Sec. 643 regulations revised the definition of trust accounting income for tax years ending after January 2, 2004, to recognize and respond to state law changes. This article analyzes these regulations and examines how they affect the computation of fiduciary accounting income and distributable net income.
- Under the Sec. 643 regulations, income is determined under the governing instrument and applicable local law.
- The regulations recognize a reasonable apportionment of income, gains and appreciation between income and remainder beneficiaries under state law.
- Special rules are provided for computing (1) income for CRUTs and pooled income funds, (2) marital deductions and (3) gains or losses on property distributions.
In December 2003, the IRS released final regulations revising the definition of trust accounting income under Sec. 643(b). 1 The regulations responded to the states' widespread adoption of the Uniform Principal and Income Act of 1997 (UPIA) 2 and "unitrust" provisions 3 that redefined trust accounting income under state law. This article analyzes the new regulations and examines their effect on fiduciary accounting income and distributable net income (DNI). The final regulations are generally effective for tax years ending after Jan. 2, 2004.
Power to Adjust
The UPIA's centerpiece is the "power to adjust." It allows a disinterested trustee 4 to adjust from income to principal, or principal to income, if the trustee determines that traditional fiduciary accounting income provides too much or too little income for an income beneficiary after taking into account, among other things, the grantor's intentions, the trust's investments and the adjustment's anticipated tax consequences. The power to adjust was provided in response to the difficulties trustees encountered in obtaining sufficient income for income beneficiaries when investing in times of declining interest and dividend income, while honoring their duty under the Prudent Investor Act, 5 to invest for "total return." If the trustee shifts to income-producing assets to provide sufficient income for the income beneficiary, this would ignore the duty to achieve portfolio growth for the remainder beneficiary. The power to adjust allows the trustee to share the trust's total return between the income beneficiary and the remainder interest holder, thereby complying with the prudent investor rule and still meeting the duty to both the income and remainder beneficiaries.
A unitrust provides payment of a fixed percentage of a trust's assets to an income beneficiary on an annual basis (usually between 3% and 5%). Traditional concepts of fiduciary accounting income do not apply; rather, the unitrust amount is "fiduciary accounting income." For purposes of recognizing unitrust methods of computing fiduciary accounting income, Regs. Sec. 1.643(b)-1 requires the unitrust percentage to be no less than 3%, nor greater than 5%.
Regs. Sec. 1.643(b)-1 explains that it will respect state statutes that provide for a reasonable apportionment between the income and remainder beneficiaries of a trust's total return for the year, including ordinary and tax-exempt income, capital gains and appreciation.
Because the new regulations depend so much on state laws, careful thought should be given to choosing a trust's situs. It might even be prudent to consider shifting the trust situs, if permitted under the instrument. Such a shift, however, requires a thorough understanding of the state's principal and income statutes and trust code. An equally important element is the potential for exposing the trust and its beneficiaries to additional state income taxes.
Neither the power to adjust nor the unitrust provisions should be confused with the trustee's power to invade principal. Principal invasions are generally not eligible for a reallocation of principal to income, and the resulting inclusion of capital gains in DNI. An exception applies if, pursuant to the (1) governing instrument and applicable local law or (2) fiduciary's reasonable and impartial exercise of discretion, the fiduciary consistently treats such distributions on the trust's books, records and returns as including current-year capital gains. 6
Income and DNI
Understanding the interplay of fiduciary accounting income and DNI is a minimum requirement for properly preparing a fiduciary income tax return. Tax advisers must be fully acquainted with the regulations to compute DNI correctly. Also, a full awareness of applicable state laws is required to properly compute fiduciary accounting income. Failure to compute either DNI or fiduciary accounting income correctly can result in an improper income distribution deduction and, possibly, in income being taxed to the wrong taxpayer.
Certain trusts, simple trusts, pooled income funds, marital deduction trusts, qualified domestic trusts (QDOT), net income charitable trusts, grandfathered generation-skipping transfer (GST) trusts and qualified subchapter S trusts must determine the amount of income required to be distributed. This can be especially critical if the trust is a QDOT; the failure to compute fiduciary accounting income properly could result in inadvertent principal distributions, accelerating estate taxes.
