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Inclusion of Capital Gains in Distributable Net Income for Trusts and Estates: Allocations for Optimal Tax TreatmentFiduciary Accounting Rules, Treas. Reg. Section 643(a)-3(b) Provisions, State Unitrust Rules, Crummey Powers
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Robert F. Brogan, President, Brogan Law Group, Brick, NJ
Gregory V. Gadarian, Partner, Gadarian & Cacy PLLC, Tucson, AZ
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Strafford
Allocating Capital Gains to Distributable
Net Income in Estates and Trusts:
Achieving Optimal Tax Treatment
Gregory V. Gadarian
2200 East River Road Suite 123
Tucson Arizona 85718
1
What is Income?
A key to understanding the income taxation
of non-grantor trusts and estates is to
understand the difference between:
trust accounting income (“TAI”),
taxable income, and
distributable net income (“DNI”).
2
Conduit Taxation
Taxable income earned by a trust or an estate is
taxable either to the trust, or, to the beneficiaries.
If the trust or estate makes distributions, then the
trust is a allowed a deduction for the distributions
made to the beneficiary and the beneficiary reports
the item as income on his own tax return. See §§
651, 652, 661 and 662.
3
Trust Accounting Income
TAI refers to the amount of income the fiduciary
has available for current distributions to the income
beneficiaries of a trust or estate.
TAI of the estate or trust determined under the
terms of the governing instrument and applicable
local law. §643(b)
Local law--state Principal and Income Act
determines whether a receipt is “income” or
“principal” for trust accounting purposes.
4
Uniform Principal and Income
Act
• The National Conference of Commissioners on Uniform
State Laws (www.uniformlaws.org)
• The Act’s purpose is to provide procedures for trustees
administering trusts and personal representatives
administering estates in allocating assets to principal and
income, and to govern their proper distribution to
beneficiaries, heirs, and devisees.
• UPIA adopted by 41 states
5
Uniform Fiduciary Income and
Principal Act
• 2018 Uniform Fiduciary Income and Principal Act
• UFIPA adopted by Colorado and Kansas
6
Net Income under UPIA
and UFIPA• UPIA. “Net income” means the total receipts allocated to income
during an accounting period minus the disbursements made from
income during the period, plus or minus transfers under the UPIA
to or from income during the period.
• UFIPA. ”Net income” means the total allocations to income
under the UFIPA and the terms of the trust during an accounting
period minus the disbursements, other than distributions, allocated
to income under the UFIPA and the terms of the trust during the
period.
• Net income includes adjustments from principal to income and
excludes adjustments from income to principal under Section 203.
If the trust is a unitrust or has been converted to a unitrust, net
income includes the unitrust amount determined under Article 3.
77
UFIPA
Sec. 203 Fiduciary’s Power To Adjust.
• (a) A fiduciary may adjust between income and principal to
the extent the fiduciary considers the adjustment to be in
the best interest of the beneficiaries.
• No mention of three requirements of UPIA § 104:
• (1) The trustee invests and manages trust assets as a
prudent investor,
• (2) The terms of the trust describe the amount that may
or must be distributed to a beneficiary by referring to the
trust’s income, and
• (3) The trustee determines that he is unable to
administer a trust or estate impartially.
88
UPIA – Receipts from Entities
Section 401. Character of Receipts from Entity
(c) a trustee shall allocate to income moneyreceived from an entity
(d) A trustee shall allocate the following receiptsfrom an entity to principal:
(1) property other than money;
(2) money received in one distribution or aseries of related distributions in exchange for part or all of a trust’s interest in the entity;
(3) money received in total or partialliquidation of the entity
9
UPIA – Receipts from Entities
(cont)Section 401. Character of Receipts from Entity
(d) Money is received in partial liquidation:
1) to the extent that the entity, at or near the timeof a distribution, indicates that it is a distributionin partial liquidation; or
2) if the total amount of money and propertyreceived in a distribution or series of relateddistributions is greater than 20 percent of theentity’s gross assets, as shown by the entity’syear-end financial statements immediatelypreceding the initial receipt.
1010
Computation of Taxable Income of
Non-Grantor Trusts and Estates
General Rule -- § 641(a) imposes an income tax on the income of estates
and trusts.
§641(b) directs that the tax is to be computed in the same manner as that
of an individual with certain exceptions, and that the tax be paid by the
fiduciary.
