As a trustee - you are in charge for the trust and if the trust has any income - either distributed or not - your should file trust income tax return - form 1041 - http://www.irs.gov/pub/irs-pdf/f1041.pdf
and report distributed income to beneficiaries on schedule K-1 - http://www.irs.gov/pub/irs-pdf/f1041sk1.pdf
according to instructions - http://www.irs.gov/pub/irs-pdf/i1041.pdf page 3
The fiduciary (or one of the joint fiduciaries) must file Form 1041 for a domestic trust taxable under section 641 that has:1. Any taxable income for the tax year,2. Gross income of $600 or more (regardless of taxable income), or3. A beneficiary who is a nonresident alien.
As long as trust's income is distributed - it is taxable on each beneficiary tax return and not taxable on the trust tax return. Medical expenses paid by the trust on behalf of beneficiary deemed distribution. You may report that information in the box 14 with the code H and may add a separate sheet with details.
There will be two option from tax prospective:
Usually individual tax rate is more beneficial, but that depend on other circumstances as well.
on Schedule B, line 10 of Form 1041 you would report distribution that may be deducted from taxable income - as medical expenses are not deductible for the trust - you should not report that amount. You will report only distributed income - that is $300; The same amount will be reported on the K-1. Other distribution was not from income but from trust assets - that are not reported on the trust income tax return nor may reduce tax liability.
But you may report that information in the box 14 with the code H and may add a separate sheet with details - so beneficiary would know the source and type of distribution. for instance - in your situation - medical expenses may be deductible for beneficiary.
Medical expenses paid on behalf of beneficiary deemed distribution - thus the beneficiary received of $1700.
Then - what is the source of that money? - $300 is distributed income and $1400 form trust's assets... Thus $300 will be reported on the schedule K-1 and deducted on the trust income tax return and reported on the beneficiary's income tax return.
Usually individual tax rate is more beneficial than one the trust would pay. However generally - you may treat this income taxable for trust and do not need to issue K-1 for beneficiary. You likely will have more taxes on that income.
I think after you complete all these paperwork - you will be a pro.