Embed Size (px)
Citation preview
The audio portion of the conference may be accessed via the telephone or by using your computer's
speakers. Please refer to the instructions emailed to registrants for additional information. If you
have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.
NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no
longer permitted.
Mastering Fiduciary Accounting Income
for Estate Planners and AdministratorsInterpreting Operating Documents, Applying UPIA & State Law,
Designing Distribution Strategies, Avoiding Beneficiary Challenges
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, JANUARY 23, 2019
Presenting a live 90-minute webinar with interactive Q&A
Ellen M. Deeter, Of Counsel, Dale & Eke, Indianapolis
Michael D. Humphrey, Counsel, Vishnick McGovern Milizio, New York
Tips for Optimal Quality
Sound Quality
If you are listening via your computer speakers, please note that the quality
of your sound will vary depending on the speed and quality of your internet connection.
If the sound quality is not satisfactory, you may listen via the phone: dial
1-866-961-9091 and enter your PIN when prompted. Otherwise, please
send us a chat or e-mail [email protected] immediately so we can address the
problem.
If you dialed in and have any difficulties during the call, press *0 for assistance.
NOTE: If you are seeking CPE credit, you must listen via your computer — phone
listening is no longer permitted.
Viewing Quality
To maximize your screen, press the F11 key on your keyboard. To exit full screen,
press the F11 key again.
FOR LIVE EVENT ONLY
Continuing Education Credits
In order for us to process your continuing education credit, you must confirm your
participation in this webinar by completing and submitting the Attendance
Affirmation/Evaluation after the webinar.
A link to the Attendance Affirmation/Evaluation will be in the thank you email that you
will receive immediately following the program.
For CPE credits, attendees must participate until the end of the Q&A session and
respond to five prompts during the program plus a single verification code. In addition,
you must confirm your participation by completing and submitting an Attendance
Affirmation/Evaluation after the webinar.
For additional information about continuing education, call us at 1-800-926-7926 ext. 2.
FOR LIVE EVENT ONLY
Program Materials
If you have not printed the conference materials for this program, please
complete the following steps:
• Click on the ^ symbol next to “Conference Materials” in the middle of the left-
hand column on your screen.
• Click on the tab labeled “Handouts” that appears, and there you will see a
PDF of the slides for today's program.
• Double click on the PDF and a separate page will open.
• Print the slides by clicking on the printer icon.
FOR LIVE EVENT ONLY
Strafford CLE
January 23, 2019
Mastering Fiduciary Accounting
Income for Estate Planners and
Administrators
Ellen M. Deeter
Of Counsel
Dale & Eke, P.C.
Indianapolis, IN
c. 2018
Michael D. Humphrey
Counsel
Vishnick McGovern Milizio
Long Island, NY
c. 2018
GENERAL TOPICS COVERED
I. Specific challenges in allocating income and expenses to FAI
II. UPIA factors in calculating FIA
III. Impact of FAI on estate and trust distributions
IV. Tax considerations of FIA and DNI
V. Planning considerations and trap avoidance
6
What is Fiduciary Accounting Income?
Generally, fiduciary accounting income (often called trust
or estate accounting income or simply “net income”) is the
amount of money the fiduciary calculates to be on-hand
and available to currently distribute to the income
beneficiaries of a trust or an estate.
7
FIA Basics
FIA is calculated by the fiduciary based on the terms of the
governing instrument and the local laws of the trust’s and/or
estate’s situs.
For purposes of this presentation, local law is the Uniform
Principal and Income Act (UPIA).
To the extent the governing instrument is silent as to the
allocation of receipts and allocation of disbursements to
principal or income, the UPIA determines such allocations.
8
Situs and State Law
Generally, the applicable local laws governing the trust or estate
is determined by the their situs.
Situs and “choice of law” are usually specifically set forth in
the governing instruments.
In those rare instances where the governing instruments are
silent as to situs or “choice of law,” the domicile of the
grantor or testator will usually be the default.
9
I. Specific Challenges in Allocating
Income and Expenses to FIA
10
The Parties
To fiduciary accountants, there are only two kinds of people in
the world: (1) those who are interested in income and (2) those
interested in principal.
Income beneficiaries are those beneficiaries who are
currently entitled to receive distributions of FIA.
Principal beneficiaries are those beneficiaries who are
currently entitled to receive distributions (usually
discretionary) of trust or estate property that is not income
and/or some future portion of the trust or estate when the
income interest ends.
11
Source of Conflict
Generally, the interests of the income beneficiaries are
diametrically opposed to those of the principal beneficiaries.
Allocation of trust and estate assets to generate income
generally limits the potential capital appreciation of such
allocated assets.
Allocation of trust and estate assets for capital appreciation
generally limits the amount of income generated from such
allocated assets.
12
Potential For Litigation
The opposing interests of the income and principal
beneficiaries can easily spark litigation, especially when
beneficiaries seek to settle old scores and release repressed
family animus.
Fiduciaries can easily become the scapegoat and can draw the
ire of the income beneficiaries, the principal beneficiaries, or
worse, both beneficiary classes, by failing to follow the rules
of the governing instrument or local law in calculating FAI.
13
Reduce Litigation Risk
Fiduciaries should be mindful of the
inherent conflict between beneficiary
classes.
