Estates, Trusts & Gifts
With more assets held in trust and higher marginal tax rates, many clients and advisers are now considering distributions from trusts to beneficiaries as a way to shift the tax burden to individuals in lower tax brackets. However, under the traditional definition of fiduciary accounting income (FAI), capital gains are typically excluded from distributable net income (DNI) and, thus, are taxed at the trust level.
The implementation of the Uniform Principal and Income Act of 1997 (UPAIA) and the 2004 revisions to the regulations under Sec. 643 have provided fiduciaries with some flexibility in making distributions of capital gains to beneficiaries. Tax advisers should understand the options available under state law, including the "power to adjust" and "unitrust" provisions, and how those provisions intersect with Regs. Sec. 1.643(a)-3. Additionally, advisers should consider the grantor trust rules and how they may provide further options for income shifting.
FAI, also referred to as trust accounting income, is determined by the governing instrument and applicable local law. Although it is not a tax concept, FAI is important in determining whether the fiduciary or beneficiaries pay tax on the trust's income. When the Internal Revenue Code refers to "income," the reference is to the definition of FAI in the governing instrument and applicable local law (Sec. 643(b)).
If the governing instrument is silent as to the treatment of capital gains for FAI purposes, the fiduciary should look to applicable local law. Currently, 46 states and the District of Columbia have adopted some form of the 1997 UPAIA (see RIA Checkpoint, "List of States Following One of the Revised Uniform Principal and Income Acts," Table T309). Three states (Georgia, Illinois, and Louisiana) currently operate under the 1962 UPAIA. Rhode Island has not adopted any form of the UPAIA. The UPAIA typically allocates money or property received from the sale, exchange, or liquidation of an asset to principal (UPAIA §404). For fiduciary accounting purposes, this means that capital gains are generally excluded from income absent another exception.
However, the UPAIA was adopted in part to update the current income and principal rules to reflect the concept of total return investing, which includes the gain or loss that the asset realizes. Total return "encourages investors to seek the highest overall return (given a certain risk tolerance and within the bounds of prudent investing), without being needlessly hampered by how that return is created" (Lee, Implementing Total Return Trusts , p. 4 (2003)). For trusts with a payout to a current beneficiary based on income, a fiduciary relying on total return investing (particularly in the current low-yield environment) may not generate sufficient cash from sources typically considered income, such as interest and dividends, thus inadvertently reducing the payout due to the income beneficiary.
Example 1: A Trust is a marital trust required to distribute all income to the surviving spouse, B , during his life, with the remainder to the decedent's children. The governing instrument is silent regarding treatment of capital gains, but the governing state has adopted the 1997 UPAIA. The trustee invests for total return with a 70/30 allocation between equities and fixed income. In 2014, the trust has $10,000 of dividend income and $25,000 of realized long-term capital gain income. FAI is $10,000, which is the total amount the fiduciary should distribute to B for 2014. The trust receives an income distribution deduction of $10,000, and the remaining $25,000 of capital gain income is taxed to the trust since capital gains are generally excluded from DNI and are unavailable for distribution to any beneficiary (Regs. Sec. 1.643(a)-3(a)).
Given that the top marginal tax rate of 39.6% and the 3.8% net investment income tax apply to estates and trusts with taxable income in excess of only $12,150 in 2014 (not to mention state income taxes), the tax impact of retaining capital gains in a trust can be severe. In Example 1, $12,850 of long-term capital gains will be subject to a total federal tax rate of 23.8% (20% top marginal long-term capital gains rate plus the 3.8% net investment income tax). If the beneficiary is in a lower tax bracket and not subject to the 3.8% net investment income tax, what options does a fiduciary have to minimize tax on undistributed capital gains?
Generally, capital gains are excluded from DNI to the extent they are allocated to corpus and are not paid, credited, or required to be distributed to any beneficiary during the tax year (Sec. 643(a)(3)). However, Regs. Sec. 1.643(a)-3(b) allows capital gains to be included in DNI to the extent authorized by the governing instrument and local law or pursuant to a reasonable and impartial exercise of discretion by the fiduciary if one of three exceptions applies.
Exception 1: Allocated to Income
Capital gains actually allocated to income per the governing instrument or a reasonable and impartial exercise of discretion by the fiduciary may be included in DNI (Regs. Sec. 1.643(a)-3(b)(1)). In this exception, either through the governing instrument or through a power provided under state law, capital gains are allocated to FAI and, thus, are available for distribution to a beneficiary. Clearly, if the governing instrument allows for capital gains to be allocated to income, then the fiduciary has the power to do so, but what if this is an older document? What options are available to the fiduciary?