Regs. Sec. 1.643(b)-1 defines "income" as follows:
For purposes of subparts A through D, part I, subchapter J, chapter 1 of the Internal Revenue Code, "income," when not preceded by the words "taxable," "distributable net," "undistributed net," or "gross," means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Trust provisions that depart fundamentally from traditional principles of income and principal will generally not be recognized.
Thus, in computing fiduciary accounting income for a given trust, the tax adviser has to look first at the governing document (i.e., the will or trust) to determine whether any departures from local law have to be considered in computing fiduciary accounting income. If such departures are substantial, the Service may choose not to recognize them, thus jeopardizing a marital, charitable or a grandfathered GST tax-exempt trust.
A qualified terminable interest property trust is meant to qualify for the marital deduction. According to the trust document, only dividends from XYZ Co. are considered income; all other dividends are principal.
This departure may be sufficient to deprive a surviving spouse of the enjoyment of the underlying property, resulting in a loss of the marital deduction. Under UPIA Section 104(c)(1), a trustee cannot exercise a power to adjust if it would reduce the income to be paid to a spouse below traditionally computed fiduciary accounting income. As a result of the new Sec. 643 regulations, a few states that have adopted the UPIA are considering whether to amend their statutes to allow a power to adjust for trusts qualifying for the estate or gift tax marital deduction. 7
For a domestic trust, Sec. 643(a) generally defines DNI as the taxable income of the trust, adjusted by adding back the applicable exemption, the distribution deduction, net municipal income and capital losses. Capital gains are then deducted to arrive at DNI, under Sec. 643(a)(3). Distributions of short-term capital gains from mutual funds are included in DNI for both simple and complex trusts, according to IRS rulings. 8 The distribution deduction is the lesser of DNI, or the sum of income required to be distributed plus other income or principal paid, credited or otherwise set aside. Thus, if DNI is larger, the distribution deduction could also be larger. The character of items included in DNI (e.g., interest, dividends and capital gains) is retained in the beneficiary's hands.
When Are Capital Gains Included in DNI?
If trustees are sharing some of the total return with an income beneficiary, they will be reclassifying some items traditionally considered "principal" (e.g., capital gains). The new regulations provide guidance on when to include capital gains in DNI, thus shifting the income tax burden from the trust to the beneficiary.
Under Regs. Sec. 1.643(a)-3(b), gains from the sale or exchange of capital assets are included in DNI to the extent so included pursuant to the governing instrument or local law. They are also included in DNI if the trustee has the discretion to allocate them to income, pursuant to a reasonable and impartial exercise of discretion granted either by the governing instrument (when not prohibited by local law) or local law. Also, when income under a state statute is defined as (or consists of) a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently; the trustee cannot allocate more gains to income than necessary to meet the unitrust amount.
If, however, gains are allocated to corpus, but are always treated on the trust's books, records and returns as part of a distribution to a beneficiary, they may be included in DNI, under Regs. Sec. 1.643(a)-3(b)(2). Also, if gains are allocated to corpus, but the trustee actually distributes them to the beneficiary or uses them in determining the amount distributed (or required to be distributed) to a beneficiary, they may be included in DNI, under Regs. Sec. 1.643(a)-3(b)(3).
Losses from a sale or exchange of capital assets must first be netted at the trust level against gains from the sale or exchange of capital assets, under Regs. Sec. 1.643(a)-3(d). However, losses need not first be netted when capital gains are used in determining the amount distributed to a particular beneficiary. In other words, if the fiduciary determines that current-year capital gains will be included in computing income distributions, such gains will not be available to be offset by capital loss carryovers.
A trust has a $100,000 capital loss carryforward. In 2005, it realizes $50,000 net capital gain, of which $30,000 is allocated to income and included in DNI. Under Regs. Sec. 1.643(a)-3(d), only the $20,000 capital gain remaining in the trust can be offset by the capital loss carryforward.
How does this apply to clients? Tax advisers preparing the return of a trust that is either a unitrust or in which the trustee has exercised a power to adjust, must thoroughly understand the trustee's intentions as to the inclusion of capital gains in DNI. Inclusion is not mandatory: rather, it is elective, and the trustee's intent to so elect must be clearly reflected on the trust's books, records and returns. The election is not made by tax advisers. However, they can greatly assist a trustee in determining whether such an election is advisable. Failure to include capital gains in DNI could be seen, in some circumstances, as favoring the income beneficiary over the remainder interest holders; while the income beneficiary enjoys additional income, the remainder interest holder pays the income tax on the capital gains, to the extent not included in DNI and carried out to the income beneficiary. In making the election, trustees should consider the income tax rates paid by both the trust and beneficiary.
