Distributions from a charitable remainder unitrust are taxed to income recipients based on what is known as the “four-tier system” of taxation. The system prioritizes the order in which income is distributed from the trust.
Under the four-tier system, to the extent the trust produces any ordinary income in the current or prior years, these amounts are considered distributed first. Capital gains come next, followed by tax-exempt income, and finally trust principal (which is also tax-exempt). As a result, the taxation of income distributions depends entirely on the tax character of the assets you contribute, if and when those assets are sold, and the types of income the trust subsequently earns on its investments.
As a general rule, if you transfer highly appreciated long-term capital gain property to the trust, after which the trustee sells it and reinvests in a balanced portfolio of stocks and bonds, you can expect a portion of your income distributions to be taxable as capital gains and a portion as ordinary income. Conversely, if you transfer tax-exempt bonds and the trustee continues to hold them, your income distributions would be tax-exempt.
After the close of each year, you will receive a Form K-1 that describes the tax character of your income distributions for inclusion on your income tax return.
