Trusts and the 23.8% Cap Gains Tax: Having Capital Gains Included in DNI and Distributed. John Goldsbury

Transcription

1 Trusts and the 23.8% Cap Gains Tax: Having Capital Gains Included in DNI and Distributed John Goldsbury

2 Disclosure Any examples presented are hypothetical and do not reflect specific strategies we may have developed for actual clients. They are for illustrative purposes only. The availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. This material is current as of the date specified and is for informational purposes only. It is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. U.S. Trust, Bank of America Private Wealth Management, operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. Jan2016JGO 2

3 New increased rate differential Trust has $ 50,000 of taxable income; Beneficiary has $ 150,000 Federal Ordinary Income Bracket Federal Capital Gain Bracket Beneficiary Trust Beneficiary Trust Regular Tax 28% 39.6% 15% 20% Surtax 0% 3.8% 0% 3.8% Total 28% 43.4% 15% 23.8% Difference -15.4% 15.4% -8.8% 8.8% 3

4 That extra 3.8%: How is a trust surtaxed? 4

5 How is a trust surtaxed -- the DNI results dictate the NII results The rules for the surtax: Step #1: A trust calculates its DNI under the usual rules; Step #2: A trust must now also track whether each item of income in DNI is NII or not; Step #3: Items of income that both are considered distributed under the DNI rules, and are items of NII are considered distributions of NII Step #4: The beneficiary includes distributed NII in his/her NII; and Step #5: The trust s undistributed NII will be (i) the total NII of the trust, less (ii) the amounts deemed distributed under #3. 5

6 How is a trust surtaxed -- Example 1 from final surtax regs Total Income In DNI In NII Dividend $ 15,000 $ 15,000 $ 15,000 Interest $ 10,000 $ 10,000 $ 10,000 Capital Gain $ 5,000 X $ 5,000 IRA Distribution $ 75,000 $ 75,000 X TOTAL $ 105,000 $ 100,000 $ 30,000 6

7 Example 1 cont d: $10,000 discretionary distribution Income tax (DNI) results Surtax (NII) results DNI Distributed Total Distributed Retained Dividend $ 15,000 $ 1,500 $ 15,000 $ 1,500 $ 13,500 Interest $ 10,000 $ 1,000 $ 10,000 $ 1,000 $ 9,000 Capital Gain $ 5,000 $ 0 $ 5,000 IRA Distribution $ 75,000 $ 7,500 TOTAL $ 100,000 $ 10,000 $ 30,000 $ 2,500 $ 27,500 7

8 Having Capital Gains Taxed to Beneficiaries Preliminaries 8

9 Before we go over examples Any distribution must be consistent with the trust s terms and the trustee s fiduciary obligations. 2. Must be aware of collateral effects of increasing a bene s income. 3. Reverse thinking: In many scenarios, it s a given that there is an $X distribution. Given that, then we ask can it carry out capital gain? 4. It is not always a choice! 9

10 Short n Sweet: The rules for including capital gain in DNI: Reg (a)-3(b) (b) Capital gains included in distributable net income. Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of 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 distributable net income 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. 10

11 5 Ways to Have Cap Gain in DNI Summary of Reg (a)-3(b) Income 1. Allocation Method #1(a): Allocated to income 2. Allocation Method #1(b): For a total return unitrust, allocated to income as a matter of discretion, but such discretion must be exercised consistently (we ll go over what that means) Principal 1. Allocation Method #2: Allocated to corpus but treated consistently as part of a distribution to a beneficiary 2. Allocation Method #3(a): Allocated to corpus but actually distributed to a beneficiary 3. Allocation Method #3(b): Allocated to corpus but utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary 11

12 Organizing the Regulation and its 14 Examples Authorization #1 (mandatory) Allocation #1(a) Example 4, 11 Authorization #2 (discretionary) Allocation #1(b) Allocation #2 Allocation #3(a) Example 6, 7, 8, 9 Example 1, 2, 3, 12, 13, 14 Example 10 (unclear) Allocation #3(b) Example 5 12

13 Having Capital Gains Taxed to Beneficiaries Examples of some of the 21 ways 13

14 Allocation #1(a) Allocation #1(b) Allocation #2 Authorization #1 (mandatory) Allocated to trust income Authorization #2 (discretionary) Allocation #3(a) Allocation #3(b) 14

15 #1: Capital Gains are allocated to trust income (1/21) Trust Capital gains realized by the Trust shall be allocated to income. Allocation Method #1(a): Allocated to income Example 4 of the Regulations. Once an item of federal taxable income is in fiduciary accounting income, it is in DNI. No discretion; no choice! Planning opportunity -- fully discretionary trusts. Drafting to require that capital gain be allocated to income will cause that capital gain to be in DNI. 15

16 Allocation #1(a) Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) Authorization #1 (mandatory) Authorization #2 (discretionary) Allocated to corpus but actually distributed to the beneficiary 16

17 #2: Distributions in Kind (14, 15, 19/21) Allocation Method #3(a): Allocated to corpus but actually distributed to the beneficiary Distributions in kind 3 variations 1. The distribution triggers gain. Meeting a fixed obligation with appreciated property 2. The distribution does not trigger gain, but an election is made to recognize gain 3. The distribution does not trigger gain. 17

18 Allocation #1(a) Allocation #1(b) Allocation #2 Authorization #1 (mandatory) Authorization #2 (discretionary) UPIA Power to Adjust Allocation #3(a) Allocation #3(b) 18

