Partnership interests held in trusts create unique dilemmas for trustees and advisers. When a trust document requires that all income be paid to the beneficiary, this refers to trust accounting income (TAI), not taxable income. Therefore, if the taxable income generated by the partnership exceeds the amount the partnership distributes to its partners (including the trust), the simple trust will often owe income tax. In this situation, the trustee should work closely with the tax adviser to determine how much cash to withhold from the trust’s income beneficiary in order to pay this tax.
Typically, a simple trust will pay income tax only on its net capital gains because of two trust tax concepts:
- Amounts that the trust document “requires to be distributed” are, for tax purposes, deemed to have been distributed to the beneficiary even if the amount actually paid is smaller; and
- Amounts distributed (whether actually or deemed paid) to the beneficiary shift taxable income to the beneficiary only up to a maximum cap called distributable net income (which is basically taxable income other than capital gains).
What some return preparers may not realize, however, is that under Sec. 643(b) the amount required to be distributed is measured by TAI, which may (particularly if the trust owns a partnership) have no correlation whatsoever with the amount of taxable income of the trust. If a tax return preparer does not properly understand and compute the TAI (and thus recognize the situations in which TAI is less than the taxable income), the tax liability may ultimately be borne by the incorrect beneficiaries of the trust.
Trust Accounting Income
Ultimately, a trustee’s duty is to administer the trust impartially, based on what is fair and reasonable for all beneficiaries, including not only the current income beneficiaries but also the remainder beneficiaries. As an oversimplification, if the trust holds only marketable securities, the interest and dividend “income” (net of expenses) is payable to the income beneficiary, but the proceeds (also net of expenses) from the sale and reinvestment of the assets are considered principal and are instead retained for eventual distribution to the remainder beneficiaries.
The determination of whether receipts (or disbursements) are included in (or charged against) income versus principal could conceivably be stipulated in the trust document itself. However, since most trust documents are silent on this issue, the decision is generally determined based upon state statutes. Even if the trust’s terms provide the trustee with a discretionary power of administration (allowing the trustee to exercise discretion in allocating receipts and disbursements between principal and income), most trustees are reluctant to stray too widely from the state statutes governing the trust. Most state statutes will generally adhere to some variation of the 1997 version of the Uniform Principal and Income Act (UPIA). Although each state may use a different numbering convention, the provisions typically follow the original UPIA.
UPIA Section 103(b) directs the trustee to administer the trust “impartially.” Unfortunately, some provisions of the UPIA itself can create inequities between the income and remainder beneficiaries, leaving the trustee unable to be fair and reasonable to all beneficiaries. One particularly difficult situation is the allocation between principal and income of receipts and expenses related to passthrough entities.
Example 1: A testamentary trust (a trust created under the provisions of a decedent’s will) requires the trustee to distribute “all income” (i.e., TAI) to the surviving spouse for her lifetime but does not direct the trustee to distribute principal to the spouse. The trust document does not give guidance to the trustee as to how to allocate receipts between principal and income and does not provide the trustee with a discretionary power of administration. The trust is worth $2 million, including $500,000 of marketable securities (with a total cost basis of $503,000) and a limited partnership interest worth $1.5 million. The securities generate $18,000 of dividend income and the partnership reports the trust’s share of partnership taxable income of $200,000, but the partnership makes no distributions of profits. During the year, the trustee sold some of the securities, generating $100,000 in cash proceeds and a $3,000 capital loss. The trust also incurred $10,000 in expenses, half of which (according to state statutes) are allocated to income.Under the general rule of UPIA Section 401(b), the dividends are allocated to TAI, while the sales proceeds from the assets sold are allocated to principal under UPIA Section 404(2). UPIA Section 401 also directs that monies received from a passthrough entity are allocated to income. However, in this example no cash distributions were received from the partnership that would comprise TAI. Therefore, TAI, which is required to be paid to the spouse for the year, is only $13,000 ($18,000 dividends minus $5,000 expenses allocated to income). Therefore, even if the trustee makes no distributions to the beneficiary at all, the amount required to be distributed is $13,000, and the simple trust income tax return should show a distribution deduction (per Secs. 651 and 643(b)) of only $13,000, not the full taxable income of $205,000. Thus, the allocation of receipts and disbursements and the calculation of taxable income would be as in Exhibit 1.
Therefore, unless the trustee is authorized to (and actually does) distribute principal to the income beneficiary, the net amount taxable at the trust level will be $192,000, with $66,200 of tax due at the trust level, but the trustee will have to use principal cash to pay the tax, even though the sale that generated the principal cash actually caused a capital loss. From a fairness standpoint, the trustee may determine that the $13,000 of income to be distributed to the surviving spouse is insufficient to meet her needs and is not a reasonable rate of return for a $2 million trust. Paying principal to the income beneficiary would increase the distribution deduction (and thus reduce the tax). However, the remainder beneficiaries may not consider the payment of principal to the income beneficiary (even if permissible) fair and reasonable.