Timeliness
Consistency
Transparency
Impartiality
Thoroughness
14
Fairness
The allocation of receipts and disbursements pursuant to the
UPIA may often produce results that may seem “unfair” to one
or more beneficiaries.
Fiduciaries have a duty to evaluate these results regularly to
determine if the trust or estate is generating appropriate
distributable amounts.
Low interest environments create significant challenges for
fiduciaries to generate “sufficient” FAI.
The unitrust provisions of the UPIA is a good benchmark and
may be an appropriate alternative.
15
Power to Adjust
UPIA Section 203 gives the fiduciary the power (expressly
stating that it’s not a duty) to adjust between income and
principal to assist the fiduciary to administer the trust or estate
impartially.
Requires that the fiduciary is managing investments pursuant
to the prudent investor rule.
Requires the instrument to define “income” rights.
Requires the fiduciary to determine that without exercising
the power, the status quo is unfair and not reasonable.
16
Power to Adjust (Cont.)
The fiduciary’s determination to exercise or refrain from
exercising the power to adjust creates an opportunity for
litigation.
Fiduciaries will be well-served to maintain detailed records
concerning their analysis and their decisions to adjust or not.
17
II. UPIA Factors in Calculating
FAI
19
Allocation of Receipts
If the instrument is silent as to the allocation of receipts, the UPIA
provides:
That receipts of money and tangible personal property
(of nominal value) from an entity, is to be allocated to
income; and
That receipts of property that is not money nor tangible
personal property (of nominal value) from an entity, is to
be allocated to principal.
20
Principal “Money” Exceptions
Money received from an entity in exchange for all or part of the fiduciary’s interest in such entity;
Money received from an entity that the fiduciary determines or estimates to be a distribution of capital;
Money received from a mutual fund or REIT if the money received is treated as or comparable to a capital gain distribution for income tax purposes; and
Distributions from deferred accounts such as IRAs and annuities.
21
Brokerage Accounts
Most receipts from assets held within a brokerage accounts
should be allocated properly without too much
consternation.
Ordinary interest, tax-exempt interest, ordinary
dividends, and qualified dividends are all allocated to
income.
Short and long-term capital gain distributions, short and
long-term capital gains realized on sale, cash from
“tendered” securities, and cash from spin-offs and
exchanges is allocated to principal.
22
Brokerage Accounts (cont.)
Special provisions for bonds and other debt instruments:
No adjustment to interest received for amortization.
For bonds with a stated interest rate, the amount received from
the sale or redemption is allocated to principal.
For bonds without a stated interest rate, the amount received from
the sale or redemption thereof in excess of the consideration paid
is allocated to income.
23
Example #1 – Brokerage TransactionsThe monthly brokerage account statement shows the following transactions:
1) 100% of Corporation A were “tendered” and the account was credited with $10,000;
2) 100 shares of Corporation B paid a dividend of $100;
3) The $100 dividend from Corporation B was reinvested for 1 additional share of Corporation B;
4) $100,000 par Springfield Municipal Bond 5%, with an inventory value of $105,000 matured. Final interest payment of $2,500 was
received.
Allocations to Income:
$100 dividend (Fiduciary can hold the 1 reinvested share as income or can make a transfer from principal cash to “buy” the share
from income)
$2,500 interest payment from Springfield Municipal Bond
Allocations to Principal:
$10,000 from “tender” of Corporation A shares and a gain or loss is recognized.
$100,000 from maturity of Springfield Municipal Bond, which results in a realized loss of $5,000.
24
Example #2 – Accrued IncomeGrantor of revocable trust died on April 1. The trust provides upon the death of Grantor, income to A for life, remainder to B. The
Estate tax return sets for the following from the trust’s brokerage account:
Cash on deposit $1,000,000.00
Accrued interest $ 100.00
Bond A $200,000 5% due 3/15/2020 $ 201,000.00
Accrued interest $ 410.00
Bond B $200,000 5% due 4/15/2020 $ 201,000.00
Accrued interest $ 4,590.00
100 shares XYZ Corp $ 100,000.00
Dividend: ex. date 3/15 payable 4/15 $ 200.00
100 shares ABC Corp $ 150,000.00
Dividend: ex. date 3/15 payable 3/31 $ 200.00
25
Example #2 – Accrued IncomeFor purposes of the fiduciary’s accounting, the following allocations are made:
Cash on deposit $1,000,000.00 Principal
Accrued interest $ 100.00 Income – regularly paid interest with no due date
Bond A $200,000 5% due 3/15/2020 $ 201,000.00 Principal
Accrued interest $ 410.00 Income – due date after DOD (next payment 9/15)
Bond B $200,000 5% due 4/15/2020 $ 201,000.00 Principal
Accrued interest $ 4,590.00 Income – due date after DOD (next payment 4/15)
100 shares XYZ Corp $ 100,000.00 Principal
Dividend: ex. date 3/15 payable 4/15 $ 200.00 Income – due date after DOD
100 shares ABC Corp $ 150,000.00 Principal
Dividend: ex. date 3/15 payable 3/31 $ 200.00 Principal – due date before DOD
26
Receipts From Business Interests
Cash receipts from entities are allocated to income unless such
distribution is due to some liquidation event.
Cash receipts from entities due to a liquidation event are allocated
to principal.
If the amount received is more than 20% of the FMV of the
fiduciary’s interest in the entity, the distribution may be deemed a
liquidation.
Fiduciary may make a determination of the proper allocation
between income and principal based on the facts and
circumstances.
