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Allocating Capital Gains to Distributable Net Income in Estates and Trusts: Achieving Optimal Tax Treatment
TUESDAY, JANUARY 4, 2022, 1:00-2:50 pm Eastern
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January 4, 2022
Allocating Capital Gains to Distributable Net Income in Estates and Trusts: Achieving Optimal Tax Treatment
Jeremiah W. (Jere) Doyle, IV Senior Vice President
Bank of New York Mellon jere.doyle@bnymellon.com
Jacqueline Patterson Partner
Buchanan & Patterson jpatterson@bplawllp.com
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
Including Gains in Distributable Net Income
Jeremiah W. Doyle IV, Esq.
Senior Vice President BNY Mellon Wealth
Management One Boston Place
Boston, MA
Jere.doyle@bnymellon.com
January, 2022
Jacqueline A. Patterson, Esq.
Buchanan & Patterson, LLP 400 S. Beverly Dr.
Suite 320
Beverly Hills, CA 90212-4405 jpatterson@bplawllp.com
What We’ll Cover
• Background
• The Problem – Generally, Gains Are Taxed to the Trust or Estate
• Reg. 1.643(a)-3(b) – Three Ways To Include Gains in DNI
– Method 1 – Method 2 – Method 3
• In-Kind Distribution Under Section 643(e)
• Grantor Trust
• Conclusion
Background
• Traditionally, the income beneficiary of a trust would be paid and taxed on the trust accounting income (e.g., interest and dividends) and capital gains would be allocated to principal and taxed to the trust.
• Changes have occurred in investment world
– Low yield on equities and bonds
– Trusts investing for total return per the Prudent Investor Act
• Two changes in determination of definition of “income”
– Adoption of “power to adjust” under Section 104 of the UPIA – Adoption of unitrust statutes
• Changes in tax rates for trusts and estates versus rates for individuals
– For 2022, estates and trusts reach the 20% maximum rate for long-term capital gains at $13,700 of taxable income, while the 37% bracket for ordinary income (including short-term capital gains) and the 3.8% surtax applies to taxable income over $13,450.
– Individuals reach maximum rate for long-term capital gains, ordinary income and the 3.8% surtax at higher thresholds.
Income Taxation of Trusts and Estates Code Outline
• PART I, SUBCHAPTER J
–
Subpart A - Sec. 641-646 - General Rules
–
Subpart B - Sec. 651-652 - Simple Trusts
–
Subpart C - Sec. 661-664 - Complex Trusts and CRTs
–
Subpart D - Sec. 665-668 - Accumulation Distributions
–
Subpart E - Sec. 671-679 - Grantor Trusts
–
Subpart F - Sec. 681-685 - Misc. Rules
• PART II, SUBCHAPTER J
–
Sec. 691-692 - Income in Respect of a Decedent
2022 Tax Rates – Ordinary Income
If Taxable Income is: The Tax is
Not over $2,750 10%
Over $2,750 but not over $9,850 $275 plus 24% of amount over $2,750
Over $9,850 but not over $13,450 $1,979 plus 35% of amount over
$9.850
Over $13,450 $3,239 plus 37% of amount over
$13,450
2022 Tax Rates – Capital Gains and Qualified Dividends
If Taxable Income is: Maximum Capital Gain Rate
Not over $2,800 0%
Over $2,800 but not over $13,700 15%
Over $13,700 20%
Background - Income Taxation of Trusts and Estates
• Income Taxed to Either Entity or Beneficiary
– If income is accumulated and not deemed distributed, it is taxed to the trust or estate
– If income distributed:
• Trust gets deduction for amount of distribution, limited to DNI
• Beneficiary accounts for income distributed on his own
tax return, limited to DNI
Background - Income Taxation of Trusts and Estates - Distributable Net Income (DNI)
• Distributable Net Income (DNI) governs:
– Amount of trust or estate’s distribution deduction
– Amount beneficiary accounts for on his own return
– Character of income in beneficiary’s hands
Background - Income Taxation of Trusts and Estates
Trust/Estate Beneficiary DNI acts as ceiling
on entity’s distribution
deduction
DNI acts as ceiling on amount
beneficiary
accounts for on his return
DNI
Background - DNI - Sec. 643(a)
• Start With Taxable Income and . . .