Gross income less allowable deductions produces the taxable income of
the trust. §642.
Personal exemption (§642(b)(3))
– Estate $600
– Simple trust $300
– Complex trust $300 or $100
11
Simple Trusts and Complex
Trusts
Simple trusts – §§ 651 and 652.
– Income (fiduciary accounting income) is requiredto be distributed currently.
Complex trusts and estates – §§ 661 and 662.
- All fiduciary entities that do not qualify as simpletrusts.
12
Special Rules for Complex and
Simple Trusts
Beneficiary of a simple trust must include in gross
income the amounts of income required to be
distributed currently whether or not the income
was distributed [however, amount is limited by
DNI]
A “65-day" rule applies to a complex trust and the
executor of an estate. - §663(b)(1).
13
DNI
◦ Function
◦ Computation
Taxable Income
Adjustments to Determine DNI
Capital Gains
14
Role of DNI
Limits Beneficiaries' Taxable Income.
◦ Separate share rule
◦ Contrast with Trust Accounting Income
Character Rule.
◦ Character flows through
◦ Pro-rata rule
Limits Trust/Estate's Distribution Deduction.
15
Distribution Deduction
The distribution deduction is limited to thelesser of trust accounting income (§651) orDNI for simple trusts, and the lesser ofdistributions or DNI for complex trusts(§661)
DNI is the maximum amount of taxableincome of the trust that is taxed to abeneficiary of a trust as the result of adistribution to the beneficiary as determinedunder §643(a)
16
Distributable Net Income
Computation of Distributable Net Income
• Taxable income before
– Personal exemption
– Distribution deduction
– Special deductions
• Add back
– Capital losses
– Net tax-exempt income
• Subtract capital gains?
17
Capital Gains
• Are capital gains included in computation of trust
accounting income?
• Are capital gains included in computation of
distributable net income?
1818
Capital Gains Excluded from DNI
Capital gains are generally allocated to principal and
taxed to the estate or trust even if distributed to
the current beneficiary
Compressed tax rate schedule for estates and
trusts
– Short-term capital gains taxed at 37% if taxable
income exceeds $13,050
– Long-term capital gains taxed at 20% if taxable
income exceeds $13,250
– 3.8% surtax under §1411 if taxable income
exceeds $13,050
19
Capital Gains under § 643(a)(3)
Distributable net income. … the term “distributable net
income” means, …the taxable income of the estate or trust
computed with the following modifications
• (3) Capital gains and losses. Gains from the sale or
exchange of capital assets shall be excluded to the extent
that such gains are allocated to corpus and are not (A)
paid, credited, or required to be distributed to any
beneficiary during the taxable year, or (B) paid,
permanently set aside, or to be used for the purposes
specified in section 642(c).
2020
Capital Gains --Treasury
Regulation §1.643(a)-3
Circumstances where capital gains are allocated
to trust accounting income and therefore
included in DNI.
Circumstances where capital gains are allocated
to principal, but are paid, credited, or
required to be distributed to a beneficiary, and
therefore included in DNI.
21
Situations where Capital Gains may
be allocated to income
The regulations specifically acknowledge that
capital gains may be allocated to trust
accounting income under:
◦ (1) a state unitrust statute,
◦ (2) the terms of the governing instrument [and
state law], or
◦ (3) a discretionary power granted to the trustee
under either local law (such as a power to adjust)
or under the governing instrument, provided that
the power is exercised in a reasonable and
impartial manner.
22
Treas. Reg. §§ 1.643(a)-3(b) and
1.643(b)-1
An allocation of capital gains to income
will generally be respected if:
◦ the allocation is made either pursuant to the
terms of the governing instrument and
applicable local law, or
◦ pursuant to a reasonable and impartial
exercise of a discretionary power granted to
the fiduciary by applicable local law or by the
governing instrument, if not prohibited by
applicable local law.
23
Consistency Requirement
Consistency rule does not apply to allocation of
capital gains to income except in the case of a
unitrust.
Consistency rule may apply if capital gains are
allocated to principal per §1.643(a)-3(b)(2), but not
actually distributed to the beneficiary, or utilized by
the fiduciary in determining the amount that is
distributed or required to be distributed to the
beneficiary per §1.643(a)-3(b)(3).