Power to adjust: Section 104 of the UPAIA provides the fiduciary with the "power to adjust" between income and principal to ensure a fair result for all beneficiaries. For states that have adopted it, a fiduciary may use a power to adjust if the fiduciary invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed by referring to the trust's income, and the trustee exercises the power to adjust impartially and based on what is fair and reasonable to all beneficiaries.
In Example 1, the trustee might have originally allocated the portfolio 20% to equities and 80% to fixed income. However, the trustee determines that a 70/30 equity/fixed-income portfolio allocation is more in line with the trust's investment objectives and the prudent investor rules. This results in less FAI, which negatively affects B . Under the power to adjust granted by the UPAIA, the trustee of A Trust may transfer a portion of the capital gain receipts from principal to income, to the extent he or she impartially determines it is necessary to ensure fairness among B and the children. (This example is adapted from Example (1) of the comments to UPAIA §104.) The trustee reallocates all or a portion of the $25,000 of capital gains to income, and once they are included in income, the capital gains would be required to be distributed to B under the terms of the trust agreement.
However, the tax treatment of this adjustment is unclear. Citing the numerous potential variations in circumstances and applicable state law, the IRS has declined to include any examples illustrating the tax treatment of including capital gains in DNI pursuant to a power of adjustment (preamble to T.D. 9102). Additionally, the IRS noted that it agrees "the power does not have to be exercised consistently, as long as it is exercised reasonably and impartially." This comment and the lack of other guidance in the examples suggest that consistent treatment is not required when exercising a power to adjust.
For trusts that do not have discretionary power to distribute principal, the trustee should generally be able to rely on the power to adjust to shift capital gains to income and include them in DNI. However, taking another look at the A Trust example, if the trust provides the trustee discretion to make distributions to B for health, maintenance, and support, then the power to adjust might be exercised independently of realized capital gains. This would suggest that the discretionary power to adjust has no effect on the amount of the distribution. In this case, such a power, similar to a unitrust, will be respected for tax purposes only to the extent the discretionary power is exercised consistently.
Given the uncertainty in tax treatment and the fact that the power to adjust fundamentally alters the amounts allocated to each class of beneficiaries, the exercise of a power to adjust may or may not provide a trustee with the desired tax result. Fiduciaries looking to use a power to adjust to include capital gains in DNI should consider several issues, including, most importantly, whether it makes economic sense, applicable state law, whether the practice must be applied consistently, and the lack of IRS guidance. Depending on the amount involved, a trustee may wish to seek a private letter ruling.
Unitrust provision: An alternative to the power to adjust is the use of a state unitrust statute. While the IRS declined to provide any examples illustrating the power to adjust, it did provide several examples of the application of a unitrust statute. Unitrusts are not addressed by the UPAIA but exist under state law. However, they generally allow a fiduciary to calculate the trust's income as a percentage of the trust's assets as of either the beginning of the year or averaged over some period. A unitrust provision is consistent with total return investing and can ease the administrative burden on a client, since calculating a percentage of trust assets is generally easier than calculating FAI.
Example 2: The facts are the same as in Example 1, except that the state law governing A Trust allows for a conversion to a unitrust. The trustee relies on state law and elects to convert to a 4% unitrust based on the trust's value as of the beginning of the year. Assuming A Trust is worth $500,000 at the beginning of the year, the trust's income equals $20,000 ($500,000 × 4%). B is to receive the income from the trust, which, following the conversion to a unitrust, is now $20,000 rather than the previously calculated $10,000.
Treatment for tax purposes depends on whether the governing instrument or the state's unitrust provision has an ordering rule for the character of the unitrust amount. If the state provides for the order from which the unitrust should first be considered paid (typically, from the highest-taxed income first, followed by a return of principal, similar to the federal tax rules for a charitable remainder trust), then B will receive a distribution of $20,000, consisting of $10,000 of dividend income and $10,000 of long-term capital gain income (see Regs. Sec. 1.643(a)-3(e), Example (11)). If neither the state statute nor the governing instrument provides for an ordering rule but, rather, leaves that determination to the trustee's discretion, then capital gains can be distributed to the beneficiary, assuming the trustee follows a consistent and regular practice of including capital gains in the unitrust distribution to the extent the unitrust exceeds ordinary and tax-exempt income (id., Example (13)).
