Have a Finance Question? Ask a Financial Expert Online.
If the trust has a net capital gain, then how it is treated depends upon whether net capital gain is allocable to income or principal under the terms of the trust agreement or state law. Generally it is better for the capital gain to be allocated to beneficiaries, because individual tax rates are less than estate tax rates.
If the gain is not allocable to income, then it is allocated to principal of the trust. As such, you will need to file Form 1041, U.S. INcome Tax Return for Estates and Trusts, and Schedule D for Form 1041 to figure the tax. The capital gain is not tax free, it is taxable to the trust.
Trusts can be very complex, and have all types of rules and specifications that must be considered before making a general statement regarding whether or not such income is taxable and to whom. For example, there are rules on accumulated distributions, capital gain set aside to corpus for charities where a deduction is allowed, etc. These types of sophisticated arrangements are beyond my scope and I do not know the particulars of your trust.
However, in general, capital gains allocated to the corpus (or body, principal) of the trust are taxable not to the beneficiary, but to the trust. I am not sure why the trustees are telling you that the capital gain is never taxed, unless there is some sort of tax deferral strategy in use that is spelled out within the trust.
Here is a page from the IRS regulations on taxation of undistributed capital gain, and there is an example which shows that capital gain retained by corpus is taxable to the trust:
Here is the actual Code and section which discusses the options of allocating capital gain to either corpus or income, and the implications. There are multiple examples, and example 1 shows capital gain retained by the trust is taxable to the trust:
Again, these are the general rules of the trust. I would find an enrolled agent or CPA in your area who specializes in trust taxation, (or speak to the person who actually prepares the trust return and K-1's) and can look at the trust document, so that he or she can give you more specific advise about your particular trust and how the income/gains are taxed.
I hope this helps!