– Add back the distribution deduction – Add back the personal exemption
– Subtract out capital gains/add back capital losses allocable to principal (except in the year of termination)
– Subtract out extraordinary dividends and taxable stock dividends allocated to corpus for simple trust
– Add back net tax-exempt income
Background - DNI - Sec. 643(a)
• General Rule: capital gains generally taxed to trust or estate – Exceptions:
• 3 situations under Reg. 1.643(a)-3
• Paid to or set permanently set aside for charity. Reg. 1.643(a)-3(c)
• year of termination
Including Capital Gains in DNI – The Problem
• Generally, capital gains are allocated to principal and taxed to the estate or trust
• Compressed tax rate schedule for estates and trusts
– Short-term capital gains taxed at 37% + 3.8% surtax if taxable income exceeds $13,450 (2022)
– Long-term capital gains taxed at 20% if taxable income exceeds
$13,700 (2022)
• Planning point – have gains taxed to beneficiary where gains would most likely be taxed at a lower tax rate
Including Capital Gains in DNI – The Problem
• Check to see if the trustee has authority to make discretionary distributions of principal.
• First, look in the trust instrument for the authority to make discretionary distributions of principal.
• If there is no authority under the trust instrument to make discretionary distributions of principal, look at the state’s version of the uniform principal and income act (UPIA).
• Do not forget to check the fiduciary powers incorporated by reference in the state statute. For example, the state statute may provide a laundry list of fiduciary powers that may be incorporated by reference into the trust instrument.
• Also, check the state’s trust code. For example, the state’s version of the Uniform Trust Code may grant a trustee a specific power to make
discretionary distributions of principal. The UTC §816(22) is of no help.
Including Capital Gains in DNI – The Problem
• Where a beneficiary is entitled to distributions of principal, the beneficiary is not taxed on the capital gain unless one of the specific exceptions under Reg. 1.643(a)-3 is satisfied.
• For capital gains to be taxed to a beneficiary, the capital gain must be included in DNI.
• Analysis:
– May the fiduciary include capital gains in DNI and have them taxed to the beneficiary?
– Should the fiduciary allocate capital gains to DNI?
• Overriding factor – trustee must consider his fiduciary duty to both the
income beneficiary and the remainderman in making principal distributions.
– Uniform Trust Code imposes a “duty of impartiality” on the trustee
Including Capital Gains in DNI
• The regulations describe 3 circumstances under which capital gains can be included in DNI. Reg. 1.643(a)-3(b).
• The regulations contain 14 examples. They do not cover all possibilities.
• The exact language of the regulation is on the following slide.
Including Capital Gains in DNI
• Gains are included in DNI where they are, pursuant to the governing instrument and applicable local law, or pursuant to a reasonable and
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 prohibited by applicable local law:
1. Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate
gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of DNI determined without regard to this subparagraph 1.643(a)-3(b));
2. Allocated to corpus but treated consistently by the fiduciary on the trust’s books, 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 by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.
Analyzing Regulation 1.643(a)-3(b)
• Reg. 1.643(a)-3(b) has specific requirements must be met in order to have capital gains taxed to the beneficiary
• No pressing the “easy button”
• Regulations have:
– Two prerequisites and – Three methods
Analyzing Regulation 1.643(a)-3(b)
• Two prerequisites – capital gains included in DNI only if inclusion is pursuant to:
– Trust agreement and local law; or
– A reasonable and impartial exercise of discretion by the trustee in
accordance with a power granted to the trustee by local law or the trust agreement if not prohibited by local law.