19 #3: UPIA Power of Adjustment (5/21) Allocation Method #1(a): Allocated to income Once an item of federal taxable income is in fiduciary accounting income, it is in DNI. There are no examples in the Regulations for the power of adjustment. That is intentional. Regs seem to confuse principal with capital gain There is no consistency requirement (because of statutory requirements) The grid offers a fascinating way to extrapolate from this... 19

20 #3: cont d Allocation #1(a) Allocation #1(b) Allocation #2 Authorization #1 (mandatory) Authorization #2 (discretionary) What else???? Allocation #3(a) Allocation #3(b) 20

21 #3 cont d: My Too Good To Be True Example (5/21) Trust The trustee shall have the power to allocate capital gains to income, whenever the trustee feels like it. 21

22 Allocation #1(a) Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) Authorization #1 (mandatory) Authorization #2 (discretionary) Discretionary principal distributions 22

23 #4: Discretionary Principal Distributions (9/21) Trust Trustee has discretion to invade principal and to deem discretionary distributions to be made from capital gains. Allocation Method #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. Regulations: consistently = one bite at the apple. If you treat capital gains as distributed in the first year you can, you are obligated to do to the same in the future. If you fail to do so, you are prohibited in the future. 23

24 #4: cont d Trust Trustee has discretion to invade principal and to deem discretionary distributions to be made from capital gains. You manifest this treatment by including it in DNI on 1041 Query: Does consistently apply only to fiduciary, not trust? Authorization method is important nuance here. Some states have changed their law. 24

25 Allocation #1(a) Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) Authorization #1 (mandatory) Authorization #2 (discretionary) Discretionary principal distributions 25

26 #5: Trick question Example Assume a Trustee has the power to allocate capital gains to distributions (as in last example). In Year 1, Trustee sells ABC stock for capital gain and declares (by including it in DNI on the tax return) that capital gain to be part of a discretionary distribution of principal. Must the trustee consistently treat capital gains as being distributed in the future? 26

27 #5: Discretionary Principal Distributions of Cap Gain from certain assets (11/21) Allocation Method #2 again: Allocated to corpus but treated consistently as part of a distribution to a beneficiary Example 3 of the Regs: The facts are the same as in Example 1, except that Trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid from any net capital gains realized by Trust during the year from the sale of certain specified assets or a particular class of investments. This treatment of capital gains is a reasonable exercise of Trustee's discretion. [Emphasis added.] Now re-consider the Example again. 27

28 #5: Trick question Example Assume a Trustee has the power to allocate capital gains to distributions (as in last example). In Year 1, Trustee sells ABC stock for capital gain and declares (by including it in DNI on the tax return) that capital gain to be part of a discretionary distribution of principal. Must the trustee consistently treat capital gains as being distributed in the future? If the ABC stock can be treated as certain specified assets or a particular class of investments, then no. 28

29 Allocation #1(a) Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) Authorization #1 (mandatory) Authorization #2 (discretionary) Utilized by the fiduciary in determining the amount that is distributed 29

30 #6: Utilizing Cap Gain as the basis for distribution (16/21) Allocation Method #3(b): Allocated to corpus but utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary Example (5) of the Regs (excerpt): The Trustee decides that discretionary distributions will be made only to the extent Trust has realized capital gains during the year. Because Trustee will use [ utilize ] the amount of any realized capital gain to determine the amount of the discretionary distribution to the beneficiary, the gain is included in DNI 30

31 #6: cont d Planning opportunity -- capital gains can be somewhat controlled by choosing when to sell, what to sell, and harvesting losses. Can have a year s net capital gain be a particular dollar amount. If this applies, presumably not optional? 31

32 Allocation #1(a) Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) Authorization #1 (mandatory) Utilized by the fiduciary in determining the amount that is distributed Authorization #2 (discretionary) 32

33 #7: Utilizing Proceeds as basis for distribution (17/21) Allocation Method #3(b): Allocated to corpus but utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary Example (6) of the Regs: Trust's assets consist of Blackacre and other property. Under the terms of Trust's governing instrument, Trustee is directed to hold Blackacre for ten years and then sell it and distribute all the sales proceeds to A. Because Trustee uses [viz. utilizes ] the amount of the sales proceeds that includes any realized capital gain to determine the amount required to be distributed to A, any capital gain realized from the sale of Blackacre is included in Trust's distributable net income for the taxable year. 33

34 #7 cont d: Example Trust The trustee shall have discretion to distribute to a beneficiary the proceeds from the sale of an asset. Assume the trustee sells ABC stock for $100, triggering $35 of capital gain. Assume pursuant to the power granted by the trust document, the trustee distributes the $100 to the beneficiary. Has the trustee utilized the proceeds to determine the amount of distribution? If yes, the $35 of capital gain must be included in DNI. 34

35 #8: Invest via an LLC (20/21) The most fascinating of the lot! Not on the grid but gets the result that capital gains are in DNI Section 643(a) defines distributable net income as the taxable income of the estate or trust computed with the following modifications... If we stop right there, all capital gains begin in DNI 643(a)(3) continues: Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year... 35

36 #8: Quiz: Is this capital gain in DNI to begin with? Is it excluded from DNI? LLC/PS Capital gain flow through (no distributions) Trust Other Members 36

37 #8: Compare these two LLC LLC Capital gain flow through (no distributions) Distribute appreciated stock in-kind and let Trust sell Trust Other Members Trust Other Members 37

38 Other possibilities Grantor Trust for an asset 38