2017 National Conference on Special Needs Planning. Trust Income, Trust Expenses and Calculating Distributable Net Income Bradley J.

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1 2017 National Conference on Special Needs Planning and Special Needs Trusts Trust Income, Trust Expenses and Calculating Distributable Net Income Bradley J. Frigon Law Offices of Bradley J. Frigon 6500 S. Quebec St. Suite 330 Englewood, CO

2 Income In general, the definition of income is the same for an individual as for a trust. 61 defines gross income as income from whatever source derived, including (but not limited to) items of income specifically enumerated in that section. Some of the specifically enumerated items that are common to trusts are interest,dividends,rents,royalties,grossincomederivedfrom business, the distributive share of a partnership's gross income, gains derived from dealings in property, and income in respect of a decedent.

3 Income (cont.) For a trust, the initial question is whether or not the item received would be taxable income in the hands of an individual. If the answer is yes, then it will be income to the trust. If the income would not be recognized by an individual or would be exempt from income of an individual, then the same treatment will apply to the trust, as long as the trust met the requirements for nonrecognition or exemption.

4 Income (cont.) Example: A trust owns a residence that is used by a beneficiary as their principal residence. The trust sells the residence for a gain. Section 121 provides that gross income will not include gain from the sale or exchange of property if, during the five year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating two years or more. Because a non grantor trust cannot have a principal residence, a trust cannot take advantage of this section. This is so even though the beneficiary would have qualified under this section.

5 Income (cont.) A trust will have gross income when it sells, exchanges, or otherwise disposes of an asset for an amount realized in excess of its adjusted basis in the property. For a trust, the sale, exchange, or other disposition may be made to pay expenses necessary to administer the trust and maintain its assets, to have funds available for distribution to beneficiaries, or to change investments.

6 Deductions A trust is entitled to the deductions allowed to individuals, with certain exceptions, modifications, and additions. If a trust has an expense, the initial question is whether such expense would be deductible for tax purposes for an individual. If the answer is no, then such expense is not deductible in the hands of the trust, unless an exception exists under Subchapter J. If the answer is yes, then such expense is deductible in the hands of the trust, unless an exception exists.

7 Deductions in Context Most of the deductions allowed to trusts arise out of several contexts involving business or investments. Certain deductions are trade or business related. Some arise with respect to income producing property. Others fit into a quasipersonal type category miscellaneous deductions allowed to trusts, regardless of their activities. In general, trust deductions fall within three categories.

8 Deductions in Context (cont.) (1) Trade or Business Deductions (2) DeductionswithRespecttoInvestments Income Producing Activities A trust is entitled to various deductions if it holds property for the production of income, whether for current income or long term growth. The deductions in this group include:

9 Deductions in Context (cont.) (a) ordinary and necessary expenses paid or incurred (i) for the production or collection of income, or (ii) for the management of property that is held for the production of income, including administration expenses such as fees for executors, trustees, attorneys, and accountants; (b) interest paid or incurred on indebtedness properly allocable to property held for investment (subject to the restrictions on investment interest and passive activity losses);

10 Deductions in Context (cont.) (c) taxes paid or incurred in connection with the production of income or property held for the production of income; (d) losses incurred in a transaction entered into for profit, not connected with a trade or business (including any short term capital loss resulting from the total worthlessness of a non business bad debt), subject to the limitations on capital losses;

11 Deductions in Context (cont.) (e) depreciation of property held for the production of income, but only to the extent the deduction is not allocable to the beneficiaries of the estate or trust; and (f) a reasonable allowance for depletion of a mine, oil or gas well, other natural deposits, and timber held for the production of income, to the extent not allocable to the beneficiaries of the estate or trust.

12 Deductions in Context (cont.) Example: A trustee borrows funds to invest in stock for the purpose of producing dividends for the income beneficiaries and potential growth for the remainder beneficiaries. The trustee pays an accountant to prepare the fiduciary income tax return and the state accounting for the beneficiaries. The trustee receives an annual fee. The accountant's fee and the trustee's fee, as well as the interest, are deductible by the trust subject to the limitations on investment interest.

13 Deductions in Context (cont.) (3) Other General or Personal Deductions A trust is entitled to certain deductions that are not dependent upon the trust engaging in a trade or business, an income producing activity, or a profit transaction. These include deductions for: (a) ordinary and necessary expenses paid or incurred for tax advice and representation, with respect to the determination, collection, or refund of any tax; (b) personal casualty or theft losses, subject to the $100 deductible and the 10% adjusted gross income limitation;

14 Deductions in Context (cont.) (c) taxes set forth in 164, including real and personal property taxes, state income taxes, and the GST tax imposed on income distributions; and (d) charitable contributions for amounts paid for charitable purposes (or set aside for such purposes by estates or under certain pre October 9, 1969, trusts).