27
Example #3 – Character Swapping
Grantor established a revocable trust and funded the trust by
transferring 100% of Grantor’s interest in “Mutual Fund, LLC.”
Mutual Fund, LLC’s assets consist of a well-balanced portfolio of
mutual funds that, on average, enjoys an overall rate of return of
10% annually, of which, 5% is capital gain distributions and 5% is
unrealized capital appreciation. Upon Grantor’s death, income to A
for life, remainder to B.
If the LLC distributes the capital gain distributions to the trust,
such distributions are allocated to income because they are
distributions from an entity.
28
Receipts from IRAs, Annuities, and
Deferred Compensation Plans
If the fiduciary can determine the “internal income” of
the payor account, such amount is allocated to income
and the balance of the receipt is allocated to principal.
Prior to 2008, if the fiduciary could not determine the
“internal income” of the payor account, the default split
for mandatory distributions WAS 10% income 90%
principal and elective distributions WERE 100%
allocated to principal.
29
IRAs, Annuities, and Deferred
Compensation Plans (Cont.)
2008 amendment to UPIA addressed IRS concerns about trusts
owning deferred accounts qualifying for the marital deduction for
estate tax purposes. Now, UPIA Section 409 allocates
distributions from deferred accounts as follows:
An amount equal to some percentage between 3% and 5%
of the total value of the deferred account is allocated to income, the
balance to principal.
30
Example #4 – Deferred Accounts
Trust is the sole beneficiary of an annuity with a FMV of
$1,000,000 as of 12/31 of the preceding year. The annuity
statements merely provide the gross value of the annuity
quarterly. In the current year, the trust received distributions
from the annuity totaling $100,000.00.
An amount between $3,000 and $5,000 is allocated to
income.
An amount between $95,000 and $97,000 is allocated to
principal.
31
Receipts From Real Estate
Provided the fiduciary does not account for the
management of the property as a business:
Rents are allocated to income
Amounts received for cancelling and/or renewing a
lease is allocated to income
Security deposits are allocated to principal and held
pursuant to the terms of the lease. It cannot be allocated
to income until the obligations under the lease are fully
satisfied.
32
Receipts From Intellectual Property
If the value of the asset producing the receipt is known, then
an amount between 3% and 5% of the value of the asset is
allocated to income, the balance to principal.
If the value of the asset producing the receipt is not known,
then 10% of the receipt is allocated to income and the
balance, to principal.
33
Disbursements Allocated to Income
One-half (1/2) fiduciary commissions, investment advisory fees, account custody fees, and other services to the fiduciary
One-half (1/2) judicial or non-judicial accounting proceeding or other matter that involves income and successive interests
Some portion of the “other half ” of the above expenses an independent fiduciary deems appropriate and in the best interest of the beneficiaries to charge to income
34
Disbursements Allocated to Income (Cont.)
Ordinary expenses incurred in connection with the
administration, management, or preservation of property
and distribution of income, including interest, ordinary
repairs, regularly recurring taxes assessed against principal,
and an expense of an accounting, judicial or non-judicial
proceeding, or other matter that involves primarily an
income interest
Insurance premiums covering the loss of a principal asset or
income from or use of the asset.
35
Disbursements From Principal
Intuitively, principal would be charged for every disbursement not
charged to income
UPIA Section 502 set forth all of the particular charges to
principal, including:
Fiduciary commissions calculated on principal value
Expenses of sale
Payment of a trust debt
Estate and/or inheritance taxes
Environmental expenses
The income obligations of encumbered principal assets
36
III. Impact of FAI on Trust
Distributions
37
Simple Trusts (Income Only)
For simple trusts, the income beneficiary is entitled to
receive FAI only.
Fiduciary has a duty to analyze performance of trust
asset allocation and determine if the FAI is an
appropriate distributable amount.
Consider power to adjust.
Unitrust amount may be a good litmus test.
38
Discretionary Distributions
Discretionary Income – part of the fiduciary’s analysis in
determining the appropriate distributable amount should
include consideration of the tax brackets of both the
beneficiary and trust or estate and should take advantage
of the spread.
May create an opportunity for the fiduciary to make tax-
advantaged in-kind distributions of appreciated assets.
39
“Phantom” Income
If the trust or estate owns interests in entities that issue
Forms K-1, be aware of “phantom” income.
Forms K-1 may show taxable income that exceed actual
amounts distributed.
This discrepancy may unreasonably increase beneficiary
expectations and cause significant income taxes on the
trust and/or estate level.
Additional income taxes will further reduce FAI.
40
Allocation of Income Taxes
Income taxes paid by the fiduciary for receipts allocated to
income are charged to income. Thus, FAI is reduced to such
extent.
Generally, the trust or estate receives a deduction for
amounts of income distributed. This may create a circular
calculation.
UPIA Section 507 provides an additional power to adjust
between income and principal due to burdens and benefits of
certain tax elections.
41
Contact Information
Michael D. Humphrey, Esq.
Vishnick McGovern Milizio LLP
3000 Marcus Avenue
Suite 1E9
Lake Success, NY 11042
(516)437-4385
42
IV. TAX CONSIDERATIONS
“Fiduciary accounting income” (also called “net accounting
income” or “net income” ) is a trust accounting concept.
“Taxable income” is a tax concept.
“Distributable net income” is a tax concept.