The major disadvantage of this approach is that A Trust still has taxable capital gain income subject to the top marginal rate and net investment income tax. While it enables the fiduciary to shift some taxable income to the beneficiary, a unitrust provision may not enable complete income shifting, and in states with no ordering rule, the decision to include capital gains in DNI must be exercised consistently every year. However, there is some concern with the other options as to whether the fiduciary can adopt a consistent practice for an existing trust. The preamble to T.D. 9102 notes 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." This ability to select a new consistent method regardless of the trustee's prior treatment is a major benefit of adopting a unitrust over alternative options.
Exception No. 2: Allocated to Corpus but Consistently Treated as Part of a Distribution
Capital gains 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 may be included in DNI (Regs. Sec. 1.643(a)-3(b)(2)). In the A Trust example, the trustee has discretionary power to distribute principal to B for health, maintenance, and support. After calculating FAI of $10,000 per Example 1, the trustee distributes $10,000 of income plus, at his or her discretion, an additional $25,000 of principal to B . Assuming the trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains realized by A Trust during the year, the trustee can treat the $25,000 principal distribution as consisting of the capital gains and include it in DNI (see Regs. Sec. 1.643(a)-3(e), Example (2)). However, the trustee must continue to treat principal distributions as coming from realized capital gains for all future years.
The consistent practice is adopted during the trust's initial tax year (id., Example (1)). For new trusts, this is not an issue, since the capital gains could be included in DNI under this exception, with the limitation that the fiduciary must continue to do so going forward. (Given the uncertainty of future tax rates for both the trust and beneficiaries, this decision should not be taken lightly.) However, will older trusts be allowed to adopt a new consistent practice, particularly following new tax legislation? A commentator on the IRS's proposed net investment income tax regulations asked this question, and the IRS indicated that the final net investment income tax regulations do not allow a fiduciary to adopt a new consistent practice going forward (preamble to T.D. 9644). Existing trusts for which the statute of limitation has expired on prior tax returns will likely be unable to adopt a new methodology despite the subsequent creation of tax rules that were not contemplated when the initial tax return was prepared.
Exception No. 3: Allocated to Corpus but Actually Distributed
Capital gains may also be included in DNI when they are allocated to corpus but actually distributed to the beneficiary or used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary (Regs. Sec. 1.643(a)-3(b)(3)). A fiduciary could distribute capital gains to a beneficiary when relying on this regulation in a couple of different scenarios.
First, the trust can actually distribute the capital gains to the beneficiary. This exception is valuable in situations such as an age-attainment trust, where specific proportions of the trust are distributed at certain ages of a beneficiary. For example, a trust whose governing instrument provides for distribution of one-half of the principal at age 35 with the remainder distributed at age 45 sells one-half of its assets and distributes the proceeds to the beneficiary at age 35. All or a portion of the capital gain distributed to the beneficiary is included in DNI since it is actually distributed (Regs. Sec. 1.643(a)-3(e), Examples (9) and (10)).
This approach has limited utility, as the regulation examples focus solely on mandatory principal distributions and situations when the proceeds of a specific asset are to be distributed to a beneficiary. The IRS has noted that in this circumstance, "the inclusion of capital gains in [DNI] applies only where there is a distribution required by the terms of the governing instrument upon the happening of a specified event" (Rev. Rul. 68-392). Furthermore, the exception in the regulation does not seem to apply when the trust has sufficient cash to fund its required principal distribution.
Second, the trust can use the amount of capital gains in determining the amount distributed to the beneficiary. In Example 1, the trustee could elect to make discretionary distributions to the beneficiary based on the trust's realized capital gains. If the trustee of A Trust decides that discretionary distributions will be made to the extent the trust has realized capital gains, then the trustee would distribute $35,000 to B and include the full $25,000 of capital gains in DNI (see Regs. Sec. 1.643(a)-3(e), Example (5)). However, the IRS commentary on the regulations (preamble to T.D. 9102) notes that it is rare for a trust to consider recognized capital gains in determining the amount to be distributed, suggesting that Example (5) of the regulations has limited applicability.
