Allocating Capital Gains to Distributable Net Income in...
Transcript of Allocating Capital Gains to Distributable Net Income in...
WHO TO CONTACT DURING THE LIVE EVENT
For Additional Registrations:
-Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10)
For Assistance During the Live Program:
-On the web, use the chat box at the bottom left of the screen
If you get disconnected during the program, you can simply log in using your original instructions and PIN.
IMPORTANT INFORMATION FOR THE LIVE PROGRAM
This program is approved for 2 CPE credit hours. To earn credit you must:
• Participate in the program on your own computer connection (no sharing) – if you need to register
additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford
accepts American Express, Visa, MasterCard, Discover.
• Listen on-line via your computer speakers.
• Respond to five prompts during the program plus a single verification code. You will have to write
down only the final verification code on the attestation form, which will be emailed to registered
attendees.
• To earn full credit, you must remain connected for the entire program.
Allocating Capital Gains to Distributable Net Income
in Estates and Trusts: Achieving Optimal Tax Treatment
THURSDAY, FEBRUARY 16, 2017, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
Tips for Optimal Quality
Sound Quality
When listening via your computer speakers, please note that the quality
of your sound will vary depending on the speed and quality of your internet
connection.
If the sound quality is not satisfactory, please e-mail [email protected]
immediately so we can address the problem.
FOR LIVE PROGRAM ONLY
Feb. 16, 2017
Allocating Capital Gains to Distributable Net Income in Estates and Trusts
Jeremiah W. Doyle, IV, Senior Wealth Strategist
BNY Mellon Wealth Management, Boston
Jacqueline Patterson, Partner
Buchanan & Patterson, Los Angeles
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
5
Including Gains in Distributable Net Income
Jeremiah W. Doyle IV, Esq.
Senior Vice President
BNY Mellon Wealth Management
One Boston Place
Boston, MA
February, 2017
Jacqueline A. Patterson, Esq.
Buchanan & Patterson, LLP
1000 Wilshire Blvd.
Suite 570
Los Angeles, CA 90017
6
What We’ll Cover
• Background
• The Problem – Generally, Gains Are Taxed to the Trust or Estate
• Reg. 1.643(a)-3(b) – Three Ways To Include Gains in DNI
– Method 1
– Method 2
– Method 3
• In-Kind Distribution Under Section 643(e)
• Grantor Trust
• Conclusion
7
Background
• Traditionally, the income beneficiary of a trust would be paid and taxed on the trust accounting income (e.g., interest and dividends) and capital gains would be allocated to principal and taxed to the trust.
• Changes have occurred in investment world – Low yield on equities and bonds
– Trusts investing for total return per the Prudent Investor Act
• Two changes in determination of definition of “income”
– Adoption of “power to adjust” under Section 104 of the UPIA
– Adoption of unitrust statutes
• Changes in tax rates for trusts and estates versus rates for individuals – Estates and trusts reach 20% maximum rate for long-term capital gains, the
39.6% bracket for ordinary income (including short-term capital gains) and the 3.8% surtax at $12,400 of taxable income (2016)
– Individuals reach maximum rate for long-term capital gains and the 3.8% surtax at higher thresholds
8
Income Taxation of Trusts and Estates Code Outline
• PART I, SUBCHAPTER J
– Subpart A - Sec. 641-646 - General Rules
– Subpart B - Sec. 651-652 - Simple Trusts
– Subpart C - Sec. 661-664 - Complex Trusts and CRTs
– Subpart D - Sec. 665-668 - Accumulation Distributions
– Subpart E - Sec. 671-679 - Grantor Trusts
– Subpart F - Sec. 681-685 - Misc. Rules
• PART II, SUBCHAPTER J
– Sec. 691-692 - Income in Respect of a Decedent
9
Background - 2016 Fiduciary Income Tax Rates
Over Not Over
0 2,550 15%
2,550 6,000 25%
6,000 9,150 28%
9,150 12,500 33%
12,500 39.6%
10
Background - Income Taxation of Trusts and Estates
• Income Taxed to Either Entity or Beneficiary
– If income is accumulated and not deemed distributed, it is
taxed to the trust or estate
– If income distributed:
• Trust gets deduction for amount of distribution, limited to
DNI
• Beneficiary accounts for income distributed on his own
tax return, limited to DNI
11
Background - Income Taxation of Trusts and Estates - Distributable Net Income (DNI)
• Distributable Net Income (DNI) governs:
– Amount of trust or estate’s distribution deduction
– Amount beneficiary accounts for on his own return
– Character of income in beneficiary’s hands
12
Background - Income Taxation of Trusts and Estates
Trust/Estate Beneficiary
DNI acts as ceiling
on entity’s
distribution
deduction
DNI acts as ceiling
on amount
beneficiary
accounts for on his
return
DNI
Distribution Deduction (DDNI) Schedule B — Form 1041(Simple Trust)
13
Distribution Deduction (DDNI) Schedule B — Form 1041 Complex
Trust
14
15
Background - DNI - Sec. 643(a)
• Start With Taxable Income and . . .