24
Redline comparison proposed and final
regulations inclusion of capital gains in DNI
(b) Capital gains included in distributable net income. Gains from thesale or exchange of capital assets are included in distributable net income to theextent they are, pursuant to the terms of the governing instrument andapplicable local law, or pursuant to a reasonable and consistent impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument, if not inconsistent with prohibited by applicable local law)-
(1) Allocated to income (but if income under the state statute is defined as, orconsists of, a unitrust amount, a discretionary power to allocate gains toincome must also be exercised consistently and the amount so allocated maynot be greater than the excess of the unitrust amount over the amount ofdistributable net income determined without regard to this subparagraph§1.643(a)-3(b));
(2) Allocated to corpus but treated consistently by the fiduciary on the trust'sbooks, records, and tax returns as part of a distribution to a beneficiary; or
(3) Allocated to corpus but actually distributed to the beneficiary or utilized bythe fiduciary in determining the amount whichthat is distributed or requiredto be distributed to a beneficiary.
25
Methods of Including Capital Gains in
DNI when Capital Gains are allocated
to Principal
Capital Gains are allocated to principal, but treated
consistently by the fiduciary on the trust's books,
records, and tax returns as part of a distribution to a
beneficiary.
Capital Gains are allocated to principal but actually
distributed to the beneficiary.
Capital Gains are allocated to principal but utilized by
the fiduciary in determining the amount that is
distributed or required to be distributed to a
beneficiary.26
State Statutes Wyoming Statutes § 2-3-835. Trustee
discretion to include capital gains in income
“(a) To the extent a trustee is given the power to make mandatory or discretionary distributions of income, the trustee may, on an annual basis, include realized capital gains in trust income and in determining section 643(a) of the Internal Revenue Code distributable net income, if the allocation is reasonable and impartial.
“(b) To the extent a trustee is given the power to make mandatory or discretionary distributions of principal, the trustee may, on an annual basis, include realized capital gains in determining Section 643(a) Internal Revenue Code distributable net income, if the allocation is reasonable and impartial.”
27
Sample Trust Language –Trustee
discretion to allocate Capital Gains to
DNI
The Trustee (other than a Trustee who is also a qualifiedbeneficiary, and other than the Grantor) may allocaterealized short term capital gains and/or realized longterm capital gains to either trust income or trustprincipal, and such gains shall be includable indistributable net income,
(1) to the extent that such gains are allocated toincome; or
(2) if such gains are allocated to principal, to the extentthey are distributed to the trust beneficiary, or, used bythe Trustee in determining the amount distributable tothe trust beneficiary, or treated consistently on thetrust's books, records, and tax returns as part of adistribution to the trust beneficiary.
28
Examples in Treas. Reg.§1.643(a)-3
The first 5 examples involve a trust agreement
which provides for mandatory income
distributions and discretionary distributions of
principal.
The Regulations apply the consistency
requirement in Examples 1, 2, 12 and 13.
Examples 11,12 and 13 involve unitrust
payments
29
Example 1
All income is to be paid to A. Trustee has discretionary power to invade principal for A's
benefit and to deem the discretionary distributions to be made from capital gains.
First taxable year, Trust has $5,000 of dividend income and $10,000 of capital gain. Pursuant to
governing instrument and applicable local law, Trustee allocates the $10,000 capital gain to
principal. Trustee distributes $5,000 to A, representing A's right to trust income. In addition,
Trustee distributes to A $12,000, pursuant to the discretionary power to distribute principal.
Trustee does not exercise discretionary power to deem the discretionary distributions of
principal as being paid from capital gains. Therefore, the capital gains realized are not included
in distributable net income and the $10,000 of capital gain is taxed to the trust. In future
years, Trustee must treat all discretionary distributions as not being made from any
realized capital gains.
The Example equates the term “deem” with the distribution being "treated by the
fiduciary on the trust's books, records, and tax returns as part of a distribution to a
beneficiary."
3030
Example 2Same as 1.
Trustee distributes $5,000 to A, representing A's right to trust income. Trustee also
distributes to A $12,000, pursuant to the discretionary power to distribute principal.
The Trustee intends to follow a regular practice of treating discretionary distributions
of principal as being paid first from any net capital gains realized by Trust during the
year. Trustee evidences this treatment by including the $10,000 capital gain in
distributable net income on Trust’s income tax return, so it is taxed to A. This
treatment of the capital gains is a reasonable exercise of Trustee's discretion. In
future years Trustee must treat all discretionary distributions as being made first
from any realized capital gains.
