My sister took a distribution from our trust. I did not. Can we keep the income in the trust and report the distribution as a principal reduction?

This is actually a question for you legal counsel, although it certainly has tax implications.

First, you must seek an answer in your governing instrument. A well-drafted trust document will have addressed this question in advance.

Second, trust distributions generally are subject to the provisions of the Principal and Income Act of the state where the trust was formed.