“Distribution deduction” is a tax concept.
These four concepts are not the same.
As discussed previously, net accounting income has to do with the
allocation of receipts and disbursements between the income and
principal “buckets” of a trust, based upon the terms of the trust
document, the exercise of Trustee discretion, and applicable state law.
44
Taxation of Trusts as Separate
Taxable Entities
The taxation of trusts and estates is governed by IRC
§§641-691 and Regulations 1.641(a)-0 to 1.691.
IRC §641(b) provides that the taxable income of a trust
or estate is to be computed in the same manner as an
individual.
Reg. 1.641(a)-2 provides that gross income of a trust or
estate is determined in the same manner as an individual.
45
The Trust/Estate as a Conduit
A trust has a dual nature as both a taxpayer and as a
conduit of income.
The general rule is that income retained by a trust is
taxed to the trust and the income that is distributed to
the beneficiaries is taxed to the beneficiaries on their
personal returns.
46
The Distribution Deduction
IRC Sections 651(a) and 661(a) permit a trust to deduct
amounts paid, credited, or required to be distributed to
beneficiaries in computing the trust or estate’s taxable
income.
IRC Sections 652(a) and 662(a) require the income
beneficiary to include in his or her gross income any
amounts for which a deduction was permitted under
IRC Sections 651(a) and 661(a), respectively.
47
Simple Trust versus Complex Trust
A simple trust is one which is required to distribute all
its net income currently, does not make any principal
distributions, and does not provide that any amounts are
to be paid, permanently set aside, or used for charitable
purposes. Reg. 1.6519(a)-1
48
Simple versus Complex
A trust might be a simple trust in one tax year and a
complex trust is another tax year.
Example: Trust document states that income is to be
accumulated and added to principal while the beneficiary
is under the age of 21. At 21 all current net income is to
be distributed to the beneficiary. The trust starts as a
complex trust and later becomes a simple trust.
49
The Distribution Deduction
The distribution deduction determines:
How much of a deduction the estate or trust receives.
How much taxable income the beneficiary must report
on his or her personal return.
The character of the income that the beneficiary must
report.
The distribution deduction cannot exceed the trust’s
distributable net income (“DNI”). However, the
distribution deduction may end up being less than DNI.
50
Distribution Deduction
If for some reason the income which is required to be
distributed currently is not distributed, the trust will still
take the distribution deduction and the beneficiary will
still report it in his income.
Practice tip: Review the statement of transactions for
the trust. If the trust document states that “all net
income shall be distributed” and you don’t see any
disbursements, there is a problem.
51
Distributable Net Income
DNI is defined in IRC §643(e) as the taxable income of the trust
with the following modifications:
No deduction is allowed for distributions.
No personal exemption is allowed.
Capital gains are excluded to the extent allocated to corpus and
not paid, credited, or required to be distributed to any
beneficiary, or paid or permanently set aside for charity.
Capital losses are excluded except to the extent they enter into
a determination of capital gains paid, credited or required to be
distributed to a beneficiary.
Net tax-exempt interest is included.
52
Taxable Income versus Net Accounting
Income
As noted previously, there is a difference between net
accounting income and taxable income.
Whether a receipt or disbursement is allocated to
income or principal is governed by the trust agreement,
the exercise of the trustee’s discretion, and the governing
state’s principal and income act.
Whether a receipt is taxable is governed by the Internal
Revenue Code.
53
Net Accounting Income (or FAI)
When a trust is invested in stocks and bonds, net income
is typically (barring a different definition in the trust
document) dividends and interest less ½ the trustee’s
fee.
However, for computing taxable income, 100% of the
trustee’s fee is deductible against gross income, even if
paid from principal.
54
Distributable Net Income versus Net
Accounting Income
As a result, DNI is frequently less than the trust’s net
income, and the distribution deduction will be limited to
DNI.
As a practical matter, this is one of the reasons that a
beneficiary needs to wait for his or her Schedule K-1
from the trust before filing his/her 1040.
If the beneficiary simply includes the total amount of
distributions received he most likely will be over-
reporting his income.
55
Net Accounting Income v. DNI v.
Distribution Deduction – Example #1
Total Dividends $4000
Total Taxable Interest $2000
Total Fees Paid $ 400
Distribution to Beneficiary $5800
Net Accounting Income $5800
Distributable Net Income $5600
Distribution Deduction $5600
56
Example #1 – How was net accounting
income calculated?
Dividends $4000
Interest $2000
Less ½ Trustee Fee $ 200
Net Accounting Income $5800
57
Example #1 – How was DNI
calculated?
Taxable income of the trust, but no deduction for
distributions and no personal exemption allowed:
Dividends $4000
Interest $2000
Less Trustee Fee $ 400
DNI $5600
Distribution Deduction $5600
58
Example #2 – DNI and DD w/ Tax-
exempt income
Same facts as before, only the interest is tax-exempt
Total Dividends $4000
Total T/E Interest $2000
Total Fees Paid $ 400
Net Accounting Income $5800
Distributable Net Income $5600
Distribution Deduction $3733
59
Example #2 – Net accounting income
How was “net accounting income” calculated?
Dividends $4000
Tax Exempt Interest $2000
Total Income $6000
Less ½ Trustee Fee $ 200
Net Accounting Income $5800*
*Note this is the same amount as in Example #1. The
amount has not changed, but the character of income
has.