The Example equates the term “deem” with the distribution being "treated
by the fiduciary on the trust's books, records, and tax returns as part of a
distribution to a beneficiary."
3131
Example 4
Same as 1.
Under the terms of Trust, all income is to be paid to A for life.
During Trust's first taxable year, Trust has $5,000 of dividend income and $10,000 of capital gain from the sale of securities.
Pursuant to the terms of the governing instrument (in a provision not prohibited by applicable local law), capital gains realized by Trust are allocated to income. Because the capital gains are allocated to income pursuant to the terms of the governing instrument, the $10,000 capital gain is included in Trust's distributable net income for the taxable year.
Capital gains are allocated to income under the trust agreement. Thus, there is no discretion and no consistency requirement.
3232
Example 11State statute allows trustee may make an election to pay an income beneficiary an amount equal to 4% of the fair market value of the trust assets, in full satisfaction of the beneficiary's right to income.
State statute also has an ordering rule that unitrust amount shall be considered paid first from ordinary and tax-exempt income, then from net short-term capital gain, then from net long-term capital gain, and finally from return of principal.
Trust's governing instrument provides that A is to receive each year income as defined under state statute. Trustee makes the unitrust election under state statute.
At the beginning of the taxable year, Trust assets are valued at $500,000. During the year, Trust receives $5,000 of dividend income and realizes $80,000 of net long-term gain from the sale of capital assets. Trustee distributes to A $20,000 (4% of $500,000) in satisfaction of A's right to income.
Net long-term capital gain in the amount of $15,000 is allocated to income pursuant to the ordering rule of the state statute and is included in distributable net income for the taxable year.
Capital gains are treated as income under state law.
33
Compensatory (Equitable)
Adjustments
Trustee Duty of Impartiality.
Example. An estate is subject to payment of FET may make
a §642(g) election to use estate expenses as an FET
deduction under § 2053 and § 2054, or to use those
expenses (to the extent possible) to reduce estate income
taxes
The unavoidable choice is between reducing taxable income
that will reduce DNI that should reduce the income tax
that income beneficiaries would incur, or reducing FET that
would leave more corpus for the remainder beneficiaries
3434
Compensatory (Equitable)
Adjustments (cont.)
Trustee Duty of Impartiality.
Example. Trustee makes a distribution of cash to the
income beneficiary. Trustee raised the cash by the sale of
stock. Trustee has discretion to treat the capital gain as
part of DNI.
The unavoidable choice is between increasing DNI that
will increase the income tax that the income beneficiary
would incur or excluding the capital gain from DNI that
would cause the income tax burden to be borne by the
remainder beneficiaries.
3535
Computation and Allocation of
Trust Income◦ In General
◦ Tier Rules
◦ Charitable Deduction
◦ Separate Share Rule
◦ Exclusion of Specific Bequests
◦ Distributions in Kind
◦ Trust Termination--Deductions and
Carryovers
36
Tier Rules
The "tier" rules are necessary in the taxationof complex trusts because of the ability toaccumulate income for later distribution.
The term "tier" is not used in the Code orRegulations but refers to the distinctiondrawn in §§661(a)(1) and 661(a)(2),
◦ between amounts of income required to bedistributed currently (first tier), and
◦ other amounts properly paid, credited, orrequired to be distributed (second tier).
37
Tier Rules (cont.)
Under §661(a)(1), first tier distributions arerequired current distributions of income (not toexceed DNI). A required distribution that couldhave been made from corpus (such as an annuitypayment or payment of a family allowance) still isa first tier distribution if it actually is made fromfiduciary accounting income.
Under §661(a)(2), second tier distributions are allothers, whether required or discretionary andwhether made from current fiduciary accountingincome, from prior years’ accumulated income, orfrom corpus.
38
Tier Rules (cont.)
Under the tier rules, DNI is initially allocatedto all first tier required distributions ofcurrent income.
Any excess DNI would be pro rated amongany second tier beneficiaries on the basis oftheir respective second tier distributions.
The amount of any second tier distributionsin excess of any remaining DNI would be atax free distribution of trust corpus.
39
Specific Bequests
Specific Bequests--distributions of assets insatisfaction of specific bequests do not carryout income if the distribution must be madein less than four installments and is notpayable only from income. §663(a)(1).
These distributions have no income taxeffect at all, either to the trust or estate(which is entitled to no distributionsdeduction) or to the recipient.
