Final Regs. Issued on Ordering Rules for Estates and Trusts

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Regulations

The IRS issued final regulations (T.D. 9582) requiring that a provision in a trust, will, or local law that specifically indicates the source out of which amounts are to be paid, permanently set aside, or used for a charitable purpose must have an independent economic effect aside from income tax consequences if the allocation is to be respected for federal tax purposes. If the applicable provision does not have economic effect independent of income tax consequences, income distributed for a purpose specified in Sec. 642(c) will consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes. T.D. 9582 amends Regs. Secs. 1.642(c)-3(b)(2) and 1.643(a)-5(b).

The primary target of the final regulations is charitable lead trusts (CLTs, trusts that first pay amounts to charitable beneficiaries and later to noncharitable beneficiaries) and the ordering rules generally contained in CLTs’ governing instruments, which often provide for the following ordering of classes of annuity or unitrust payments, until the class has been exhausted: (1) ordinary income, (2) capital gain, (3) other income (including tax-exempt income), and (4) corpus.

Because a CLT is a taxable entity, any amount of income not paid to charity through the annuity or unitrust payment is taxable to the CLT. Thus, the ordering rules ensure that taxable income is exhausted through the payment of the annuity or unitrust interest before the use of nontaxable sources such as tax-exempt income and corpus. The IRS has consistently taken the position in letter rulings that this method of allocation does not have economic effect.

In the preamble, the IRS addressed the written comments it received on the proposed regulations, including an objection that the regulations are contrary to the clear language of Sec. 642(c) and Sec. 643(a)(5) and their regulations. According to the IRS, subchapter J of the Code, which governs the taxation of estates, trusts, beneficiaries, and decedents, generally mandates that the tax character of distributions to beneficiaries must consist of a pro rata allocation of all types of a trust’s income.