60
Example #2 - DNI
How was DNI calculated?
Start with taxable income of the trust (without
distribution deduction or personal exemption)
Dividends $4000
Less Trustee Fee $ 267 *
Taxable Income $3733
*The trustee fee has to be allocated between taxable and
tax-exempt income. $400 x 4000/6000 = $267
61
Example #2 – Distribution Deduction
Taxable Income $3733
Plus net tax exempt interest $1867 *
Distributable Net Income $5600
Less net tax exempt interest adj $1867 **
Distribution Deduction $3733
* Net tax exempt income calculation: $2000 minus pro-rata share of fee= $2000 – ($400 x $2000/$6000) = $2000 - $133 = $1867
** The estate or trust is not allowed a deduction for any item of the DNI that is not included in the gross income of the trust or estate.
62
Form 1041 for Example #2
63
Impact of the Tax Cuts and Jobs Act of
2017 (“TCJA”)
There are a number of changes made by TCJA that affect the
taxation of trusts and estates, including:
The elimination of a deduction for investment advisory fees,
and
The limitation on the amount that can be deducted for state and
local taxes (“SALT” to $10,000.
As a result, there may now be situations where net income
and the distribution deduction are less than DNI, with the
result of income being taxed to the trust.
64
Impact of TCJA on FAI, DNI, and DD
Trust has the following income and expenses:
Dividends $50,000
Trustee Fee $10,000
Investment Fee $10,000
State Income Tax $20,000 (allocated to income
under T/A)
65
Impact of TCJA on FAI, DNI, and DD
Trust accounting income is determined as follows:
Dividends $50,000
Less ½ Trustee Fee ( 5,000)
Less ½ Investment Fee ( 5,000)
Less State Income Taxes ( 20,000)
Net Income $20,000
66
Impact of TCJA on FAI, DNI, and DD
DNI is the taxable income of the trust, but with no deduction
for distributions or personal exemption allowed:
Dividends $50,000
Less Trustee Fee (10,000)
Less State Income Tax (10,000) *
DNI $30,000
*The deduction for state taxes is limited to $10,000. No
deduction is allowed for any of the investment advisory fees paid.
67
Impact of TCJA on FAI, DNI, and DD
The distribution deduction is limited to the lesser of
trust accounting income and DNI in a simple trust (one
that is required to distribute all its income or the lesser
of amounts actually distributed and DNI in a complex
trust.
In this case, the amount distributed as net income was
$20,000, which is less than DNI, so the distribution
deduction is limited to $20,000.
Impact of TCJA on FAI, DNI, and DD
In our example the trust had:
Net income (FAI) $20,000
DNI $30,000
DD $20,000
The trust’s taxable income is:
Dividends $50,000
Less Trustee Fee (10,000)
Less State Income Tax (10,000)
Less DD (20,000)
Taxable Income $10,000
69
Character of Income
The character of the income distributed is in the same
proportions as the character of the income that is earned
by the trust. IRC §652(b)
The trust cannot specify that different classes of income
be allocated among different beneficiaries on the basis of
its taxability. The income is distributed proportionately
among the beneficiaries.
However, the trust document may state that the income
received from a specific asset be distributed to a
particular beneficiary.
70
Character of Income
The trust has $10,000 of taxable income and $10,000 of
tax-exempt income, and is required to distribute ½ the
income to John and ½ the income to Betsy.
Each beneficiary receives a distribution of $10,000,
comprised of $5000 taxable income and $5000 of tax-
exempt income.
Note: Be cognizant of the duty of impartiality when making the
decision to invest in tax exempt versus taxable securities when you
have multiple beneficiaries with different tax brackets.
71
Distribution Deduction for Complex
Trusts
When calculating the distribution deduction for a
complex trust there is a tier system. Under this tier
system, DNI is allocated first to those beneficiaries who
receive income that is required to be distributed
currently. The balance of DNI is allocated to other
beneficiaries who receive distributions, on a pro-rata
basis. IRC §661(a)
72
Example #3 – Discretionary Trust
Trustee has discretion to distribute income and principal to
Beneficiary. The trust has $24,000 of dividend income and
takes a fee of $2000. It makes a discretionary distribution of
$10,000 to Beneficiary.
What is net accounting income? $23,000
What is DNI? $22,000
What is the distribution deduction? $10,000
The beneficiary is taxed on $10,000 and the trust is taxed on
$12,000.
Note: Is this example, the distribution deduction is less than DNI.
73
Example #4 Complex Trust, Different
Tiers
Trust document states that the trustee is to pay A the
sum of $10,000 from net income each year. The trustee
has the discretion to pay B and C the balance of the
income and to invade principal on their behalf. The trust
has DNI of $12,000.
Trustee pays $10,000 to A, $10,000 each to B and C.
A receives $10,000 of DNI (Tier One)
B receives $1,000 of DNI (Tier Two)
C receives $1,000 of DNI (Tier Two)
74
Distribution Deduction – Example #5
Contrast this to a trust where distributions of income
and principal are discretionary as to all the beneficiaries:
DNI of the trust is $12,000.
The trustee distributes $10,000 each to A, B, and C.
Each beneficiary receives $4,000 of DNI. The remaining
$6,000 of their distribution is tax free.
75
Distribution Deduction
A payment of a specific bequest does not carry out
income. IRC §663(a)(1)
However, it must be paid in not more than three
installments.