40
Distributions in Kind
Unless a distribution from a trust or an estate qualifies forthe §663(a)(1) exclusion as a specific bequest, income will becarried out to the recipient.
The amount of income carried out by a distribution ofproperty in kind is limited by §643(e)(2) to the lesser of theproperty's FMV or basis.
§643(e) is applicable on its face only to noncash second tierdistributions (which means that it is limited to discretionarydistributions by complex trusts and estates), §643(e)is notapplicable (because it is not needed) to distributions thatqualify as specific bequests that are excluded from the DNIcarry out rules entirely.
41
Distributions in Kind and
Recipient’s Basis § 643(e)(1) provides that a beneficiary's basis in property
distributed by a trust or estate will be the adjusted basis of such
property in the hands of the trust or estate prior to distribution
adjusted for any gain or loss recognized by the estate or trust upon
distribution.
Generally, a distribution of property in kind does not result in the
recognition of a gain or loss to the trust or estate unless the
distribution is in satisfaction of a pecuniary (fixed-dollar) gift or
bequest. Therefore, where no gain or loss is recognized, the
income tax basis of the property received by the beneficiary would
be the trust's or estate's adjusted basis prior to the distribution.
42
Distributions in Kind and
Recipient’s Basis (cont.) § 643(e)(3) provides that a fiduciary may irrevocably
elect to recognize gain or loss on the distribution, as if
the property distributed had been sold to the
beneficiary at its fair market value on the date of the
distribution.
If such an election is made, the income tax basis of the
property received by the beneficiary would be the
adjusted basis of such property in the hands of the trust
or estate prior to distribution adjusted by the gain or
loss recognized by the trust or estate on the
distribution
43
Separate Share Rule
Substantially independent and separatelyadministered shares of a single trust or of anestate will be treated as separate trusts orestates for DNI allocation. §663(c).
Separate shares are deemed to exist ifbeneficiaries (or a class of beneficiaries) haveidentifiable economic interests that "neitheraffect nor are affected by the economicinterests accruing to another beneficiary orclass of beneficiaries.” Treas. Reg. §1.663(c)-4(a).
44
Separate Share –Special Rules
A specific bequest is a separate share if it fails to qualify for the §663(a)(1) exclusion from the DNI carryout rules because it is payable in more than three installments.
A surviving spouse’s community property interest in an estate are in effect a separate share, entitled to its own income but do not otherwise carryout DNI.
Special rule that IRD that has been received by an estate (as opposed to the right to receive IRD in the future) is allocable only among those separate shares "that could potentially be funded with these amounts ... [with the allocation] based on the relative value of each share that could potentially be funded with such amounts.” Treas. Reg. §1.663(c)-2(b)(3). Thus, an instrument will be respected that apportions IRD among various beneficiaries for income tax purposes.
45
Charitable Deduction
§642(c) allows a deduction for distributions toqualified charities.
§642(c)(1) permits an unlimited income taxdeduction to an estate or trust for amounts ofgross income that are applied under the terms ofthe governing Instrument to a §170(c) qualifiedcharitable purpose during the taxable year.
§642(c)(1) also includes an election to treatdistributions to charity made in one year as ifthey were made in a prior year.
46
Charitable Deduction
§642(c) requires a tracing of amounts distributed and limits
the deduction to amounts actually paid from gross income of
the estate or trust.
The tracing rule is intended to preclude claiming an income
tax deduction for unrealized appreciation in corpus
distributed to charity. But see Green decision where a
§642(c) deduction was allowed for appreciated property
purchased out of gross income based on the property's fair
market value rather that or the property’s adjusted basis.
IRD qualifies for the deduction, but the right to receive IRD
does not.
47
Charitable Deduction
The regulations preclude special allocations of income to charities
unless the allocation has economic effect. Thus the allocation of
taxable income to charity first, followed by capital gains, then tax
exempt income, and finally corpus would be valid only “to the
extent such provision has economic effect independent of income
tax consequences.” Treas. Reg. §§1.642(c)-3(b) and 1.643(a)-5(b).
48
Charitable Deduction – Governing
Instrument Requirement
A distribution to as charity which does not qualifyunder §642(c) will not be eligible for a deduction§661(a)(2) distributions deduction. Thus, if thedistribution fails the governing instrument then itwill not be eligible for the distributions deduction.