• Three methods
– Allocated to income
– Allocated to corpus, but treated consistently by the fiduciary on the trust’s books, records and tax returns as part of distribution to the beneficiary
– Allocated to corpus, but 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
Analyzing Regulation 1.643(a)-3(b)
• Two prerequisites – capital gains included in DNI only if inclusion is pursuant to:
– Trust agreement and local law. Note: there is no discretion.
– A reasonable and impartial exercise of discretion by the trustee in
accordance with a power granted to the trustee by local law or the trust agreement if not prohibited by local law.
Analyzing Regulation 1.643(a)-3(b)
• Method 1, requiring an allocation to income, is limited unless the trust
instrument or state law allocates gains to income (unlikely) or the fiduciary has broad discretion to allocate capital gains to income. Power to adjust or unitrust statute are relevant here. Once an item of federal taxable income is in trust accounting income, it is in DNI. There is no discretion. Since there is no discretion, there is no consistency requirement.
• Method 2 requires the a consistent practice of allocating capital gains to DNI. This method may not be available if the trust is not in its first year of existence or if the fiduciary does want to be obligated to allocate capital gains to DNI in the future.
• Method 3 appears to be the most flexible
Regulation 1.643(a)-3(e) – Example 1
• Trust says pay all income to A
• Trust gives trustee discretion to distribute principal to A and to deem it to be made from capital gains realized during the year.
• Trust has $5,000 of dividends and $10,000 of capital gain
• Trustee allocates $10,000 capital gain to principal
• Trustee distributes $5,000 to A (TAI) and $12,000 discretionary distribution of principal
• Trustee does not deem the discretionary distribution of principal as being paid from capital gains
• Gains not included in DNI and are taxed to the trust
• In future years trustee must treat all discretionary distributions of principal as not being made from capital gain.
28
Method 1 - 1.643(a)-3(b)(1)
• Allocated to income
• By state law (unlikely)
• Trust agreement specifically provides that capital gains are allocated to income
– A mere general boilerplate statement that the trustee has discretion to allocate receipts and disbursements between income and principal may not be enough
• The trustee allocates gains to income by a reasonable and impartial exercise of discretion granted by the trust instrument
• Solution if trust instrument is silent as to whether capital gains are allocated to income
– Decant
• Most states require trustee have significant discretion to distribute principal.
Method 1 - 1.643(a)-3(e) – Example 4
• Trust agreement allocates capital gain to income
• Same as Example 1 except that terms of trust allocate gains to income.
• $10,000 capital gain is included in DNI and taxed to the beneficiary
Trust Accounting Income - TAI
• TRUST ACCOUNTING INCOME – Could be TAI defined under:
• Traditional definition of income and principal
• Unitrust statute
– Must be no less than 3%, no more than 5% of FMV of trust assets
• Uniform Principal and Income Act – power to adjust – Requirements:
» Trust is managed under the Uniform Prudent Investor Act
» The beneficiary must be eligible for income distributions
» The distribution is not favorable to one beneficiary over another
Method 1 - 1.643(a)-3(b)(1)
• Two alternative ways capital gains can be allocated to income:
– Power adjust under UPIA – Unitrust statute
Method 1 - 1.643(a)-3(b)(1)
• Power to adjust - theory
– Trust invests for total return, i.e., income and appreciation
– Trustee makes adjustment to allocate a portion of the capital gains to income to satisfy his duty of impartiality to the income and remainder beneficiary
– Section 104 of the UPIA gives the trustee the authority to allocate capital gains to income to satisfy his duty of impartiality
• Section 104 of the UPIA is the applicable state statute that gives the trustee authority to allocate gains to income
• IRS agrees that “the power does not have to be exercised consistently, as long as it is exercised reasonably and impartially.” Preamble to T.D. 9102.
– Thus, the requirements of Reg. 1.643(a)-3(b)(1) to allocate capital gains to income and include them is DNI is satisfied
Method 1 - 1.643(a)-3(b)(1)
• Power to adjust - planning
– §643 regulations don’t have an example if or how capital gains enter into DNI if trustee exercises the power to adjust.
