Beneficiaries of a trust typically pay taxes on distributions they receive from the trust's income. However, they are not subject to taxes on distributions from the trust's principal. When a trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. The K-1 indicates how much of the beneficiary's distribution is interest income versus principal and, thus, how much the beneficiary is required to claim as taxable income when filing taxes.
Interest Versus Principal Distributions
When a trust beneficiary receives a distribution from the trust's principal balance, he does not have to pay taxes on it: The Internal Revenue Service (IRS) assumes this money was already taxed before it was placed into the trust. Once money is placed into the trust, the interest it accumulates is taxable as income, either to the beneficiary or the trust itself. The trust must pay taxes on any interest income it holds and does not distribute past year-end. Interest income the trust distributes is taxable to the beneficiary who receives it.
The two most important tax forms for trusts are the 1041 and the K-1. Form 1041 is similar to Form 1040. On this form, the trust deducts from its own taxable income any interest it distributes to beneficiaries. At the same time, the trust issues a K-1, which breaks down the distribution, or how much of the distributed money came from principal versus interest. The K-1 is the form that lets the beneficiary know his tax liability from trust distributions.
For additional info, see "Designating a Trust as Retirement Beneficiary" and "Pros/Cons of Naming a Trust as Beneficiary."