Typically, the amount distributable to the beneficiary is determined without regard to the amount of capital gains realized during the year. Furthermore, money is fungible, and it may be difficult to determine the source of the funds actually distributed to the beneficiary. For trusts with discretionary power to distribute principal, unless the trustee consistently uses realized capital gains in determining the amount distributable to the beneficiary, it is hard to see how the third exception differs from the other two exceptions in requiring a consistent methodology adopted in the first year of the trust. The regulations do not specifically state that consistency is required; however, the key seems to hinge on whether the trustee has discretion over allocating capital gains to DNI. Any discretionary power to include capital gains in DNI seems to require a consistent exercise.
Another consideration when applying exception No. 3 is the ordering rule for capital losses. Generally, any capital losses will first be netted against capital gains at the trust level (Regs. Sec. 1.643(a)-3(d)). Any net remaining capital gains are available for inclusion in DNI. However, netting does not apply when capital gains are distributed under the third exception; rather, the distributed capital gains are taxed to the beneficiary prior to netting. Trusts with capital losses must consider this rule when planning capital gain distributions.
Perhaps the regulations are not even necessary if the trust or part of the trust is treated as a grantor trust. In the case of a whole or partial grantor trust, all income, deductions, and credits including capital gains attributable to the grantor portion of the trust are taxed to the grantor. For example, in the case of the age-attainment trust described above, assume instead that the beneficiary does not withdraw his one-half principal distribution at age 35. Under Sec. 678(a), the beneficiary has the power to vest the corpus and income of one-half of the trust in himself, so the beneficiary is treated as the owner of one-half of the trust. The trustee would file a partial grantor trust tax return including one-half of the income and one-half of realized capital gains on a grantor information letter to the beneficiary and prepare Form 1041, U.S. Income Tax Return for Estates and Trusts , under the normal subchapter J rules for the remaining one-half of the trust. If distributions are made from the trust, then it is possible that the beneficiary would receive both a grantor information letter and a Schedule K-1.
Trusts with "Crummey" powers or "5 and 5" powers are also subject to Sec. 678(a), resulting in partial grantor trusts. A Crummey power is a power held by the trust beneficiary to vest a portion of the principal for a specified period of time, typically 30 to 60 days. During the withdrawal period, the beneficiary is treated as owner of the portion of the trust over which he or she has the right of withdrawal, plus any related income and realized capital gains (Letter Ruling 8521060).
Under a "5 and 5" power, the beneficiary has the right to withdraw up to the greater of $5,000 or 5% of the trust assets each year. The IRS has ruled that the beneficiary will be treated as the owner under Sec. 678(a)(1), until the power is exercised, released, or lapses, over the portion of the trust subject to the withdrawal power. If the withdrawal power is not exercised, the beneficiary is treated as if he or she released a power to withdraw and will be treated as the owner under Sec. 678(a)(2). Each year of an unexercised power will result in the beneficiary's owning an increasing percentage of the trust's corpus (Letter Ruling 9541029). While this section can produce unintended tax results, it can also facilitate shifting capital gains to a beneficiary in a lower tax bracket.
Obviously, the application of the grantor trust rules is specific to the governing instrument and trust history. However, these rules are often overlooked and can often solve the issue of capital gains taxed at the fiduciary level. Under Sec. 678(b), any other grantor trust power trumps grantor treatment under Sec. 678(a). For example, if a trust were grantor with respect to the settlor because he or she possessed a power of substitution under Sec. 675, then the trust would be a grantor trust with respect to the settlor rather than beneficiaries holding a Crummey power.
Although this item focuses on minimizing income tax, there are numerous nontax issues to consider, such as spendthrift protection, estate inclusion, asset protection, and balancing the competing interests of beneficiaries. While forcing out distributions or grantor trust status may produce the desired income tax result, it could lead to unnecessary estate taxes or subject assets to the claims of creditors. Additionally, the many limitations of the regulations have been noted above. If the regulations do not provide the fiduciary sufficient flexibility to distribute capital gains from an existing trust, it is appropriate to consider whether a trust amendment or decanting could be used to add the necessary administrative language to the governing instrument. Lastly, for newly drafted governing instruments, it is appropriate to consider whether the document will provide the fiduciary the flexibility needed to distribute capital gains and minimize income tax.
The author gives special thanks to Damon Rose, director of Wealth Management Tax Services at PricewaterhouseCoopers LLP, for his assistance.
Anthony Bakale is with Cohen & Co. Ltd., Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.