A distribution to a charity by a beneficiary’sexercise of a nongeneral inter vivos power ofappointment, has been deemed to satisfy the“pursuant to” requirement even though thegoverning instrument did not specify a charitablebequest – it only authorized exercise of thepower in favor of charity.
49
Charitable Deduction--Sample
Language
The Trustee is authorized to distribute
current gross income to fund bequests or
distributions to charitable organizations.
50
Set Aside Deduction
§642(c)(2) permits a deduction for amounts of gross incomepermanently set aside for a qualified charitable purposepursuant to the terms of a governing instrument for anyestate but only by trusts created before 1969.
Treas. Reg. §1.642(c)-2(d) provides that the deduction willnot be allowed if “under the terms of the governinginstrument and the circumstances of the particular case thepossibility that the amount set aside . . . will not be devotedto [a qualifying] purpose or use is so remote as to benegligible.
In Belmont a §642(c)(2) deduction was denied the taxpayerfailed the § so remote as to be negligible test.
51
Set Aside Deduction
In Sid W. Richardson Foundation, the estate owned stock of an S corporation.
The corporation did not distribute the income to the estate. The estateclaimed a charitable deduction under § 642(c) with respect to the
undistributed income of the S corporation. The deduction was denied since
the amounts in question were not paid or permanently set aside or otherwise
properly designated for charitable purposes.
In PLR 201246003 the IRS ruled that an estate will be allowed a charitablededuction under § 642(c) to the extent an S corporation holding receivable
actually distributes the receivables, and the estate either pays or “sets aside”
those receivables for Foundation.
In Rev. Rul. 2003-123, the IRS restated its position that a trust is notallowed a charitable deduction under § 642(c), nor a distribution deduction
under § 661(a)(2) for a contribution of trust principal to charity. The ruling
involved a qualified conservation easement under §170(h).
52
Trust Termination-Deductions
and Carryovers Ordinarily, deductions allowable to a trust or
an estate only benefit income beneficiariesindirectly, by reducing taxable income and,correspondingly, DNI.
Deductions that exceed taxable income,however, do not pass out to the beneficiariesand are wasted unless they constitute a§172(a) net operating loss or a §1212(b)(1)capital loss carryover to the entity's next taxyear.
53
Trust Termination-Deductions
and Carryovers (cont.) §642(h) provides that excess deductions in
the year of termination of a trust or estatepass through to the beneficiaries.
For example, a termination fee or stateincome taxes or property paid in the finalyear with respect to capital gain, along withany net operating loss or capital losscarryover not previously used by the entity,all pass out as if the entity had not existedfor that final year.
54
Inclusion of Capital Gains in Distributable Net Income for Trusts and Estates: Allocation for
Optimal Tax Treatment
Robert F. Brogan, LL.M. in Taxation Certified Elder Law Attorney*74 Brick Blvd.Bldg. 2, Suite 203Brick, NJ 08742
732-701-9999WWW.BROGANELDERLAW.COM
*Certified as an Elder Law Attorney by the ABAAccredited National Elder Law Foundation
Understanding the taxation of trusts is one of
the more complicated endeavors under the
Internal Revenue Code.
Subchapter J is the Section of the Code which
governs trusts
What’s the Job of the Trustee?
• Subject to each state’s prudent investor rules, the trustee will:
• 1) invest the assets, factoring the potential impact of those investments in
terms of total return on the initial and remainder beneficiaries;
• 2) allocate the income earned by the trust each year;
• 3) make (or not make) distributions as guided by the trust terms;
• 4) allocate between the appropriate parties the taxes on the income the assets
earn each year; and, lastly, if appropriate,
• 5) submit to the IRS a timely filed 1041 fiduciary income tax return on behalf
of the taxable entity, the trust.
Want Answers? Then You’ve Got To Ask Questions!
• Several variables impact the tax allocation, so to do proper drafting,reporting, or utilization of a trust you must ASK QUESTIONS
• 1) What type of trust has been or should be drafted?
• 2) What are or should be its terms?
• 3) Who is or should be the grantor?
• 4) What indicia of ownership and control should or did the grantorretain or was given in the original trust or a subsequent amendment?
• 5) Who’s the Trustee?
• 6) What relationship, if any, does the Trustee have with the Grantor?
Asking Questions (The Dirty Dozen Continued)
7) Who are the beneficiaries?
8) Did they or should the get distributions…and when?
