The impact of tax reform on DNI, and a reason to revisit trust accounting income

By Jeremy Mertens, CPA, J.D., Grand Rapids, Mich.

Editor: Kevin D. Anderson, CPA, J.D.

Trust accounting requires a trustee to prepare an annual report of the cash receipts and disbursements made throughout the year. In preparing the trust, or fiduciary, accounting, the trustee is guided by the terms of the document as established by the settlor upon the trust's creation. The settlor may have delineated how the trustee allocates receipts and disbursements between income and principal or may have granted the trustee broad discretionary powers to be the ultimate decision-maker concerning those allocations (Uniform Principal and Income Act (UPAIA), §§103(a)(1) and 103(a)(2)). The trust document also might be silent when it comes to allocations for accounting purposes. This results in the trust's defaulting to the guidance established in accordance with the governing law where the trust is administered (UPAIA, §103(a)(3)). Regardless of the approach provided by the settlor, it is important to note the role trust accounting income plays when preparing the annual income tax return for the trust, a role that has become more prominent since the enactment of the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97.

When preparing the income tax return for a trust, the preparer should be provided all relevant information (e.g., Forms 1099, Schedules K-1, expenses, distributions), which includes the trustee's annual accounting. For a simple trust, the terms of the document must state that "all of its income is required to be distributed currently," and the trust document cannot allow for any amount to "be paid, permanently set aside, or used" for charitable purposes (Sec. 651; Regs. Sec. 1.651(a)-1). If the trust document fulfills these requirements and does not make any distributions other than current income, then it is entitled to a deduction from taxable income equal to the amount of income that is required to be distributed annually (Sec. 651). The distribution deduction is limited to the lesser of trust accounting income required to be distributed and distributable net income (DNI) (Sec. 651(b)). In general, DNI is calculated by taking the taxable income of the trust and modifying it as follows: Increase taxable income for tax-exempt interest received by the trust; do not reduce taxable income for the distribution deduction or the trust's personal exemption; exclude capital gains to the extent they are allocated to corpus; exclude extraordinary dividends and stock dividends allocated to corpus; and in the case of foreign trusts, include foreign income (Sec. 643(a)).

Unlike a simple trust, a complex trust is not required to distribute all its accounting income currently; rather, the accounting income of a complex trust may be accumulated (Sec. 661), distributed to charity (Regs. Sec. 1.661(b)-2), or both. A complex trust can also make distributions from corpus (Sec. 661). A complex trust is permitted a deduction, when computing taxable income, equal to the "sum of any amount of income for such taxable year required to be distributed currently (including any amount required to be distributed which may be paid out of income or corpus to the extent such amount is paid out of income for such taxable year); and any other amounts properly paid or credited or required to be distributed for such taxable year" (Sec. 661(a)). The deduction received by a complex trust for distributions made during the year cannot exceed the trust's DNI (Sec. 661(a)).

"[T]he term 'income,' when not preceded by the words 'taxable,' 'distributable net,' 'undistributed net,' or 'gross,' means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law" (Sec. 643(b)). Based upon the definition of income in Sec. 643(b), the income required to be distributed annually from a simple trust is trust accounting income and not taxable income as determined when preparing the income tax return.

Among the many changes the TCJA made to the Code, certain changes affecting individual taxpayers are also important in preparing fiduciary income tax returns. Sec. 641(b) states that, except as otherwise provided, "taxable income of an estate or trust shall be computed in the same manner as in the case of an individual." Two major changes affecting individual income taxation were the $10,000 limitation placed on state and local tax deductions (Sec. 164(b)(6)(B)) and the elimination of miscellaneous itemized deductions subject to the 2% floor of adjusted gross income (AGI) (Sec. 67(g)). At first glance, the effect of these changes and their impact on a trust accounting analysis may seem insignificant; however, upon closer examination, one can see that these changes can greatly influence the spread among DNI, trust accounting income, and the distribution deductions permitted under Secs. 651 and 661.

To better understand the interplay of these changes as they affect DNI and trust accounting income, one needs to look no further than Form 1041, U.S. Income Tax Return for Estates and Trusts, and its instructions. Calculating DNI on Schedule B, Income Distribution Deduction, of Form 1041 begins with the adjusted total income calculated on page 1, line 17 (see "Instructions for Form 1041 and Schedules A, B, G, J, and K-1"; Schedule B, line 1, "Adjusted Total Income"). (For tax years beginning after Dec. 31, 2017, through Dec. 31, 2025, Schedule B, line 1, is calculated by taking adjusted total income reported on page 1, line 17, and adding back any corresponding Sec. 199A deduction reported on Form 1041, page 1, line 15a (Regs. Sec. 1.199A-6(d)(3)(ii)).) With this as the starting point for calculating DNI, the state and local tax deduction (and the corresponding limitation imposed under Sec. 164(b)(6)(B)), as reported on page 1, line 11, has already been factored into the equation. Further, the elimination of miscellaneous itemized deductions subject to the 2%-of-AGI limitation under Sec. 67(g) means that a deduction that once factored into the calculation of DNI no longer applies.

Generally, because of these two changes, taxpayers should anticipate DNI for simple trusts will be higher in tax years beginning after Dec. 31, 2017, than in previous years. With an increase in DNI comes an increased likelihood that taxable income for simple trusts will remain at the trust level. Once taxable income exceeds $12,750 (for 2019), any additional ordinary income is subject to tax at the highest marginal rate of 37%. With the role that required distributions of trust accounting income play in determining the income distribution deduction, trustees should take this opportunity to see if any mitigating steps can be taken to shift income from trusts taxed at the highest rates to beneficiaries that are potentially in a lower income tax bracket.

When the time comes to prepare the annual trust accounting, trustees should review the trust document to ensure the accounting is being prepared in accordance with its terms. If the settlor specifically stated in the document how receipts and disbursements are to be allocated between income and principal, then the trustee is bound by the terms of the document when preparing the trust accounting. On the other hand, if the trust document is silent regarding those allocations, the trustee will want to make sure that the governing law of the jurisdiction in which the trust is administered is followed for purposes of preparing the accounting. However, trustees who have been granted discretionary power to allocate receipts and disbursements should pause to see if the allocation makes sense from a fiduciary and an income tax standpoint.

For a simple trust, it might make sense from an income tax perspective to prepare trust accounting income in a manner that parallels the DNI calculation. By doing so, the trustee can generate the largest income distribution deduction taken at the trust level. This should prevent the unnecessary taxation of income at ordinary rates.

For purposes of a complex trust, discretionary allocations or receipts and disbursement will affect Tier 1 (income) beneficiaries and Tier 2 (principal) beneficiaries. Depending upon the requirements to distribute income, the trustee could follow a similar methodology as that discussed for simple trusts. By doing so, the trustee, when making distributions to Tier 1 beneficiaries, could provide the largest income distribution deduction available without needing to make Tier 2 distributions (which would otherwise be needed to remove any remaining income taxed at ordinary rates). These opportunities should be available when the trust document provides the trustee with discretionary allocations of receipts and disbursements among trust income and principal. The trust document should be reviewed annually to determine to what extent the trustee can make these decisions.

The TCJA made many sweeping changes to the Internal Revenue Code. Trust accounting plays an integral role in the preparation of Form 1041. Whether preparing the return for a simple trust or a complex trust, the preparer needs to know accounting income to properly allocate certain items of taxable income among the beneficiaries. With the expectation of increased DNI in future years, trustees should take this time to review the terms of the trust document — specifically, the section related to trust accounting — with an eye toward mitigating any potential income tax implications.

EditorNotes

Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.

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