Also, an amount which can only be paid from the income
of the trust or estate is not considered a specific bequest.
76
Distributable Net Income
A trust cannot avoid passing out income to a beneficiary
by accumulating income and making payments out of
principal. To the extent the trust has DNI a distribution
of principal will carry out income.
This is a reason for making a specific bequest of tangible
personal property in a will, even when it is going to the
same individual as the residuary estate.
77
Capital gains and DNI
Reg. 1.643(a)-3 states that in general gains from the sale
or exchange of a capital asset are ordinarily excluded
from distributable net income and are not ordinarily
considered as paid, credited, or required to be
distributed to any beneficiary.
78
Capital Gains and DNI
Capital gains are included in DNI if:
Under applicable local law and the terms of the document, or
pursuant to a reasonable and impartial exercise of discretion,
they are allocated to income;
They 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; or
They are allocated to principal but are actually distributed to
the beneficiary or utilized by the fiduciary in determining the
amount that is distributed or required to be distributed to a
beneficiary.
79
Gains Excluded from DNI -Example #5
Trust directs that net income be paid to A. The trust agreement gives the trustee the discretion to invade principal, as well as the discretion to deem invasions as being made from realized capital gains. This is permitted under local law.
The trust has net accounting income of $5000. It has realized gains of $10,000. The trustee makes a discretionary distribution of $12,000 to the beneficiary. The trustee allocates the gains of $10,000 to principal and does not exercise its discretion to deem the invasion as coming from realized gains.
DNI does not include the gains. Therefore, the beneficiary reports $5000 of income, even though he received $17,000.
Trustee must treat future invasions as not having been made from realized gains.
80
Example #5 Form 1041 and Sch D
81
Example #5 Form 1041 and Sch D
82
Gains Included in DNI - Example #6
Same facts, except that the trustee makes a
determination that it will treat discretionary
distributions as having been made from realized gains.
DNI includes the $10,000 of capital gains.
In future years the trustee must apply the same
treatment.
83
Example #6 Form 1041 and Sch D
84
Example #6 Form 1041 and Sch D
85
Example #7 Trust Agreement alters
UPIA
Trust provides that all capital gains are to be allocated to
income. Local law permits this.
Trust provides that all net income shall be paid to A.
Trust has $10,000 of dividends and $10,000 of capital
gains. Trustee distributes $20,000 to A as net income.
Note: This is not an exercise of discretion by the Trustee. The
trust agreement itself directs that gains be allocated to
principal.
86
Distributions of Property
Special rules apply to distributions of property instead of
cash:
Distributions in satisfaction of specific dollar amount
or property.
Non pro-rata distributions.
Distributions in kind.
Note that the related party rules apply to estates and
trusts.
87
Related Parties
Under IRC §267(a) no deduction shall be allowed in
respect of any loss from the sale or exchange of property,
directly or indirectly, between related parties.
Under IRC §1239(a) in the case of a sale or exchange
between related parties any gain recognized shall be
treated as ordinary income if the property is, in the
hands of the transferee, of a character which is subject to
the allowance for depreciation.
88
Related Parties
Under IRC §267(b)(6) a fiduciary of a trust and a
beneficiary of that trust are considered related parties.
Under IRC §267(b)(13) an executor of an estate and a
beneficiary of the estate are considered related parties
(except for distributions in satisfaction of a pecuniary
bequest).
Under IRC §645 a revocable trust may make an election
to be treated as part of an estate for fiduciary income tax
purposes.
89
Payments in Satisfaction of a Specific
Bequest
When an estate uses appreciated or depreciated property
to satisfy a distribution of a specific dollar amount or of a
specific property other than that distributed, gain or loss
is realized.
This is because under IRC §267(b)(13) provides an
exception to the related party rules for an executor and
a beneficiary for a distribution in satisfaction of a specific
bequest.
90
Example #8 Use of Appreciated Property to
Satisfy a Specific Bequest in an Estate
The John Smith Estate makes a specific bequest of
$10,000 to Mary Smith. The estate has 100 shares of
Widget Company that has a date of death value of
$1,000 and a date of distribution value of $10,000. The
estate distributes the 100 shares of Widget Company to
Mary in satisfaction of the bequest of $10,000. The
estate recognizes capital gain of $9,000.
Note: this is same result that would have occurred if the estate
had sold the stock and distributed the cash to Mary.
91
Example #9 Use of Depreciated Property to
Satisfy a Specific Bequest in an Estate
The John Smith Estate has a specific bequest of $1,000 to
Mary Smith. The estate has 100 shares of Widget
Company that have a date of death value of $10,000 and
a date of distribution value of $1,000. The estate
distributes the shares to Mary in satisfaction of the
$1,000 bequest. The estate recognizes a capital loss of
$9,000.
Note: this is the same result that would have occurred if the
estate had sold the shares and distributed the cash to Mary.
92
Example #10 Use of Depreciated Property
to Satisfy Specific Bequest in a Trust
Same facts as the prior slide, only the bequest is made in
the John Smith Trust
No 645 election is made. As a result the trust is not able
to take a deduction for the loss of $9000. Mary’s cost
basis is $1,000.
A 645 election is made. The trust’s income and
deductions are included on the estate’s 1041. The estate
is able to take a deduction for the $9000 loss.