– Add back the distribution deduction
– Add back the personal exemption
– Subtract out capital gains/add back capital losses allocable to
principal (except in the year of termination)
– Subtract out extraordinary dividends and taxable stock dividends
allocated to corpus for simple trust
– Add back net tax-exempt income
16
Background - DNI - Sec. 643(a)
• General Rule: capital gains generally taxed to trust or estate
– Exceptions:
• 3 situations under Reg. 1.643(a)-3
• Paid to or set permanently set aside for charity. Reg. 1.643(c)
• year of termination
17
Including Capital Gains in DNI – The Problem
• Generally, capital gains are allocated to principal and taxed to the estate or
trust
• Compressed tax rate schedule for estates and trusts
– Short-term capital gains taxed at 39.6% + 3.8% surtax if taxable income
exceeds $12,400 (2016)
– Long-term capital gains taxed at 20% + 3.8% surtax if taxable income
exceeds $12,400 (2016)
• Planning point – have gains taxed to beneficiary where gains would most
likely be taxed at a lower tax rate
18
Including Capital Gains in DNI – The Problem
• Where a beneficiary is entitled to distributions of principal, the beneficiary is
not taxed on the capital gain unless one of the specific exceptions under
Reg. 1.643(a)-3 is satisfied
• For capital gains to be taxed to a beneficiary, the capital gain must be
included in DNI
• Analysis:
– May the fiduciary include capital gains in DNI and have them taxed to the
beneficiary?
– Should the fiduciary allocate capital gains to DNI?
• Overriding factor – trustee must consider his fiduciary duty to both the
income beneficiary and the remainderman in making principal distributions
– Uniform Trust Code imposed a “duty of impartiality” on the trustee
19
Including Capital Gains in DNI – Understatement!!!
Preamble to the proposed regulations:
“. . . The circumstances in which capital
gains are considered paid or credited to a
beneficiary during the year, and therefore
included in distributable net income, are
not entirely clear.”
20
Including Capital Gains in DNI
• The regulations describe 3 circumstances under which capital gains can be
included in DNI. Reg. 1.643(a)-3(b).
• Gains are included in DNI where they are, pursuant to the governing
instrument and applicable local law, or pursuant to a reasonable and
impartial exercise of discretion by the fiduciary in accordance with a power
granted to the fiduciary by applicable local law or by the governing
instrument if not prohibited by applicable local law:
1. Allocated to income (but if income under the state statute is defined as,
or consists of, a unitrust amount, a discretionary power to allocate
gains to income must also be exercised consistently and the amount so
allocated may not be greater than the excess of the unitrust amount
over the amount of DNI determined without regard to this subparagraph
1.643(a)-3(b));
2. 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; or
3. Allocated to corpus but actually distributed to the beneficiary or utilized
by the fiduciary in determining the amount that is distributed or required
to be distributed to a beneficiary.
21
Analyzing Regulation 1.643(a)-3(b)
• Reg. 1.643(a)-3(b) has specific requirements must be met in order to have
capital gains taxed to the beneficiary
• No pressing the “easy button”
– Capital gains cannot be distributed to a beneficiary without authority in the trust
instrument or state law
• Regulations have:
– Two prerequisites and
– Three methods
22
Analyzing Regulation 1.643(a)-3(b)
• Two prerequisites – capital gains included in DNI only if inclusion is
pursuant to:
– Trust agreement and local law; or
– A reasonable and impartial exercise of discretion by the trustee in
accordance with a power granted to the trustee by local law or the trust
agreement if not prohibited by local law.