– For trusts that do not have discretionary power to distribute principal, the trustee should be able to rely on the power to adjust to shift capital gains to income and include them in DNI.
– However, the power to adjust is limited and may only be exercised under the appropriate facts and circumstances.
Method 1 - 1.643(a)-3(b)(1)
• Unitrust - theory
– Term “unitrust” is used to describe a payment to the income beneficiary equal to a fixed percentage of the fair market value of the trust property determined at the beginning of the tax year or averaged over some period.
– A unitrust amount is “fake” income – it is a substitute for actual trust accounting income
– Tax treatment depends on whether the governing instrument or the state unitrust statute has an ordering rule for the character of the unitrust amount.
Method 1 - 1.643(a)-3(b)(1)
• Ordering rule
– “Ordering rule” sets forth the type or source of income which will be deemed to satisfy the unitrust distribution e.g., first from trust accounting income, next from STCG, then from LTCG, next from tax-exempt income and lastly from principal.
– If state has an ordering rule, to the extent capital gains are allocated to satisfy the unitrust amount, the capital gains are included in DNI. See Reg. 1.643-3(b), Example 11.
– No consistency requirement
Method 1 - 1.643(a)-3(e) – Example 11
• Ordering rule
– Beneficiary A is entitled to trust income
– State statute says unitrust amount considered paid first from ordinary income and tax-exempt income, then from STCG, then from net LTCG and finally from principal
– Income of trust defined by unitrust statute – 4% of FMV of assets – Trust’s assets FMV of $500,000
– Unitrust amount is $20,000 (4% x $500,000)
– Trust receives $5,000 of dividends and $80,000 of net LTCG – Trustee distributes $20,000 to A
– $15,000 net LTCG included in DNI ($20,000 unitrust amount less $5,000 of dividend income deemed distributed first under the ordering statute)
Method 1 - 1.643(a)-3(b)(1)
• No ordering rule
– Within the trustee’s discretion to allocate short-term and long-term gains to the unitrust amount
– If trustee intends to follow a regular practice of treating any capital gains as distributable to the beneficiary to the extent the unitrust amount exceeds the trust’s accounting income, the gains will be included in DNI
• Note: the amount of gains included in DNI cannot be more than the amount of the unitrust amount in excess of the trust accounting income
• The above requirement (amount of gain allocated to DNI cannot exceed the unitrust amount less trust accounting income) does not apply if the unitrust has an ordering rule – Consistency requirement
Method 1 - 1.643(a)-3(e) – Example 12
• No ordering rule – doesn’t include gains in DNI
– Same as Example 11 but neither state law nor trust instrument has an ordering rule
– Trust gives trustee discretion what type of income makes up unitrust amount – Trustee intends to follow a regular practice of treating principal, other than
capital gain, as distributed to A to the extent the unitrust amount exceeds the trust’s ordinary and tax-exempt income.
– Trustee does not include capital gain in DNI so the $80,000 capital gain is taxed to the trust.
– Trustee must consistently follow this treatment of not allocating capital gain to income
Method 1 - 1.643(a)-3(e) – Example 13
• No ordering rule –includes gains in DNI
– Same as Example 11 but neither state law nor trust instrument has an ordering rule
– Trust gives trustee discretion what type of income makes up unitrust amount – Trustee intends to follow a regular practice of treating capital gain as distributed
to A to the extent the unitrust amount exceeds the trust’s ordinary and tax- exempt income.
– Trustee includes $15,000 of capital gain in DNI
– $15,000 of the capital gain is taxed A and the remaining $65,000 of capital gain is taxed to the trust.
– Trustee must consistently follow this treatment of allocating capital gain to income
Method 1 - 1.643(a)-3(b)(1)
• Disadvantage of unitrust
– Most likely will leave trust with some capital gains
– While a unitrust provision enables the fiduciary to shift some taxable income to the beneficiary, it may not enable complete income shifting
– In states with no ordering rule, the decision to include capital gains in DNI must be done consistently.