93
Example #11 Use of Appreciated Property
to Satisfy Specific Bequest in a Trust
Under the terms of a testamentary trust that has been in
existence for 20 years, Mary Smith is entitled to receive
$20,000 upon attaining age 40. Instead of distributing
$20,000 cash to Mary the trustee distributes Widget
Company stock with a fair market value of $20,000 and
a cost basis of $10,000. The trust reports a gain of
10,000. Mary’s cost basis in the stock is $20,000.
Note: this is the same result that would have occurred if the
trust had sold the stock and distributed the proceeds.
94
Example #12 Using Depreciable Asset
to Satisfy a Specific Bequest
Instead of distributing appreciated stock to Mary the
trustee distributes a rental property with a fair market
value of $20,000 and a cost basis of $10,000. The trust has
ordinary income of $10,000, not a capital gain of $10,000
because the property distributed is a depreciable asset in
Mary’s hands.
95
Non Pro-rata Distributions
If an instrument or local law does not authorize non pro-
rata distributions, then they will be treated as taxable
exchanges between the beneficiaries.
96
Distributions in Kind
IRC §643(e) provides two options with respect to
distributions in kind and how they affect the amount of
DNI carried out by the distribution and the basis of the
distributed property in the hands of the beneficiary.
97
Distributions in Kind
If the trustee does not make an election under IRC
§643(e)(3) then:
The distribution deduction is limited to the lesser of
FMV of the property or the basis of the property in
the hands of the trust immediately before distribution
(but not exceeding DNI), and
The basis of the property in the hands of the
beneficiary is the basis of the property in the hands of
the trustee immediately before the distribution.
98
Distributions in Kind
If the 643(e)(3) election is made, then:
The distribution deduction is the FMV of the property at the
time of distribution (but not exceeding DNI) and
The basis of the property in the hands of the beneficiary is
adjusted to reflect the gain or loss recognized.
But remember, losses cannot re recognized on sales between
related taxpayers!
The election, when made, shall apply to all distributions made
during the taxable year.
99
Example #13 Distribution in Kind
John Smith has died with a will that pours over the residuary
estate to his living trust. The trust was already funded at his death.
The trust has had the following transactions:
Dividends $25,000
Taxable Interest $20,000
Trustee Fees $ 5,000
Federal Estate Tax $50,000
The trust makes a distribution to Mary Smith of 100 shares of
Widget Company. The stock has a cost basis of $10,000 and a
date of distribution value of $40,000.
100
Example 13 Distribution in Kind w/o §643
Election
Although the trust has taxable income (before the
distribution deduction) of $40,000, it does not have cash
because of the payment of federal estate taxes.
No §643 election is made. The distribution deduction
will be $10,000. The trust will have $30,000 of taxable
income. Mary Smith will be taxed on $10,000 of
income. Her cost basis for the shares is $10,000.
The trust will need to raise cash to pay the income taxes
on its taxable income of $30,000.
101
Example #14 Distribution in Kind w/ §643
Election
Same facts, except that the §643 election is made.
The trust’s distribution deduction is $40,000. The trust
will recognize a gain of $30,000. Mary Smith has
taxable income of $40,000. The cost basis of the shares
is $40,000.
Unless the trust has losses it can use to offset the gain, it
may decide to not make the election. Remember, once
made it applies to all distributions during the tax year.
The trust now has to pay taxes on $30,000 of capital
gain.
102
Method of Making 643 Election
In order to make the IRC §643(e)(3) election, check the
box for Item 7, “Other Information” on page two of
Form 1041 and attach Schedule D showing the date that
the property is distributed as the date of the sale.
103
Income in Respect of a Decedent (“IRD”)
Income in respect of a decedent or IRD can pose
additional challenges in the administration and taxation
of a trust.
IRD assets do not receive a step up in basis at the time of
death of a decedent.
104
Income in Respect of a Decedent
Typical items of income in respect of a decedent include:
Accrued E or EE bond interest
Individual retirement accounts
Qualified plan funds
Installment sales contracts
Accrued interest and dividends on securities
Final wages
105
The “65 day” Rule
Under IRC §663(b) a trust or estate may elect to treat
distributions made within 65 days after the close of the
tax year as though they were made on the last day of the
preceding tax year.
This can be particularly helpful in filing a “first and final”
return for an estate.
It can also be used to avoid the loss of excess deductions
by failure to distribute the estate or trust’s assets on a
timely basis.106
The “65 day” Rule
The 65 day election is made on a timely filed 1041 for
the tax year to which the distribution is being “pushed
back”.
The election is irrevocable after the last day prescribed
for making it. Reg. §1.663(b)-2.
107
V. Planning Considerations and Traps to Avoid
Treatment of Capital Gains
Coordinating receipts and disbursements to minimize tax
Selection of fiscal year end to defer taxes- §645 election
Use of 65 day rule
Direction to use IRD and income to pay charitable gifts
Distributions in Kind
Equitable adjustments
Duties of Loyalty and Impartiality
108
Allocating Capital Gains to DNI
When the income beneficiaries and remainder beneficiaries
are two different groups, the decision to allocate capital gains
to income results affects “who gets what”
It is not unusual for tax and/or investment professionals to
tout the benefit of allocating gains, particularly short term
gains, to DNI because it reduces the taxable income of the
trust (which is subject to very compressed brackets).