• Three methods
– Allocated to income
– Allocated to corpus, but treated consistently by the fiduciary on the
trust’s books, records and tax returns as part of distribution to the
beneficiary
– Allocated to corpus, but actually distributed to the beneficiary or
utilized by the fiduciary in determining the amount that is
distributed or required to be distributed to the beneficiary
23
Analyzing Regulation 1.643(a)-3(b)
• Method 1, requiring an allocation to income, is limited unless the trust
instrument or state law allocates gains to income (unlikely) or the fiduciary
has broad discretion to allocate capital gains to income.
• Method 2 requires a consistent practice of allocating capital gains to DNI.
This method may not be available if the trust is not in its first year of
existence or if the fiduciary does want to be obligated to allocate capital
gains to DNI in the future.
• Method 3 appears to be the most flexible
25
Regulation 1.643(a)-3(e) – Example 1
• Trust says pay all income to A
• Trust gives trustee discretion to distribute principal to A and to deem it to be
made from capital gains realized during the year.
• Trust has $5,000 of dividends and $10,000 of capital gain
• Trustee allocates $10,000 capital gain to principal
• Trustee distributes $5,000 to A (TAI) and $12,000 discretionary distribution
of principal
• Trustee does not deem the discretionary distribution of principal as being
paid from capital gains
• Gains not included in DNI and are taxed to the trust
• In future years trustee must treat all discretionary distributions of principal
as not being made from capital gain.
26
Method 1 - 1.643(a)-3(b)(1)
• Allocated to income
• By state law (unlikely)
• Trust agreement specifically provides that capital gains are allocated to
income
– A mere general boilerplate statement that the trustee has discretion to
allocate receipts and disbursements between income and principal may
not be enough
• Power to adjust - §104 of UPIA
• Unitrust provision under state law or governing instrument
• The trustee allocates gains to income by a reasonable and impartial
exercise of discretion granted by the trust instrument or by state law
27
Method 1 - 1.643(a)-3(b)(1)
• What if trust instrument is silent as to whether capital gains are allocated to
income and you want to get gains allocated to income under Method 1?
– Possible solution – decant to a new trust that contains language that allocates
(or give the trustee discretion to allocate) gains to income
– Discretion for a trustee to distribute principal in most states is a prerequisite to
being able to decant
28
Method 1 - 1.643(a)-3(e) – Example 4
• Trust agreement allocates capital gain to income
• Same as Example 1 except that terms of trust allocate gains to income.
• $10,000 capital gain is included in DNI and taxed to the beneficiary
29
Trust Accounting Income - TAI
• TRUST ACCOUNTING INCOME
– Could be TAI defined under:
• Traditional definition of income and principal
• Unitrust statute
– Must be no less than 3%, no more than 5% of FMV of trust
assets
• Uniform Principal and Income Act
– Requirements:
» Trust is managed under the Uniform Prudent Investor
Act
» The beneficiary must be eligible for income distributions
» The distribution is not favorable to one beneficiary over
another
30
Method 1 - 1.643(a)-3(b)(1)
• Two alternative ways capital gains can be allocated to income under state
law:
– Power adjust under UPIA
– Unitrust statute
31
Method 1 - 1.643(a)-3(b)(1)
• Power to adjust - theory
– Trust invests for total return, i.e., income and appreciation
– Trustee makes adjustment to allocate a portion of the capital gains to
income to satisfy his duty of impartiality to the income and remainder
beneficiary
– Section 104 of the UPIA gives the trustee the authority to allocate
principal to income to satisfy his duty of impartiality
• Section 104 of the UPIA is the applicable state statute that gives the trustee
authority to allocate gains to income
• IRS agrees that “the power does not have to be exercised consistently, as
long as it is exercised reasonably and impartially.” Preamble to T.D. 9102.