– Appears that a unitrust format can be used by an existing trust to include gains in DNI
• The preamble to T.D. 9102 states that “in implementing a different method for determining income under a state statute, the trustee may establish a pattern for including or not including capital gains in DNI.”
• Thus, it appears that the trustee can select a new consistent method regardless of the trustee’s prior treatment. This is not available with the other methods of including capital gain in DNI.
Include Capital Gains in DNI
• In addition to those circumstances mentioned in the regulations, capital gains flowing from a partnership or S corporation K-1 are included in DNI.
Crisp v. United States, 34 Fed. Cl. 112 (1995).
– Planning point: the trustee may want to consider investing through a partnership so that capital gains can be distributed and escape the income tax and the
surtax at the trust level
Investment
p/ship Trust
K-1 with gains enters into trust’s taxable income and DNI
DNI with p/ship gains
Investing via a Partnership or LLC
• Capital gain flowing through a partnership or LLC is taxable income to the estate or trust, thereby entering into the calculation of DNI.
• Section 643(a) defines “distributable net income” as “the taxable income of the estate or trust” with certain modifications.
• Thus, the capital gains from the partnership or LLC is taxable income to the estate or trust and ends up in the DNI of the estate or trust.
• Capital gains are excluded from DNI if (1) the gains must be “allocated to corpus” AND (2) the gains must not be “paid, credited or required to be distributed to any beneficiary during the taxable year.” Section 643(a)(3).
Investing via a Partnership or LLC
• If the partnership or LLC makes no distributions during the year, there is nothing to allocate to corpus.
• If the partnership or LLC actually makes a distribution to the estate or trust, as a general rule, under the Uniform Principal and Income Act, distributions from entities are allocated to trust accounting income.
• Thus, the gain from the partnership or LLC is taxable income to the estate or trust and enters into DNI. If no actual distribution is made from the
partnership or LLC to the trust or estate, there is no allocation to corpus as nothing has been distributed. If there is an actual distribution, as a general rule, the UPIA allocates that distribution to trust accounting income, not corpus.
• Thus, the gain that flows through from the partnership or LLC enters into the DNI of the estate or trust and there is no way under Section 643(a) to
Investing via a Partnership or LLC
• Bottom line: the capital gain that flows through a partnership or LLC ends up in DNI and, if the estate or trust makes distributions to its beneficiaries, the gains from the partnership or LLC flow out to the beneficiaries.
• What if instead, the partnership or LLC distributed an asset in-kind to an estate or trust and the trust sold the asset? An in-kind distribution of
property to an estate or trust from a partnership or LLC would be allocated to principal under the UPIA. Any gain on the sale of the asset would be
allocated to corpus under the UPIA and the regular rules for including gains in DNI apply.
Method 2 - 1.643(a)-3(b)(2)
• Allocated to corpus, but treated consistently by the fiduciary on the trust’s books, records and tax returns as part of the distribution to the beneficiary.
• Trustee makes discretionary distribution of principal and follows a regular practice of treating the principal distribution first from any capital gains realized by the trust.
• The trustee must clearly evidence that the capital gains are included in the distribution
– Document on trust’s books and records
– Show inclusion of capital gains on the trust’s tax return
• Key point: this practice must be consistent from year to year
– Capital gains will be included in DNI in each of the future years
– “Consistency” requirement could apply to all capital gains or to a specific asset
Method 2 - 1.643(a)-3(b)(2)
• Trustee could be given discretion to treat principal distributions consisting of capital gains
– Trustee must document that capital gains are included in DNI – Consistency requirement
• Term “consistency” not clearly defined in regulations
• Once employed, future principal distributions deemed to consist of capital gain which is included in DNI
• May prohibit existing trusts that have not treated capital gains as part of the distribution to beneficiaries from using this method
– Examples in regulations make it relatively clear that the establishment of a practice of distributing gains must
commence in the first year in which a distribution of principal occurs
Method 2 - 1.643(a)-3(b)(2)
– Consistency requirement
• The consistency requirement under Method 2 is imposed on “the fiduciary,” not the trust.