In the case of a unitrust, the trustee's decision to include capital gains in DNI will bind the trust in the future, because the decision must be exercised consistently from year to year. This election may not seem material while taxpayers enjoy a 15% capital gain rate, but that rate only applies through 2008. Future tax law may not be so generous. Additionally, if a trust has a large capital loss carryforward, tax advisers must ensure that trustees understand that only current-year capital losses can be offset against current-year gains. The capital loss carryforward will not shelter capital gains allocated to income.
Further, including capital gains in DNI affects the allocation of expenses to the various classes of income included in DNI, such as municipal income. After allocating direct expenses attributable to one class of income included in DNI, and a portion of the indirect expenses to nontaxable income (such as tax-free municipal bond interest), the remaining indirect expenses may be allocated to any other income class in any proportion. Under Regs. Sec. 1.652(b)-3, indirect expenses are allocated to municipal income based on the ratio of total municipal income to total DNI. As a result, any item of taxable income that increases DNI will result in a lesser allocation of expense to municipal income. As shown in Exhibits 1 and 2, the inclusion of $20,000 of net current-year capital gain in DNI shifts $541 of expenses from municipal to taxable income.
Thus, the decision to include capital gains in DNI can affect not only the interests of the various classes of beneficiaries, but also the income taxes paid by both the trust and beneficiary.
Net income charitable remainder unitrusts (NICRUTs), which base the unitrust distribution on the lesser of the unitrust amount or fiduciary accounting income, have their own unique problems implementing the UPIA. Unlike ordinary CRUTs, which distribute a fixed percentage of the fair market value of assets determined annually, a NICRUT can distribute the actual fiduciary accounting
income if it is less than the computed unitrust amount. 9 Further, many NICRUTs contain a "makeup" provision allowing a distribution of previously undistributed income if the actual fiduciary accounting income exceeds the unitrust amount in a given year (NIMCRUT). This allows a trustee to invest in growth assets in earlier years, resulting in less traditional fiduciary accounting income. The trustee can shift to income-producing assets in later years, when the beneficiaries have a greater need for it.
For a NICRUT or NIMCRUT in which the trustee has a power to adjust, the income will often exceed the traditional fiduciary accounting income. In such cases, if the NICRUT or NIMCRUT has current or accumulated capital gains, the excess of income computed using the power to adjust over traditional fiduciary accounting income will be taxed at capital gain rates. Many times, the accumulated capital gains in a unitrust represent pre-contribution gain from highly appreciated assets contributed by the grantor. Thus, to prevent an abuse of the power to adjust to effectively distribute pre-contribution gains to the grantor, Regs. Sec. 1.664-3(a)(1)(i)(b)(3) allows only post-contribution capital gains to be included in DNI.
Under the originally proposed regulations, NICRUTs and NIMCRUTs administered in states that define income as a unitrust amount would have been required to contain their own definition of income in the trust document. 10 This provision was dropped from the final regulations as unnecessary. 11 However, NICRUTs and NIMCRUTs must use a definition of fiduciary accounting income, whether contained in the document or in state law, that is not a unitrust amount.
Pooled Income Funds
Pooled income funds do not pay tax on capital gains, because the gains are considered permanently set aside for charitable purposes. Under Regs. Sec. 1.642(c)-2(c):
[n]o amount of net long-term capital gain shall be considered permanently set aside for charitable purposes if, under the terms of the funds [sic] governing instrument and applicable local law, the trustee has the power, whether or not exercised, to satisfy the income beneficiaries' right to income by the payment of either: an amount equal to a fixed percentage of the fair market value of the funds [sic] assets (whether determined annually or averaged on a multiple year basis); or any amount that takes into account unrealized appreciation in the value of the funds [sic] assets. In addition, no amount of net long-term capital gain shall be considered permanently set aside for charitable purposes to the extent the trustee distributes proceeds from the sale or exchange of the funds [sic] assets as income within the meaning of 1.642(c)-5(a)(5)(i).