9) Did the trustee have discretion to not make distributions?
10) If any were made, when where those distributions made?
11) What was the character of the income earned (i.e., ordinary
income versus capital gains)?
12) Are there provisions in the trust governing a trustee’s
discretionary treatment of capital gains as income rather
than additions to corpus for DNI purposes?
WHY THESE QUESTIONS ARE SO KEY
•Without All of These Questions Answered…
•How Would You Know How to Plan or Interpret?
•How Can You Properly Advise the Parties as to Their RelativeDuties and Rights?
•How Would You Fathom Who Pays What Tax?
•How Do You Know the Trust Is Doing What It Was DesignedTo Do?
• Income Tax 26 USC 1
• Capital Gains Taxes26 USC 1231
• Basis Adjustment under 26 USC 1014 & 1015 (Step-up or Step-down
on property acquired from a decedent or from a trust created by a
decedent during life ) and
Retained interests 26 USC 2036 through 2039
State Laws and Jurisdiction Issues
• Nexus
• Purposeful Availment & Minimum Contacts: Hansen & Kaestner
• Situs Shopping for Tax-Friendly States may be key.
• Automatic Principal & Income allocations under state law defaults
should be addressed and reviewed.
• Decanting may prove helpful if your state tax laws are
unfavorable.
INCOME TAXATION OF TRUSTS• Taxable v. Accounting Income
• Taxable Income
• As a general rule §641(a) imposes an income tax on the income of estates and
trusts. §641(b) provides that income computed in the same manner as an individual
with certain exceptions, and the tax is paid by the fiduciary.
• Simple trusts –§§651 and 652 (no discretion as to income distributions)
• The maximum amount of taxable income of the trust that is taxed to a beneficiary
of a simple trust as the result of a required distribution to the beneficiary is the lesser
of trust accounting income, or DNI.
• Complex trusts and estates –§§661 and 662 (Trustee has discretion to withhold)
• Pay particularly close attention to 662(b) relating to the Character
Trust Accounting Income is different than taxable income
• TAI is the amount the fiduciary has available for current
distributions to the income beneficiaries of a trust or estate.
• It is determined under the terms of the governing
instrument and applicable local law (the trust or estate’s situs)
• Note: TIA is also referred to as fiduciary accounting income, sodon’t get confused as either phrase may be used interchangeably
Distributable Net Income: How Its Calculated & Who Reports It: The Trust or its Beneficiaries.
• Think of DNI as a ceiling, i.e., the maximum amount earned which could have
been distributed to the named beneficiaries in any given tax year. Note that I did
NOT say was distributed to the beneficiaries.
• 26 U.S. Code § 643
• Treas. Reg. §§1.643(a) and (b)
• If capital gains has not been allocated by the trust terms to income, then
the trust would also be obligated to pay that tax at a 20% rate.
Tier Rules
• First Tier: Required current distributions of income.
• Second Tier: All other distributions.
• DNI is initially allocated to all first tier required distributions of current income.
• Excess DNI is allocated pro rata among second tier beneficiaries on the basis of
their respective second tier distributions.
• Second tier distributions in excess of DNI are a tax-free distribution of trust
corpus.
• Distributions to charity are treated like an intermediate tier.
Trust Deductions
The primary deduction that we think of for trust income tax reporting
is the deduction under 26 U.S. Code § 643 (a)(1) for distributions to the
beneficiaries. When the income is distributed to the beneficiaries, the trust
takes a deduction on the 1041 return (and thus does not pay income tax on
those funds). The trust issues a K-1 to the beneficiary, who then reports such
distributed income on her personal 1040 return. Thus, the trust effectively
becomes a pass-through entity as to that income.
Trustee Powers Used to Control Tax Capital Gains Tax Burdens
Treas. Reg. §§1.643(a) and (b)
Whether the capital gains tax can fall within DNI and thus
be paid at the beneficiary’s personal rate, (that is more often than not)
presumably lower than the trust’s default rate.
Understand the potential pitfall that you need a Pattern…
What did the Trustee do in Year One will dictate much?
Grantor Trusts DO NOT Generate DNI
Question: Why not?
Answer: Because ALL income is attributable to the Grantor regardless
of character or whether or not there has been distribution
I respectfully suggest that you remember this one as it will help you
answer all those calls you get during Tax-Time from CPA’s trying to treat a
grantor trust as a non-grantor trust simply because it is irrevocable.
$$ Practice Pointer: Be kind and patient with them, as they have no way to know in advance what you as scrivener were building. If anything, educating them on the differences, if they happen to be unfamiliar with the structure, will almost ensure that you have won over a new referral source.