Power to Adjust
As mentioned above, the trustee can make a discretionary distribution of principal to the income beneficiary (to increase her cashflow and reduce the tax at the trust level) only if such a distribution is allowed under the trust document. However, even where the payment of principal is not allowed, some trustees can nevertheless increase the distribution based on the power to adjust contained in UPIA Section 104. This provision allows a trustee (who is not himself or herself a beneficiary) to adjust receipts between income and principal if four prerequisites are met:
- The trustee manages and invests the assets as a prudent investor;
- The terms of the trust measure the amount that may (or shall) be distributed to a beneficiary by referring to the trust’s income;
- The trustee determines that he or she is not otherwise able to administer the trust fairly and impartially based on the other rights and powers granted to him or her in the trust document; and
- None of the eight “specifically prohibited situations” listed in UPIA Section 104(c) exist (e.g., causing grantor trust status, estate inclusion, or loss of a marital or charitable deduction).
The motive of UPIA Section 104 is not to grant the trustee the power to increase or decrease the inherent “beneficial enjoyment” of either the income or the remainder beneficiary. Instead, it allows the trustee to adjust between income and principal in order to compensate for investment decisions that may cause the income component of the total portfolio to be either too large or too small (National Conference of Commissioners on Uniform State Laws, “Uniform Principal and Income Act,” Section 104, Comment (1997)). In this example, the trustee may determine that the partnership interest that makes low (or no) distributions of profits creates TAI that is too small. Even if the trustee is not authorized to pay principal to the income beneficiary, the trustee may be able to “adjust” some of the $100,000 of proceeds from the sales of securities from being principal to instead being part of TAI. For example, if the trustee chose to adjust $70,000 from principal to income, the TAI payable to the spouse would increase from $13,000 to $83,000. In this way, the trustee has met the provisions of the UPIA (i.e., treating all beneficiaries fairly) while not distributing principal to the income beneficiary. However, even though this will increase the distribution deduction and therefore reduce the trust’s income tax liability, it may result in the trustee’s not having enough cash available to pay the tax due.
Adjustments Because of Taxes
As shown in Exhibit 2, even after the “power to adjust” (as described at UPIA Section 104) has been used, there may still be net taxable income at the trust level, particularly if the trust owns an interest in one or more passthrough entities. This may force the trustee to reduce the amount payable to the income beneficiary (even below the level the trustee believes to be “fair and reasonable”), in order to assure that the trust will have sufficient cash to pay the taxes owed. Ultimately, this results in a “simultaneous equation” because a decrease in distributions causes more taxable income to remain at the trust level, which means the trustee needs to withhold more distributions, etc.
Example 2: H’s will creates a trust for the benefit of his wife, W, and appoints his oldest son, S, as the trustee. The only assets bequeathed to the trust are several limited partnership interests (the LPs). The trust document requires that “all income” (i.e., TAI) be paid to W annually. Upon W’s death, the trust will terminate and all principal will be distributed to H’s children. In 2008, the trust receives $40,000 in cash distributions from the LPs. For the 2008 tax year, the trust receives Form 1065, U.S. Return of Partnership Income, Schedule K-1s from the LPs, which report $100,000 as the trust’s share of ordinary income. Trustee fees for 2008 are $5,000, which are allocated equally between principal and income under state law.
Under the general UPIA rule, the $40,000 distribution received by the trust during 2008 would be allocated to income. Therefore, net TAI would be $37,500 ($40,000 – $2,500), which is required under the trust instrument to be distributed to W. After that distribution, the trust’s taxable income would be $57,500 ($100,000 income minus $5,000 of expenses and a $37,500 distribution), creating a tax liability of approximately $19,000. However, a $37,500 distribution to W would deplete the cash needed to pay the tax liability, creating a dilemma for the trustee. (See Exhibit 3.)
Relief from this dilemma comes from UPIA Sections 505 and 506. UPIA Section 505(c) directs the trustee to pay income tax on income from a passthrough entity “proportionately” from TAI and principal. The portion paid from income is based on the distributions received from the entity that are allocable to income, while the portion paid from principal is based on the total of two items: the receipts allocated to principal plus the undistributed income of the partnership. In the example above, since 40% of the income was distributed and allocated to income, 40% of the tax should be paid from income and 60% from principal. Furthermore, UPIA Section 506(a)(3) permits the trustee to “make adjustments between principal and income” to offset the shifting of economic or tax benefits between income beneficiaries and remainder beneficiaries that arise because of the ownership of a passthrough entity. This provision allows the trustee to adjust the amount to be allocated to income, regardless of whether the trustee can exercise a power to adjust under UPIA Section 104(c).
In this example, the trustee’s tax adviser should calculate the simultaneous equation and recommend that the trustee allocate only $6,000 of the $40,000 partnership distribution for 2008 to trust accounting income. By doing so, the TAI will be only $3,500 ($6,000 less $2,500 of trustee’s fees). Taxable income will now be $91,500 ($100,000 less $5,000 trustee’s fees and a $3,500 income distribution deduction). The resulting tax liability to the trust will be just over $31,000. After payment of the trustee’s fees and the income distribution to W, the trustee will have approximately $31,500 cash remaining from the $40,000 partnership distribution in order to pay the $31,000 of tax liability. (See Exhibit 4.)
Ownership of passthrough entities held in trusts can create complex issues for trustees and their tax advisers. In those cases in which the trust instrument is silent and no discretionary power of administration exists, trustees and their advisers need to be knowledgeable of how partnership activity (including both taxable income and distributions received) is affected by the trust administration statutes of the state of situs of the trust. Trustees in the 43 states that follow the 1997 UPIA may be able to use the power to adjust in those situations in which the provisions of the trust accounting rules would otherwise create inequities between the income and remainder beneficiaries.
Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or email@example.com