• If a successor fiduciary is appointed does that “cleanse” the trust so that the new fiduciary can make a different choice than the
preceding trustee?
• If tax returns for multiple years have been filed, check back tax returns – perhaps the trustee never had capital gains in prior years so a consistency requirement was never established.
• Also, if statute of limitations is still open, the trustee could go back and amend prior year’s returns to establish the desired consistency of treating or not treating discretionary distributions of principal as including capital gains.
• Also, determine whether decanting to a new trust is a viable option to get a “fresh start.” However, the IRS could claim that the new trust is simply a continuation of the old trust.
Method 2 - Regulation 1.643(a)-3(e) – Example 1
• Trust says pay all income to A
• Trust gives trustee discretion to distribute principal to A and to deem it to be made from capital gains realized during the year.
• Trust has $5,000 of dividends and $10,000 of capital gain
• Trustee allocates $10,000 capital gain to principal
• Trustee distributes $5,000 to A (TAI) and $12,000 discretionary distribution of principal
• Trustee does not deem the discretionary distribution of principal as being paid from capital gains
• Gains not included in DNI and are taxed to the trust
• In future years trustee must treat all discretionary distributions of principal as not being made from capital gain. Note the consistency requirement – once the trustee has made a determination not to deem the discretionary distributions of principal as being paid from capital gains, the trustee is locked in to that determination in future years.
Method 2 - 1.643(a)-3(e) – Example 2
• Same as Example 1 except the trustee decides to follow a regular practice of treating discretionary principal distributions as being made first from any capital gains
• Trustee includes $10,000 of capital gain in DNI on the tax return so the
$10,000 capital gain is taxed to A
• In future years the trustee must treat all discretionary principal distributions as made first from capital gains.
Method 2 - 1.643(a)-3(e) – Example 3
• Same as Example 1 except the trustee decides to follow a regular practice of treating discretionary principal distributions as being made first from any capital gains from the sale of certain specified assets or a particular class of investments
• This is a reasonable exercise of the trustee’s discretion
• Must define the specified assets or the particular class of assets
Specific Assets or Particular Class of Investments
• Assume trustee has the power to allocate capital gains to distributions.
• In Year 1 trustee sells XYZ stock, realizes a capital gain and declares that the gain is part of a discretionary distribution.
• Must the trustee consistently treat capital gains as being distributed in the future?
• Under Reg. 1.643(a)-3(e) – Example 3, the sale of XYZ stock could be considered the sale of a “certain specified asset” or a “particular class of investments”. In that case, the consistency requirement will only apply to XYZ stock but not to other capital gains recognized in the future.
Specific Assets or Particular Class of Investments
• Assume the trustee has the power to allocate capital gains to distributions but hasn’t done so for the first 6 years.
• In Year 7, trustee sells ABC stock realizing a capital gain, having never sold any of ABC stock in the past.
• Can the trustee include the gain from the sale of ABC stock in DNI in Year 7?
• Under Reg. 1.643(a)-3(e) – Example 3, the sale of ABC stock could be considered the sale of a “certain specified asset” or a “particular class of investments”. In that case, the consistency requirement will only apply to ABC stock but not to other capital gains recognized in the future.
Specific Assets or Particular Class of Investments
• Trust receives a $10,000 long-term capital gain distribution from a mutual fund which is allocated to principal.
• During the year the trustee makes discretionary distributions totaling
$50,000.
• The $10,000 long-term capital gain could be included in DNI as being from a “particular class of investments,” i.e., the mutual fund.
• It shouldn’t matter than that the trustee also made other distributions - in this case the additional $40,000 of discretionary principal distributions.
