IRS was reminded that a trust’s internal classification—if made lawfully—is determinative.
Later, in Commissioner v. Estate of Bosch , 387 U.S. 456 (1967), the Court ruled that state law controls the characterization of trust distributions. Federal tax consequences must flow from those lawful classifications, not override them. This is particularly relevant when trustees, exercising lawful discretion under state law and the trust document, allocate income to corpus. Unless the IRS can show that the trustee violated fiduciary duty or misapplied the law, its authority to recast those allocations is limited.
Greenough v. Tax Commissioner , 331 U.S. 486 (1947), adds another layer of judicial reinforcement. There, the Court clarified that a distribution must represent a realized gain in order to be treated as taxable income. It rejected the idea that receipt alone—without realization or gain—could be taxed. In the case of corpus distributions, this is key: once income is properly allocated to corpus and excluded from DNI, it is no longer treated as “income” within the meaning of the tax code or the Constitution.
And in Blair v. Commissioner , 300 U.S. 5 (1937), the Supreme Court acknowledged the fundamental right of a trust’s settlor to define how the trust will operate, and for fiduciary decisions to be respected unless they violate established law. This case stands for the proposition that beneficial interests and distributions must follow the trust’s structure—not the IRS’s preference.
These statutory and fiduciary principles are also safeguarded by the Constitution. The Sixteenth Amendment authorizes Congress to tax "incomes, from whatever source derived," but not capital, property, or mere possession of wealth. In Eisner v. Macomber , 252 U.S. 189 (1920), the Supreme Court explained that “income” means a gain derived from capital or labor, and that a stock dividend, while economically valuable, was not a realized gain and thus not income under the Constitution. This definition is crucial for understanding trust corpus distributions. They are not compensation, not a profit, and not a gain realized by the beneficiary. They are transfers of capital and, thus, fall outside the reach of the Sixteenth Amendment.
Even in Commissioner v. Glenshaw Glass Co. , 348 U.S. 426 (1955), which broadened the definition of income to include “undeniable accessions to wealth, clearly realized, and over which the taxpayer has complete dominion,” the Court preserved the idea that realization is required. There must be a new gain—not merely a transfer of existing capital. For beneficiaries receiving corpus distributions, no realization occurs. The trust realized the gain, but the beneficiary does not. Therefore, no tax is imposed.
This principle is codified in IRC §102(a), which excludes from gross income the value of property received by “gift, bequest, devise, or inheritance.” Distributions from corpus— especially those made without carrying out DNI—fall squarely within this exclusion. They are capital transfers, not income events.
Moreover, IRC §662(a) provides that beneficiaries are taxed only on amounts distributed to them “to the extent of the income of the estate or trust.” If no income is distributed—because all receipts were allocated to corpus—then no tax is due. Similarly, IRC §661 permits a deduction only to the extent that the trust distributes DNI. When passive income is allocated to corpus, and no DNI exists, there is no deduction and no corresponding inclusion.
Against this backdrop, IRS Chief Counsel Memorandum AM 2023-006 appears to stem from a profound misinterpretation of established tax law. Whether the memo represents a genuine analytical failure or a deliberate attempt to create a red herring is a matter of legitimate concern. If accidental, it reflects a troubling lack of understanding at the highest levels of IRS legal guidance; if intentional, it signals a calculated effort to obscure lawful trust strategies through authoritative sounding, but fundamentally flawed, rhetoric. By conflating gross income under IRC §61 with Distributable Net Income (DNI), the memo blurs the critical lines drawn by Congress in Subchapter J—lines that distinguish between reportable income, taxable income, and fiduciary corpus. This deliberate or negligent conflation erodes the statutory structure built around DNI, ignores the exclusions codified in IRC §643(a), contradicts Treasury Regulation §1.643(a)-3, and runs afoul of the constitutional boundaries established under the Sixteenth Amendment. It further overlooks the fiduciary discretion embedded in state law and the Uniform Principal and Income Act (UPIA), which authorize trustees to classify receipts according to the trust instrument—not IRS preference. In either case, the memo's conclusions are not merely incorrect; they are dangerous in their potential to mislead practitioners and distort lawful fiduciary administration.
In truth, the legal framework leaves little ambiguity. Passive income that is properly allocated to corpus—pursuant to a valid trust instrument and in compliance with applicable state fiduciary law—is excluded from Distributable Net Income (DNI) by operation of law. So long as that income is never reclassified or distributed as income, it remains outside the reach of income taxation. Any subsequent distribution of corpus to a beneficiary, absent the presence of DNI, constitutes a non-taxable return of principal—an event grounded in capital, not income, and therefore beyond the scope of federal income tax liability.
The structure of Subchapter J is not a loophole, nor is it the product of ambiguity or oversight. It is a deliberate and carefully constructed statutory framework that reflects the considered judgment of Congress to accommodate the complex realities of fiduciary administration. At its core, Subchapter J is designed to balance multiple competing interests: the federal government's need to tax income, the fiduciary’s legal responsibility to manage and preserve trust assets, and the constitutional requirement to distinguish taxable income from untaxable capital or property. Far from being a legislative gap, this framework affirms the principle that not all economic activity within a trust is taxable—particularly when that activity involves the preservation of capital through corpus allocations rather than the creation or distribution of current income.
