When you set up a trust fund to manage assets or money for the benefit of someone else, the fund pays its own taxes. This applies whether you set up a living trust or a testamentary trust created by your will. If the trust disburses money to the beneficiary, the trust fund can claim the money as a tax write-off.
Trust funds pay taxes using Form 1041 and the various schedules that come with it. Generally, the trust pays taxes much like an individual. The IRS treats interest, capital gains, dividends and other income earned by a trust much as it does if an individual earns them. Trusts can also deduct losses on investments and take deductions the same way you do. The ability to write off disbursements is the major difference between trusts and flesh-and-blood people.
When the trust pays out a disbursement, it's the beneficiary who pays income tax on it. The trustee reports disbursements using 1041 Schedule B to calculate the size of the deduction. If the trust has more than one beneficiary, the trustee reports each beneficiary's disbursement separately. If a beneficiary can claim a deduction because the trust lost money, no other beneficiary gets to claim the same loss.
Deducting disbursements isn't as simple as adding up all the money the trust gave out. First the trustee has to figure the distributable net income -- the trust's total taxable income for the year. If DNI is less than the money the trust disbursed -- for instance if the trustee disbursed principal as well as income -- the trust's tax write-off is limited to the DNI. If the disbursements are less than DNI, the disbursement total is the write-off.
The trust is a so-called pass-through entity, meaning that the beneficiary reports income as if he'd earned it himself, rather than getting it from the trust. If the trustee disburses capital-gains income, for instance, the beneficiary pays capital gains tax. If the trust earned interest or dividends, the beneficiary pays accordingly. Likewise, tax-exempt income -- municipal bonds, for instance -- is tax-exempt to beneficiaries. Deductions don't always pass through -- it's often more advantageous for the trust to claim depreciation on its assets than the beneficiary, for instance.