– Thus, the requirements of Reg. 1.643(a)-3(b)(1) to allocate capital
gains to income and include them is DNI is satisfied
32
Method 1 - 1.643(a)-3(b)(1)
• Power to adjust - planning
– §643 regulations don’t have an example if or how capital gains enter into DNI if
trustee exercises the power to adjust
• The power to adjust ALONE does not provide the trustee with authority to include
capital gains in that adjustment.
• Consequently, drafters of new trust instruments should consider granting express
authority to allocate capital gains as part of a power to adjust in the governing
instrument.
• If the governing instrument grants the trustee discretion to determine what is income
and what is principal, it should state that the power includes the discretion over capital
gains.
– For trusts that do not have discretionary power to distribute principal, the trustee
should be able to rely on the power to adjust to shift capital gains to income and
include them in DNI
– However, the power to adjust is limited and may only be exercised under
the appropriate facts and circumstances
33
Method 1 - 1.643(a)-3(b)(1)
• Unitrust - theory
– Term “unitrust” is used to describe a payment to the income beneficiary equal to
a fixed percentage of the fair market value of the trust property determined at
the beginning of the tax year or averaged over some period.
– Tax treatment depends on whether the governing instrument or the state
unitrust statute has an ordering rule for the character of the unitrust amount.
– Reg. Examples 11-14
34
Method 1 - 1.643(a)-3(b)(1)
• Ordering rule
– “Ordering rule” sets forth the type or source of income which will be deemed to
satisfy the unitrust distribution e.g., first from trust accounting income, next from
STCG, then from LTCG, next from tax-exempt income and lastly from principal)
– If state has an ordering rule, to the extent capital gains are allocated to satisfy
the unitrust amount, the capital gains are included in DNI. See Reg. 1.643-3(b),
Example 11.
– No consistency requirement
35
Method 1 - 1.643(a)-3(e) – Example 11
• Ordering rule
– A entitled to trust income
– State statute says unitrust amount considered paid first from ordinary income
and tax-exempt income, then from STCG, then from net LTCG and finally from
principal
– Income of trust defined by unitrust statute – 4% of FMV of assets
– Trust’s assets FMV of $500,000
– Unitrust amount is $20,000 (4% x $500,000)
– Trust receives $5,000 of dividends and $80,000 of net LTCG
– Trustee distributes $20,000 to A
– $15,000 net LTCG included in DNI ($20,000 unitrust amount less $5,000 of
dividend income deemed distributed first under the ordering statute)
36
Method 1 - 1.643(a)-3(b)(1)
• No ordering rule
– Within the trustee’s discretion to allocate short-term and long-term gains to the
unitrust amount
– If trustee intends to follow a regular practice of treating any capital gains as
distributable to the beneficiary to the extent the unitrust amount exceeds the
trust’s accounting income, the gains will be included in DNI
• Note: the amount of gains included in DNI cannot be more than the amount of the
unitrust amount in excess of the trust accounting income
• The above requirement (amount of gain allocated to DNI cannot exceed the unitrust
amount less trust accounting income) does not apply if the unitrust has an ordering rule
– Consistency requirement
– Reg. Examples 12-13
37
Method 1 - 1.643(a)-3(e) – Example 12
• No ordering rule – doesn’t include gains in DNI
– Same as Example 11 but neither state law nor trust instrument has an ordering
rule
– Trust gives trustee discretion what type of income makes up unitrust amount
– Trustee intends to follow a regular practice of treating principal, other than
capital gain, as distributed to A to the extent the unitrust amount exceeds the
trust’s ordinary and tax-exempt income.
– Trustee does not include capital gain in DNI so the $80,000 capital gain is taxed
to the trust.
– Trustee must consistently follow this treatment of not allocating realized capital
gain to income
38
Method 1 - 1.643(a)-3(e) – Example 13
• No ordering rule –includes gains in DNI
– Same as Example 11 but neither state law nor trust instrument has an ordering
rule
– Trust gives trustee discretion what type of income makes up unitrust amount
– Trustee intends to follow a regular practice of treating capital gain as distributed
to A to the extent the unitrust amount exceeds the trust’s ordinary and tax-
exempt income.
– Trustee includes $15,000 of capital gain in DNI. $15,000 of the capital gain is
taxed A and the remaining $65,000 of capital gain is taxed to the trust.