109
Allocating Gains to DNI
However, what is frequently ignored in these recommendations is an acknowledgment that this takes money out of the hands of the income beneficiary and puts it into the remainderman’s pocket. Refer back to Examples #5 and #6
In Example #5, gains were allocated to principal. The Beneficiary had taxable income of $5000 and the trust had capital gain income of $10,000.
In Example #6, gains were included in DNI. The beneficiary thus had ordinary income of $5000 to report and $10,000 of capital gain to report. The trust paid no income taxes.
110
Coordinating Receipts and Disbursements
Because of the dual nature of a trust as a taxpayer and as a conduit of income, it is important to pay attention to the timing of receipts and disbursements.
When a trust directs that all net income be distributed annually, the income will be taxed to the beneficiary even if it is not distributed.
Where the distribution of income or principal is within the Trustee’s discretion, the Trustee may want to time distributions to beneficiaries to occur in the same tax year as when it has income, particularly ordinary income, due to the very compressed tax rates for trusts. The maximum tax rate of 37% applies to a trust’s income of $12,500 and above.
111
Use of the 65 Day Rule
The “65 day” rule offers another opportunity to minimize taxes.
Example: In 2018 a discretionary trust has DNI of $30,000. In January 2019 a beneficiary makes a request for a discretionary distribution of $20,000. The beneficiary is a student and has minimal taxable income. If the trustee does not make the 65 day election, the trust will pay income tax on the entire $30,000.
Alternatively, the trust can make the election, in which case the beneficiary will be taxed on $20,000 and the trust will pay tax on the remaining $10,000.
112
Tax Years
Trusts are required to be on a calendar year.
An estate may elect a fiscal year end.
The first day of the tax year of an estate is the day after
death.
The tax year must end on the last day of a month.
The tax year cannot exceed 12 months.
113
Tax Years
The ability to use a fiscal tax year for estates provides income
deferral opportunities.
Distributions from an estate are considered to have been made to
the beneficiary on the last day of the estate’s taxable year, not the
actual date of distributions.
Example: John Smith dies on March 30, 2018. His estate selects
February as the tax year end. The estate’s first tax year will run
from 3/31/18 – 2/28/19. The estate makes a distribution to
Beneficiary in May 2018. This will be taxed to the beneficiary on
his 2019 return, which will be due on April 15, 2020.
114
IRC §645 Election
Over the past several decades, the use of revocable trusts has
grown substantially. The revocable trust (which becomes
irrevocable at the decedent’s death) is often an estate substitute,
with no formal probate estate being opened for the decedent.
However, one key difference between an estate and a trust is that
while an estate may select a fiscal tax year end a trust must be on a
calendar tax year.
If a trust makes an election under §645, then it ends up being able
to take advantage of the fiscal year end opportunities (for a period
of time).
115
Using IRD and other income to pay
charitable gifts
For many years the tax benefit of making a charitable gift in an estate plan was to obtain a deduction on the federal estate tax return. Because of the increase of the federal exemption equivalent the tax focus has shifted to obtaining income tax deductions.
IRC §642(c) allows a trust or estate to take a charitable income tax deduction for amounts paid from gross income pursuant to the terms of the governing instrument. If the will or trust does not specify that the charitable gift is to be paid out of gross income, then a charitable income tax deduction is not allowed. Therefore, add language to your document that directs that income be used, particularly IRD.
116
Using IRD and other income to pay
charitable gifts – sample language
“Settlor directs that to the extent possible, the charitable gifts
made in this trust shall be paid first from trust property that
constitutes “income in respect of a decedent” as that term is
defined under the Internal Revenue Code, and second from
other trust income, it being Settlor’s intention that payments
made to satisfy such charitable gifts shall qualify for the
charitable income tax deduction under IRC Section 642(c) or
any corresponding Section of any future versions of the Internal
Revenue Code.”
117
Distributions in Kind
In Example #13 the trust had $45,000 of income and paid a fee of
$5,000. Its DNI was $40,000. The trust distributed appreciated
stock with a cost basis of $10,000 and a FMV of $40,000. No
§643 election was made, with the result that the trust had a
distribution deduction of $10,0000, the beneficiary had $10,000
of taxable income, and the trust had $30,000 of taxable income.
The beneficiary’s cost basis is $10,000.
In Example #14, the fact situation was the same, except that the
trust did make the §643 election. The trust had a distribution
deduction of $40,000, the beneficiary had taxable income of
$40,000, the trust was taxed on capital gain of $30,000. The
beneficiary’s cost basis is $40,000.
118
Comparison Using §643 Election
Facts from Example #13 and #14:
W/O 643 Election W/ 643 Election
Trust Taxable Income (ordinary) $30,000 -0-
Trust Capital Gain -0- $30,000
Beneficiary’s Ordinary Income $10,000 $40,000
Beneficiary’s Cost Basis $10,000 $40,000
119
Equitable Adjustments
Section 506 of the 2008 Uniform Principal and Income Act
and Section 507 of the 2018 Uniform Fiduciary Income and
Principal Act contain provisions for the trustee to make
adjustments between income and principal to take into
account the impact of tax decisions.
120
Above all, remember the trustee’s duties of:
•Loyalty
•Impartiality
Duties of Loyalty and Impartiality
121
Contact InformationEllen M. Deeter
Of Counsel
Dale & Eke, P.C.
9100 Keystone Crossing, Suite 400
Indianapolis, IN 46240
317/844-7400
122
