I have a friend whose parents have recently set up an irrevocable trust for estate planning purposes. My friend and her sons are the beneficiaries of the trust. Their estate planner is recommending that they transfer two accounts, totaling about $1 million, into the trust. Both of these accounts generate tax-exempt interest (federal & state). My question is: will the trust also receive this income as tax-exempt? Also, what happens when my friend receives a K-1 for distributions from the trsut? Will the income that has to be reported on her tax return also carry through as tax-exempt?

Tax-exempt income earned by the trust is indeed tax-exempt. When your friend receives her K-1 it should identify tax-exempt interest as well as taxable interest, dividends, capital gains etc.