@Opus 17 I guess I should take a stab at this as well:
<<My issue is with how the trust is funded. I don't understand how, if the trust is funded by someone else (relative, lawsuit settlement, etc.) and the beneficiary never paid tax on it, how does the beneficiary have a basis to deduct the expense? >>
While the beneficiary never paid taxes on the money funded into the trust, it is funded with after-tax funds to begin with!* Think of it as a form of inheritance with controls (the trust) on it so the beneficiary doesn't go out and buy a dozen Rolls Royce's and a half dozen yachts instead of paying critical medical bills!!
An inheritance would all be after-tax dollars, right?
Maybe this helps: since assets in the trust are after tax* dollars, then any distribution is an asset and therefore not income, so no tax impact; however, those assets generate income, and to the extent there is income, those income dollars are 'first out' in any distribution.
Compare the tax rates for a trust versus an individual. The trust tax brackets are quite compressed, so the motivation is for the beneficiary to pay any tax on the income and not the trust! (Trust top tax bracket is 37% at only $13,000 of income - it is quite compressed !!!!).
<<Separately, if I was wrong on the tax being owed on the earnings every year, and only owed when the earnings are paid to the beneficiary, then I learned something today. >>
the earnings are taxed each year - you are correct. The question is who is responsible to pay the tax! While chapter and books are written on the the optimal strategy and the trade-off of asset control, the beneficiary pays the income tax a lot lower tax rate, so financially (at the risk of control), best for the beneficiary to pay the tax.
does that help? (I have a lot of real world experience with these trusts as the trustee of a small family trust myself). Ask away as necessary.
* and let's not worry about situations where someone left a Trad IRA to a Trust under Secure2.0, with a named beneficiary of the IRA . That is whole other can of worms!