– Trustee must consistently follow this treatment of not allocating realized capital
gain to income to the extent that the unitrust amount exceeds ordinary and tax-
exempt income
39
Method 1 - 1.643(a)-3(b)(1)
• Disadvantage of unitrust
– Most likely will leave trust with some capital gains
– While a unitrust provision enables the fiduciary to shift some taxable income to
the beneficiary, it may not enable complete income shifting
– In states with no ordering rule, the decision to include capital gains in DNI must
be done consistently.
– Appears that a unitrust format can be used by an existing trust to include gains
in DNI
• The preamble to T.D. 9102 states 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.”
• Thus, it appears that the trustee can select a new consistent method regardless of the
trustee’s prior treatment. This is not available with the other methods of including
capital gain in DNI.
40
Include Capital Gains in DNI
• In addition to those circumstances mentioned in the regulations, capital
gains flowing from a partnership or S corporation K-1 are included in DNI.
Crisp v. United States, 34 Fed. Cl. 112 (1995).
– Planning point: the trustee may want to consider investing through a partnership
so that capital gains can be distributed and escape the income tax and the
surtax at the trust level
Investment
p/ship Trust
K-1 with gains
Beneficiaries
DNI with p/ship gains
41
Capital Gains from Flow Through Entities
• Capital gains from a flow through entity to a trust should be included in DNI
• Two reasons:
– No distribution from flow-thru entity - In calculating DNI, §643(a) starts with
taxable income and makes adjustments.
• §643(a)(3) says capital gains are excluded from DNI to the extent they are
allocated to corpus and are not paid or required to be distributed to a beneficiary or
for charitable purposes.
• If the gains are not allocated to corpus, there is no provision in the statute to
remove them from DNI.
• If the flow-thru entity makes no distributions of capital gain, the trust has no
receipts that are characterized as income or corpus. Since they are not allocated to
corpus, they are not excluded from DNI
– Distribution from flow-thru entity - Under the UPIA, distributions from flow-thru
entities are treated as trust accounting income rather than principal unless the
distribution is part of a liquidating distribution. Since the distribution from a flow-
thru entity is allocated to income, the gains are included in DNI under Exception
1
43
Method 2 - 1.643(a)-3(b)(2)
• Allocated to corpus, but treated consistently by the fiduciary on the trust’s
books, records and tax returns as part of distribution to the beneficiary
• Trustee makes discretionary distribution of principal and follows a regular
practice of treating the principal distribution first from any capital gains
realized by the trust
• The trustee must clearly evidence that the capital gains are included in the
distribution
– Document on trust’s books and records
– Show inclusion of capital gains on the trust’s tax return
• Key point: this practice must be consistent from year to year
– Capital gains will be included in DNI in each of the future years
– “Consistency” requirement could apply to all capital gains or to a specific asset
or class of investments
– Given the uncertainty of future tax rates for the trust and the beneficiary, the
decision to include capital gains in DNI may or may not be a good idea
44
Method 2 - 1.643(a)-3(b)(2)
• Trustee could be given discretion to treat principal distributions consisting of
capital gains
– Trustee must document that capital gains are included in DNI
– Consistency requirement
• Term “consistency” not clearly defined in regulations
• Once employed, future principal distributions deemed included in
DNI
• May prohibit existing trusts that have not treated capital gains as
part of the distribution to beneficiaries from using this method
– Examples in regulations make it relatively clear that the
establishment of a practice of distributing gains must
commence in the first year in which a distribution of principal
occurs
– Possible solution: decant into a new trust and use Method 2 in
first year
– Possible solution: amend returns and include gain in DNI if S/L
still open for first year or trust
– Possible solution: rely on method 3
45
Method 2 - Regulation 1.643(a)-3(e) – Example 1
• Trust says pay all income to A
• Trust gives trustee discretion to distribute principal to A and to deem it to be
made from capital gains realized during the year.
• During first taxable year trust has $5,000 of dividends and $10,000 of
capital gain
• Trustee allocates $10,000 capital gain to principal
• Trustee distributes $5,000 to A (TAI) and $12,000 discretionary distribution
of principal
• Trustee does not deem the discretionary distribution of principal as being
paid from capital gains
• Gains not included in DNI and are taxed to the trust
• In future years trustee must treat all discretionary distributions of principal
as not being made from realized capital gains.