Reporting Income and Trustees Duties to Provide Information with Grantor Trusts
• Two Alternatives that lead to the same result
• After the Trustee provides sufficient information to the grantor so thatthe grantor can determine the total income that had been received by thetrust, but is attributable to the grantor, then grantor reports all of thatincome on her personal 1040.
• The Info typically includes the following:(1) all items of income; (2)identifies the payor of each item of income; (3) a statement telling theowner of the income that it is his or hers; and (4) any other necessaryinformation needed for the owner to complete his or her tax filing.
• Trust can issue a 1099 to provide part of that info or alternatively a K-1
Trust Provisions Review
• Knowing if It’s Irrevocable or Revocable Isn’t Enough
• Power to Revoke
• Power to Allocate Beneficial Enjoyment
• Discretionary Power in the Trustee
• E.G., income allocation of Capital Gains for DNI purposes
• Powers of Appointment
Section 199A: 20% Deductions for
Pass-Through Entities Includes Trusts
• Keep in mind that Section 199A sunsets on January 1, 2026 and further keep abreast
of the political climate, as this deduction for business owners (which also happens to
be permissible for trusts) has been the subject of negative attention by some politicians
running for election in 2020.
• Each separate trust gets to claim its own deduction
• Note however, that with the recent release of the final Regulations for 199A, the
Service has “sent a shot across the bow” suggesting that if it believes that even a single
trust were created solely to take an abusive use of the deduction, that the deduction
may end up getting disallowed…anticipate that litigation is likely on this issue.
• Use even a greater degree of caution if a new trust is created that would be perceivedto be an attempt to be a work-around of the SALT $10K limitation.
• Don’t forget your standard deductions under 26 U.S. Code § 642 (It’s only a few
hundred bucks, but why give them a penny more than you have to?)
• A practice pointer on the 1041 returns: let the deductions go on the
1041, not the 706 for an estate below the federal thresholds.
• This way, you may actually have some tax to offset, assuming you are among the99.98% who are less than $11.4M.
Additional Deduction Thoughts
Elections• One election that you may see exercised by a trustee has to do with the trust paying
estimated taxes. The election appears at §643(g) which provides in pertinent part:
• (g) Certain payments of estimated tax treated as paid by beneficiary
• (1) In general In the case of a trust—
• (A) the trustee may elect to treat any portion of a payment of estimated tax made bysuch trust for any taxable year of the trust as a payment made by a beneficiary of suchtrust,
• (B) any amount so treated shall be treated as paid or credited to the beneficiary on thelast day of such taxable year, and
• (C) for purposes of subtitle F, the amount so treated—
• (i) shall not be treated as a payment of estimated tax made by the trust, but
• (ii) shall be treated as a payment of estimated tax made by such beneficiary on January15 following the taxable year.
Straggler Issues
• Do not forget that trusts are still subject to the Medicare surcharge tax,
such that once it earns more than $12,750 of taxable income, there is another
3.8% tax imposed and due
• Congress had thought that they would repeal this. Yet, just like personal
AMT, it would have cost too much to repeal it, so it remains in place and is
not likely to be repealed any time soon.
• In addition, all the federal taxes we’ve discussed, anticipate that state incometaxes factor too, depending on the jurisdictional issues addressed in the materials.
What’s the Compressed Rate Come To?
• The tax rate schedule for estates and trusts in 2019 is as follows:
If taxable income is: The tax is:
Less than $2,600 10% of taxable income
Over $2,600 but not over $9,300 $260 plus 24% of the excess over $2,600
Over $9,300 but not over $12,750 $1,868 plus 35% of the excess over $9,300
Over $12,750 $3,075.50 plus 37% of the excess over $12,750
Inclusion of Capital Gains in Distributable Net Income for Trusts and Estates:
Allocation for Optimal Tax Treatment
Robert F. Brogan, LL.M. in Taxation Certified Elder Law Attorney*74 Brick Blvd.Bldg. 2, Suite 203Brick, NJ 08742
732-701-9999WWW.BROGANELDERLAW.COM
*Certified as an Elder Law Attorney by the ABAAccredited National Elder Law Foundation