Congress provided trustees with this degree of flexibility for a very deliberate and practical reason. Lawmakers understood that trusts are not mere conduits for passing income— they are dynamic, adaptive legal entities designed to serve complex economic, familial, and generational purposes. Trusts must be capable of responding to market fluctuations, economic uncertainties, and the unique needs of both income and remainder beneficiaries. They are, by their nature, instruments of long-term wealth stewardship, not mechanisms for short-term distribution. Because of this, Congress intentionally delegated to trustees the authority to classify receipts and disbursements as income or principal based on the specific objectives of the trust and the fiduciary standards imposed by state law.
This delegation of authority is not incidental—it is fundamental to the proper functioning of a fiduciary system. Trustees must often make nuanced decisions regarding the allocation of passive income, the reinvestment of gains, and the preservation of purchasing power for future generations. These are not decisions that can be made by rigid federal mandates alone. That is why fiduciary accounting, as shaped by state law—especially under the Uniform Principal and Income Act (UPIA)—forms the backbone of trust administration. State law authorizes trustees to allocate capital gains, dividends, and other receipts to principal where appropriate, and allows trust instruments to override default rules to reflect the settlor’s intent. This discretion is not a workaround; it is a recognized and respected component of fiduciary duty.
Subchapter J of the Internal Revenue Code reflects and reinforces this principle. Rather than seeking to impose a uniform tax treatment that ignores the legal realities of trust administration, Subchapter J aligns tax consequences with fiduciary actions. It provides that only income included in Distributable Net Income (DNI) and actually distributed is taxable to the beneficiary, and only retained DNI is taxable to the trust. If a trustee lawfully allocates receipts to corpus, then no DNI is created, and no income tax is triggered. This outcome is not a loophole—it is the result of a statutory system designed to respect fiduciary governance.
The judiciary has repeatedly affirmed this structure. Courts have consistently held that the IRS may not disregard fiduciary classifications when they are made in good faith, pursuant to the terms of the trust, and consistent with applicable state law. In decisions such as Freuler v. Helvering , Commissioner v. Estate of Bosch , and Kenan v. Commissioner , courts have recognized that trustees act within their rights when they allocate receipts to principal and that such actions cannot be arbitrarily recharacterized for tax purposes. The IRS is not empowered to substitute its judgment for that of the trustee unless the fiduciary has violated the law or acted in bad faith.
This enduring respect for trustee discretion is essential not only for the integrity of trust administration, but for preserving the constitutional and statutory limits of federal taxation. Trusts are not mere income pass-through vehicles. They are sophisticated financial entities built upon a foundation of state law, contractual intent, and fiduciary responsibility. Subchapter J honors that foundation by aligning tax treatment with lawful fiduciary behavior, not by overriding it. For these reasons, trustee discretion—especially in the classification of income and principal—must continue to be treated not as a tax avoidance tool, but as a legitimate and necessary function of responsible trust governance.
Moreover, the constitutional guardrails imposed by the Sixteenth Amendment ensure that the federal income tax remains tethered to “income”—not capital, not unrealized appreciation, and not internal trust accounting that fails to meet the threshold of realization. As such, any attempt to redefine or expand the scope of income taxation beyond what is recognized in law and precedent constitutes a violation of both statutory design and constitutional limits.
For tax practitioners, CPAs, estate planners, and fiduciaries, understanding the nuances of Subchapter J is not optional—it is foundational. Mastery of this framework is essential not only for regulatory compliance, but for safeguarding the legal and structural integrity of the trust itself. It enables professionals to administer trusts in a manner that is both legally sound and tax- efficient, and it equips them to defend such administration against misinformed scrutiny. Ultimately, Subchapter J is not a shelter—it is a statute. And within its design lies one of the most powerful and lawful vehicles for multigenerational asset protection and tax deferral available in the American legal system.
In the final analysis, when an irrevocable, non-grantor, complex, discretionary, spendthrift trust is properly structured and lawfully administered, it possesses the legal capacity to control whether income received ever becomes taxable—either to itself or to its beneficiaries. If the trust receives only passive income—such as rents, dividends, interest, royalties, or capital gains—and the trustee, acting under express authority granted by the trust instrument and consistent with applicable fiduciary law, allocates those receipts entirely to corpus, then no Distributable Net Income (DNI) is created. In the absence of DNI, there is no deduction to be claimed by the trust under IRC §661, and no corresponding income to be reported by any beneficiary under IRC §662. The trust, in effect, reports its gross income as required under IRC §61, but lawfully retains and classifies those receipts as principal—not taxable income—under the Internal Revenue Code and Treasury Regulations. Consequently, unless and until the trustee affirmatively elects to create and distribute DNI in a future year, no taxable event arises. And as a matter of statutory and constitutional law, what is not income—either in substance or in form— cannot be taxed as such.