In essence, these regulations allow a pooled income fund to use either the power to adjust or unitrust provisions to compute fiduciary accounting income, but deny the charitable set-aside deduction for capital gains if proceeds from a sale of trust assets are allocated to income. This is done to prevent a charitable deduction for gain that may be distributed later to a noncharitable beneficiary. The regulations allow a fund to allocate capital gain to income to the extent of post-contribution appreciation or amount in excess of the price paid for an asset, and still qualify for a charitable contribution for assets transferred into the fund. However, allocating capital gain to income results in the loss of the charitable set-aside deduction.
To avoid inadvertent loss of the set-aside deduction for pooled income funds in states that have adopted a unitrust provision, but not adopted language preventing pooled income funds from calculating income in this way, Regs. Sec. 1.642(c)-2(e) allows the fund's governing instrument to be amended. A judicial reformation must be commenced, or a nonjudicial reformation must be completed, by the date that is nine months after the later of Jan. 2, 2004, or the effective date of the state statute authorizing determination of income in such a manner.
Trusts Qualifying for Gift and Estate Tax Marital Deductions
To qualify for the estate marital deduction under Sec. 2056 and gift marital deduction under Sec. 2523, the trust must provide, among other things, for the distribution of all income to the spouse. 12 Under Regs. Sec. 25.2523(e)-1(f)(1), a trust meets this requirement if the "income as defined or determined by applicable local law . . . provides for a reasonable apportionment between income and remainder beneficiaries of the total return of the trust and . . . meets the requirements of §1.643(b)-1. . . . " 13 Importantly, the power to adjust and unitrust provisions must be authorized under applicable state laws recognized by the Service.
Grandfathered GST Trusts
Trusts that were irrevocable on Sept. 25, 1985 are exempt from the GST tax. Under Regs. Sec. 26.2601-1(b)(4)(i), such trusts will lose their exemption if there is a shift in beneficial interests among beneficiaries. The new regulations provide that the exercise of a power to adjust under state law or application of a state unitrust statute will not result in such a shift and will not be a taxable gift.
Gain or Loss on Property Distributions
Regs. Sec. 1.661(a)-2 clarifies that gain or loss is realized by an estate or trust that distributes property in satisfaction of a right to receive a specific dollar amount, specific property other than that distributed or income defined under Sec. 643(b), if income is required to be distributed currently. Additionally, gain or loss is realized if a trustee or an executor elects to recognize gain or loss under Sec. 643(e). These rules do not apply to discretionary trusts not required to distribute either income or specific dollar amounts.
However, unlike distributions in satisfaction of a pecuniary devise, even though the trust or estate is deemed to have sold the property and realized a gain or loss, Sec. 267(b) bars the trust or estate from recognizing losses.
The new regulations offer tax advisers many opportunities to add value to the services they provide to their trust clients. By closely working with trustees and legal counsel to ensure they understand the prospects and pitfalls of the new regulations, tax advisers can maximize tax savings, while still respecting the grantor's intent and the trustee's duty to treat each beneficiary impartially.
. TD 9102 (12/30/03).
2. The full text of the UPIA is available at www.law.upenn.edu/library/ulc/upaia/upaia97.htm.
3. The National Conference of Commissioners on Uniform State Laws (NCCUSL) has not adopted a "uniform unitrust." Each state that has adopted a unitrust provision has different provisions governing trusts subject to that state's laws.
4. UPIA Section 104(c)(7) and (8) prohibit the exercise of a power to adjust when the trustee is a trust beneficiary, or if the trustee is not a beneficiary, but would benefit (directly or indirectly) from exercise of the power.
5. The full text is available at www.nccusl.org.
6. See Regs. Sec. 1.643(a)-3(b).
7. See, e.g., the proposal for repeal of TX Trust Code §116.005(c)(1) by the Real Estate, Probate and Trust Law Section of the State Bar of Texas (June 2004).
8. IRS Letter Rulings 9811036 and 9811037 (both dated 3/13/98).
9. See Regs. Sec. 1.664-3(a)(1)(i)(b).
10. For a discussion of the proposed regulations, see Cantrell, "Sec. 643 Regs. Redefine Trust Income," 32 The Tax Adviser 542 (August 2001).
11. See the preamble to TD 9102, note 1 supra.
12. See Regs. Secs. 20.2056(b)-5(a)(1) and 25.2523(e)-1(f)(1).
13. See Regs. Sec. 20.2056(b)-5(f)(1)