46
Method 2 - 1.643(a)-3(e) – Example 2
• Same as Example 1 except the trustee decides to follow a regular practice
of treating discretionary principal distributions as being made first from any
capital gains realized by the trust during the year
• Trustee includes $10,000 of capital gain in DNI on the tax return so the
$10,000 capital gain is taxed to A
• In future years the trustee must treat all discretionary principal distributions
as made first from capital gains
47
Method 2 - 1.643(a)-3(e) – Example 3
• Same as Example 1 except the trustee decides to follow a regular practice
of treating discretionary principal distributions as being made first from any
capital gains from the sale of certain specified assets or a particular class of
investments
• This is a reasonable exercise of the trustee’s discretion
• Must define the specified assets or the particular class of assets
48
Method 3 - 1.643(a)-3(b)(3)
• Allocated to corpus, but actually distributed to the beneficiary or utilized
by the fiduciary in determining the amount that is distributed or
required to be distributed to the beneficiary
• Regulations do not address whether this method may be used if the
principal distribution is greater than or less than the actual capital gains for
the year
• No consistency requirement (although the examples seem to require
consistency if no distribution is required but the capital gains are utilized to
to determine the amount of a distribution).
• Method 3 is useful for older or existing trusts which are silent on whether
capital gains can be allocated to income
49
Method 3 - 1.643(a)-3(b)(3)
• Two alternatives:
– Actually distribute capital gains to a beneficiary
– Use capital gains to determine amount distributed or required to be distributed to
a beneficiary
– No consistency requirement
50
Method 3 - 1.643(a)-3(b)(3)
• Actually distribute capital gains to a beneficiary
– Trusts with age attainment distribution provisions
– May have limited use.
– Regulation requires a mandatory principal distribution or a situation
where the proceeds of a specific asset are distributed to a beneficiary
– What if the trust has sufficient cash to fund the distribution? Does this
method still apply to cause gains to be included in DNI?
– Money is fungible – how do you know capital gains are being
distributed?
51
Method 3 - 1.643(a)-3(b)(3) – Example 9
• Actually distribute capital gains to a beneficiary
– Trusts says all income paid to A during trust’s term
– Distribute one-half of the principal to A at age 35 and the balance at
age 45
– Trust consists entirely of Corporation M stock with a FMV of $1,000,000
and an adjusted basis of $300,000
– When A reaches 35, trustee sells one-half of the stock and distributes
the proceeds to A
– All of the sales proceeds, including all the capital gain from the sale,
are actually distributed to A and thus all the capital gain is included in
DNI
52
Method 3 - 1.643(a)-3(e) – Example 7
• Trust termination – actually distributed
• All income payable to A
• When A reaches 35, trust terminates and all principal is distributed to A
• Since all assets of the trust, including capital gain, will actually be
distributed to A upon termination of the trust, all capital gains in the year of
termination are included in DNI and taxed to A
53
Method 3 - 1.643(a)-3(b)(3)
• Use capital gains to determine amount distributed or required to be
distributed to a beneficiary
– Trustee makes a discretionary distribution to the beneficiary based on the trust’s
realized capital gains. For example, trustee decides that discretionary
distributions will be made to the extent the trust has realized capital gains. The
capital gains distributed would be included in DNI.
– See Reg. 1.643(a)-3(b), Example 5
54
Method 3 - 1.643(a)-3(e) – Example 5
• Distribution based on capital gains
• Facts same as Example 1 except that the trustee decides that discretionary
distributions will be made only to the extent the trust has realized capital
gains during the year.
• Thus, the discretionary distribution of principal to A is $10,000 rather than
$12,000.
– In Example 1, the gains were $10,000 but the trustee made a discretionary
principal distribution of $12,000 i.e. more than the amount of the gain
• Since the trustee uses the amount of capital gain realized to determine the
amount of the discretionary distribution to A, $10,000 of the capital gain is
included in DNI and taxed to A. The $2,000 balance of the capital gain is
taxed to the trust.