Method 3 - 1.643(a)-3(b)(3)
• Allocated to corpus, but 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.
• Regulations do not address whether this method may be used if the
principal distribution is greater than or less than the actual capital gains for the year.
• No consistency requirement (although the examples seem to require
consistency if no distribution is required but the capital gains are utilized to to determine the amount of a distribution).
• Method 3 is useful for older or existing trusts which are silent on whether capital gains can be allocated to income.
Method 3 - 1.643(a)-3(b)(3)
• Two alternatives:
– Actually distribute capital gains to a beneficiary
– Use capital gains to determine amount distributed or required to be distributed to a beneficiary
Method 3 - 1.643(a)-3(b)(3)
• Actually distribute capital gains to a beneficiary
– Trusts with age attainment distribution provisions
– Example: Principal distribution required at stated ages (1/3 at 25, 1/3 at 30 and balance at 35), and asset must be sold to make the distribution. See Reg.
1.643(a)-3(e), Example 9.
– May have limited use.
– Regulation requires a mandatory principal distribution or a situation where the proceeds of a specific asset are distributed to a beneficiary
– What if the trust has sufficient cash to fund the distribution? Does this method still apply to cause gains to be included in DNI?
Method 3 - 1.643(a)-3(b)(3) – Example 9
• Income payable to A.
• Trustee is directed to distribute one-half of the principal to A when A reaches 35 and the balance to A when A reaches 45.
• Trust assets consist entirely of stock in corporation M with a fair market value of $1,000,000 and an adjusted basis of $300,000.
• When A reaches 35, trustee sells one-half of the stock and distributes the sales proceeds to A.
• All of the proceeds, including all capital gains attributable to that sale, are actually distributed to A and therefore all the capital gain is included in DNI.
Method 3 - 1.643(a)-3(b)(3)
• In Example 9 the trustee sells the exact amount of stock to fund the
distribution. Thus, it is easy to trace the distribution of the proceeds from the sale of the stock to the distribution made to the beneficiary.
• What if the trustee had $200,000 in cash on hand? How much of the
$350,000 ($500,000 proceeds less $150,000 allocable share of basis) gain is distributed to the beneficiary? Is there a pro-rata distribution of the cash and capital gain? Cash and the proceeds from the sale of the stock is
fungible and difficult to trace. The regulations do not address this issue.
Method 3 - 1.643(a)-3(e) – Example 7
• Trust termination
• All income payable to A
• When A reaches 35, trust terminates and all principal is distributed to A
• Since all assets of the trust, including capital gain, will actually be
distributed to A upon termination of the trust, all capital gains in the year of termination are included in DNI and taxed to A
Method 3 - 1.643(a)-3(b)(3)
• Use capital gains to determine amount distributed or required to be distributed to a beneficiary
– Trustee makes a discretionary distribution to the beneficiary based on the trust’s realized capital gains. For example, trustee decides that discretionary
distributions will be made to the extent the trust has realized capital gains. The capital gains distributed would be included in DNI.
– See Reg. 1.643(a)-3(e), Example 5
Method 3 - 1.643(a)-3(e) – Example 5
• Distribution based on capital gains
• Facts same as Example 1 except that the trustee decides that discretionary distributions will be made only to the extent the trust has realized capital gains during the year.
• Thus, the discretionary distribution of principal to A is $10,000 rather than
$12,000.
• Since the trustee uses the amount of capital gain realized to determine the amount of the discretionary distribution to A, $10,000 of the capital gain is included in DNI and taxed to A.
• Capital loss netting under Reg. 1.643(a)-3(d) except for gain utilized under Method 3.
Method 3 - 1.643(a)-3(b)(3) – Example 6
• Distribution based on sales proceeds
• Trust assets consist of Blackacre and other property
• Trustee is directed to hold Blackacre for 10 years and then sell it and distribute all the sales proceeds to A
– Although the regulation offers no example in which the trustee uses discretionary authority to distribute the entire proceeds of sale and include capital gains in DNI, the language of the regulation supports a discretionary distribution.
