Recently, The Tax Adviser published a very timely and informative item on trusts owning partnership interests (Bazley and Hills, “Trusts Owning Partnership Interests,” Tax Clinic, 40 The Tax Adviser 577 (September 2009)). In it, the authors discuss a special problem facing trustees whose principal or sole asset is a partnership that does not distribute all its taxable income. The problem arises because partnership distributions not in liquidation are “trust income” payable to the income beneficiary. Yet if the trustee pays the income beneficiary the full amount of the partnership distribution, the trust may not have sufficient cash to pay the trust’s own tax liability. The authors looked to Sections 505 and 506 of the Uniform Principal and Income Act (UPIA) to analyze solugrotions to the problem. This item follows up on that September item to examine how recent revisions to Section 505 of UPIA clarify how that problem should be handled. The revised Section 505 has so far been adopted in only 15 states, but practitioners should expect that number to grow.
Illustration of the Problem
In the September item, the authors provide an example to illustrate a trust that receives $40,000 from a partnership that is designated as trust income. The trust also receives a Schedule K-1 from the partnership reflecting $100,000 of taxable income. The partnership is the trust’s only asset. The trust also incurs $5,000 of administrative costs, which are allocated half to income and half to principal. After deducting $2,500 of administrative expenses from the $40,000 partnership distribution, the trustee has $37,500 of trust income to pay the beneficiary. After deducting a $37,500 payment to the beneficiary ($40,000 – $2,500 = $37,500), the trust has an income tax of approximately $19,000 (($100,000 – $5,000 – $37,500) × 33% = $19,000, assuming the trust is in the 33% tax bracket). However, the trust will have no cash to pay its tax if it pays the beneficiary $37,500.
To solve the problem, the authors look to Section 505(c) of UPIA, which, they say, “directs the trustee to pay the income tax on income from a passthrough entity ‘proportionately’ from income and principal.” Based on that, they allocate 40% of the trust’s tax to income and 60% to principal because 40% of the partnership’s income was distributed and allocated to trust income. When that does not solve the problem because the trust still has insufficient cash to pay its tax, they turn to Section 506 of UPIA, which gives the trustee a special power to adjust for income taxes caused by its ownership of an interest in a passthrough entity. They exercise this special tax power to adjust by performing a simultaneous equation and concluding that they should pay the beneficiary $3,500 in order to leave the trustee enough cash to pay its taxes.
Revised Section 505
However, recent amendments to UPIA Section 505(c) (rev. July 2008) clarify its application. It no longer requires the taxes to be paid proportionately if the distribution from the entity is allocated only to income. Amended Section 505(c) and the comments require the trustee to allocate the taxes on its share of the partnership’s taxable income entirely to income if the partnership distribution is entirely income, as it was in the example. In addition, the comments to UPIA Section 505 provide a formula for calculating the required distribution so that the trustee reserves exactly enough cash from the partnership distribution to pay its taxes on undistributed partnership taxable income.
The formula below is modified to take into account the fact that the trustee also incurs administrative expenses with no other source except the partnership distribution from which to pay them. Although this problem is not caused by the partnership’s failure to distribute all its taxable income, it does present a cashflow problem that the trustee needs to solve. In cases like this, the trustee may want to apply his or her judgment and modify the formula.
Under amended UPIA Section 505(c), the trustee in the example should determine the amount payable to the income beneficiary as follows:
Thus, the trustee would pay the beneficiary $9,179 instead of the $3,500 as illustrated in the article. This provides the trustee enough income cash after paying the beneficiary and the administrative costs allocable to income to pay the taxes on its share of the entity’s taxable income as follows:
Administrative expenses - (5,000)
Distribution deduction - (9,179)
Trust’s taxable income -$ 85,821)
Trust’s tax at 33% - $ 28,321)
Less allocated administrative expenses - (2,500)
Less payment to beneficiary - (9,179)
Cash remaining to pay tax - $ 28,321)
The treatment in the amended UPIA Section 505(c) and related comments is mandatory. It solves the trustee’s need to pay all income to the income beneficiary and at the same time to pay its own taxes on income from the passthrough entity, without relying on the special power in Section 506. It does not, however, solve the cash shortfall caused by the need to pay the $2,500 of administrative costs allocable to principal. The trustee may not rely on Section 506 to solve that problem because it was not caused by the partnership’s failure to distribute all its taxable income or other tax-related events. However, the trustee may rely on Section 506 to reimburse the principal beneficiary to the extent the income beneficiary benefited from deducting the full $5,000 of administrative expenses despite paying only half of them.
Alternatively, if permitted by the trust agreement or state law, the trustee may decide to allocate all $5,000 of the administrative expenses entirely to income, given that all receipts generated by the trust are income. In that case, the formula should be modified to show only $35,000 of income cash available, and the income beneficiary would be entitled to only $5,447 of trust income [($40,000 – $5,000 – [($100,000 – $5,000) × 33%]) ÷ 0.67 = $5,447].
In sum, readers should be aware that the amended version of UPIA Section 505(c) and the comments give detailed guidance on the proper way to allocate taxes between income and principal on the trust’s share of taxable income from a passthrough entity. Once that is done, Section 506 still leaves room for the trustee’s judgment to remedy inequities caused by mandatory tax allocations.
Carol Cantrell chairs the Section 67(e) Task Force of the AICPA Trust, Estate & Gift Tax Technical Resource Panel. Gordon Spoor chairs the AICPA Trust, Estate & Gift Tax Technical Resource Panel. They are co-authors of the Fiduciary Accounting Answer Book (CCH 2009).
David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
For additional information about these items, contact Mike Dell at (202) 327-8788 or firstname.lastname@example.org.