• Capital loss netting under Reg. 1.643(a)-3(d).
– Only net gains considered under Method 3
55
Method 3 - 1.643(a)-3(b)(3) – Example 6
• Distribution based on sales proceeds
• Trust assets consist of Blackacre and other property
• Trustee is directed to hold Blackacre from 10 years and then sell it and
distribute all the sales proceeds to A
• Since trustee uses the sales proceeds that includes any capital gain to
determine the amount required to be distributed to A, any capital gain
realized from the sale of Blackacre is included in the trust’s DNI
56
Including Capital Gains in DNI
• Bottom line
– Best when appropriate discretion is expressly granted in the trust
agreement
• Attorneys should consider including such discretionary language in trust
instruments going forward
– Alternatively, local law may provide the discretionary powers
– If not, consider:
• Power to adjust
• Decanting (if available)
57
Sample Language
Sample language giving the trustee discretion to utilize the flexibility of the
regulations to cause capital gains to be included in DNI:
“The Trustee may allocate realized short-term capital gains and/or long-
term capital gains to either trust income or trust principal, and such
gains shall be includable in distributable net income as defined in I.R.C.
§643 and the regulations thereunder (1) to the extent that such gains
are allocated to income and distributed to the trust beneficiary; or (2) if
such gains are allocated to principal, to the extent they are consistently
treated as part of a distribution to the trust beneficiary, actually
distributed to the trust beneficiary, or used by the Trustee in
determining the amount distributable to the trust beneficiary.”
58
Including Capital Gains in DNI
• Other considerations:
– Trustee’s fiduciary duty to balance competing interests of the
beneficiaries
– Spendthrift issues
– Asset protection
– Exposure to estate tax
59
In-Kind Distributions Under §643(e)
• General rule: An estate or trust does not recognize gain or loss on the in-
kind distribution of property to a beneficiary. §643(e).
– Caution: gain is triggered at trust level if in satisfaction of a mandatory income
distribution. See Reg. 1.661(a)-2(f); Reg. 1.651-2(d).
• The beneficiary takes a carryover basis in the property. §643(e)(1).
• §643(e) allows the fiduciary to determine where the gain will be recognized:
at the entity level or at the beneficiary level.
• Requirement: the trust instrument or local law must allow the trustee to make
discretionary distributions of principal and the power to distribute in cash or
in-kind, or partly in cash and in-kind
• This may allow the beneficiary to time the recognition of gain to a time when
he will not be subject to the 3.8% surtax.
– A beneficiary who holds the property until death will get a step-up in
basis and avoid the tax on the gain altogether.
60
Grantor Trust
• Gains taxed to grantor or beneficiary to extent trust is a grantor trust due to
powers held under §§673-677 or to the extent the trust is a “deemed” grantor
trust under §678.
• Irrevocable trust may be structured as a grantor trust so capital gains are
taxed to the grantor
– Structure trust for benefit of non-grantor beneficiaries as a grantor trust
• Beneficiary of irrevocable trust may have withdrawal power so that
beneficiary is taxed on some or all of the gains.
– Crummey withdrawal power
– 5 x 5 power
61
Conclusion
• Background
• The Problem – Generally, Gains Are Taxed to the Trust or Estate
• Reg. 1.643(a)-3(b) – Three Ways To Include Gains in DNI
– Method 1
– Method 2
– Method 3
• In-Kind Distribution Under Section 643(e)
• Grantor Trust
• Conclusion
62
Resources
• Federal Income Taxation of Estates, Trusts and Beneficiaries, 3rd
Edition by Ferguson, Freeland and Ascher (Aspen/CCH)
• 1041 Deskbook (Practitioners Publishing Co)
• Income Taxation of Trusts and Estates, 852-3rd (BNA portfolio –
Estate, Gift and Trust series)
• Federal Income Taxation of Decedents, Estates and Trusts,
David A. Berek (2013 Edition) (CCH)
• Federal Income Taxation of Trusts and Estates, by Zaritsky and
Lane, 3rd Edition (RIA/Thompson/West)
• Income Taxation of Fiduciaries and Beneficiaries by Byrle M.
Abbin, 2 volumes, 2015 Edition (CCH)