• Since trustee uses the sales proceeds that includes any capital gain to determine the amount required to be distributed to A, any capital gain realized from the sale of Blackacre is included in the trust’s DNI
Including Capital Gains in DNI
• Bottom line
– Best when appropriate discretion is expressly granted in the trust agreement
• Attorneys should consider including such discretionary language in trust instruments going forward
– Alternatively, local law may provide the discretionary powers – If not, consider:
• Power to adjust
• Decanting (if available)
Including Capital Gains in DNI
• Other considerations:
– Trustee’s fiduciary duty to balance competing interests of the beneficiaries
– Spendthrift issues – Asset protection
– Exposure to estate tax
In-Kind Distributions
• If a trust must distribute trust accounting income or a unitrust amount and that distribution is satisfied by a distribution of appreciated property (an in- kind distribution), capital gain is triggered. See Reg. 1.661(a)-2(f)\; Reg.
1.651(a)-2(d).
• In such a case, the capital gain would seem to have been “actually
distributed” to the beneficiary. As such, the capital gain must be included in DNI.
In-Kind Distributions Under §643(e)
• General rule: An estate or trust does not recognize gain or loss on the in- kind distribution of property to a beneficiary. §643(e).
– Caution: gain is triggered at trust level if in satisfaction of a mandatory income distribution. See Reg. 1.661(a)-2(f); Reg. 1.651(a)-2(d).
• The beneficiary takes a carryover basis in the property. §643(e)(1).
• §643(e) allows the fiduciary to determine where the gain will be recognized:
at the entity level or at the beneficiary level.
• Requirement: the trust instrument or local law must allow the trustee to make discretionary distributions of principal and the power to distribute in cash or in-kind, or partly in cash and in-kind
• This may allow the beneficiary to time the recognition of gain to a time when he will not be subject to the 3.8% surtax or have the gain taxed at a lower rate..
In-Kind Distributions Under §643(e)
• If the fiduciary makes an in-kind distribution and makes the Section 643(e) election to recognize gain at the estate or trust level, it would appear that such a gain has been “actually distributed” which would require the gain to be included in DNI.
• There is no discretion involved and no “consistency” requirement.
Grantor Trust
• Gains taxed to grantor or beneficiary to extent trust is a grantor trust due to powers held under §§673-677 or to the extent the trust is a “deemed”
grantor trust under §678.
• Irrevocable trust may be structured as a grantor trust so capital gains are taxed to the grantor
– Structure trust for benefit of non-grantor beneficiaries as a grantor trust
• Beneficiary of irrevocable trust may have withdrawal power so that beneficiary is taxed on some or all of the gains.
– Right to withdraw
– Crummey withdrawal power – 5 x 5 power
Conclusion
• Background
• The Problem – Generally, Gains Are Taxed to the Trust or Estate
• Reg. 1.643(a)-3(b) – Three Ways To Include Gains in DNI
– Method 1 – Method 2 – Method 3
• In-Kind Distribution Under Section 643(e)
• Grantor Trust
• Conclusion
Resources
• The Income Taxation of Trusts and Estates, Soled, Acker, Doyle, Siegel and Weissbart, published by Carolina Academic Press (2019)
• Federal Income Taxation of Estates, Trusts and Beneficiaries, 3rd Edition by Ferguson, Freeland and Ascher (Aspen/CCH)
• 1041 Deskbook (Practitioners Publishing Co)
• Income Taxation of Trusts and Estates, 852-3rd (BNA portfolio – Estate, Gift and Trust series)
• Federal Income Taxation of Decedents, Estates and Trusts, David A. Berek (2013 Edition) (CCH)
• Federal Income Taxation of Trusts and Estates, by Zaritsky and Lane, 3rd Edition (RIA/Thompson/West)