15 Personal Exemption Trusts, other than qualified disability trusts as defined in 642(b),arenotentitledtothepersonalexemption allowed to individuals under 151. A trust is entitled to the following deductions: Entity Amount Estate $600 Trust Required to Distribute All Income Currently $300 All Other Trusts (Other than Qualified Disability Trusts) $100

16 Miscellaneous Itemized Deductions The IRS issued revised proposed regulations regarding which costs incurred by a non grantor trust are subject to the 2% floor. Specifically, the proposed regulations provide that a cost is subject to the 2% floor to the extent the cost is: (1) included in the definition of miscellaneous itemized deductions; (2) incurred by a non grantor trust; and (3) commonly or customarily incurred by a hypothetical individual holding the same property. In analyzing whether a cost would be commonly or customarily incurred by such a hypothetical individual, the proposed regulations indicate that the determining factor is the type of product or service rendered to the estate or nongrantortrustinexchangeforthecost,ratherthanthedescriptionof the cost.

17 Miscellaneous Itemized Deductions (cont.) The proposed regulations specify that costs commonly or customarily incurred by individuals (and, thus, subject to the 2% floor) are: ownership costs that are chargeable to or incurred by a property owner simply because of the property owner status, such as condominium fees, real estate taxes, insurance premiums, maintenance and lawn services, automobile registration and insurance costs, and partnership costs deemed to be passed through to and reportable by a partner;

18 Miscellaneous Itemized Deductions (cont.) fees for preparing a non grantor trust's tax returns, such as individual income tax returns, gift tax returns, sole proprietorship tax returns, and retirement plan tax returns (but excluding estate and generation skipping transfer tax returns, fiduciary income tax returns, and the decedent's final individual income tax return); investment advisory fees, including fees for related services that would be provided to an individual investor as part of an investment advisory fee, and expenses that are not dependent on the payor's identity (particularly whether the payor is an individual rather than a trust), including (but not limited to) costs incurred to defend a claim against the estate, decedent, or non grantor trust that are unrelated to the estate's or trust's existence, validity, or administration.

19 Nondeductibility of Expenses Allocated to Tax Exempt Interest Section 265 prohibits deductions for expenses allocated to tax exempt income. This rule is easy to state, but determining how much of any expense should be allocated to tax exempt income can be difficult. The regulations require that a portion of indirect expenses be allocated to tax exempt income. The tax exempt income generally involved is interest on a municipal bond that is excluded from gross income under 103.

20 Nondeductibility of Expenses Allocated to Tax Exempt Interest (cont.) The deductions generally involved are the interest deduction and the 212 deduction for expenses attributable to income producing activities. Section 265 provides that if a debt is incurred or continued in order to purchase or carry an obligation that produces exempt interest, the interest on such debt is not deductible.

21 Nondeductibility of Expenses Allocated to Tax Exempt Interest (cont.) Example: Atrusthasanaccountwithaninvestmentbroker. The investment broker purchases municipal bonds on behalf of the trust, holds the bonds, collects the interest, and pays it to the trustee. The investment broker charges the trust a management fee for these services. The fee is not deductible, even if it is ordinary and necessary, because it is directly attributable to the production of tax exempt income and the maintenance of the income producing property.

22 Carryovers and Excess Deductions In general, if a trust has deductions in excess of income, they do not pass through to the beneficiaries. There are several exceptions to this general rule. First, if a net operating loss from a trade or business is involved, it may be carried back or forward pursuant to 170. Second, if the loss is capital, it can be carried forward by the trust during the administration of the trust.

23 Carryovers and Excess Deductions (cont.) Third, in the year of termination and only in the year of termination, certain carryovers and excess deductions do pass through to the beneficiaries, in accordance with regulations under 642(h). Any such excess deduction is carried over to the applicable beneficiary's tax year in which or with which the trust terminates. However, for purposes of determining the number of years to which a net operating loss, or a capital loss, may be carried over by a beneficiary, the last tax year of the trust (whether or not a short tax year) and the first tax year of the beneficiary to which a loss is carried over each constitute a tax year.

24 Simple Complex Trusts Distributions are the defining factors for simple and complex trusts. Simple trusts are entitled to a distribution deduction under I.R.C. 651 and the beneficiaries of a simple trust are subject to taxation on distributions pursuant to I.R.C Complex trusts are entitled to a distribution deduction under I.R.C. 661 and the beneficiaries of a complex trust are subject to taxation on distributions pursuant to I.R.C If a trust is a grantor trust, distributions from the trust are irrelevant, and all income, deductions and credits are taxed to the grantor.

25 Simple Complex Trusts (cont.) Therequirementsforatrusttobeclassifiedasasimpletrustarefound in I.R.C. 651(a) and are as follows: The terms of the trust require that all income be distributed currently; Thetermsofthetrustmustnotprovideforanyamountstobepaid, permanently set aside, or used for the taxable year for charitable purposes; The trust must not actually distribute any amounts during the year other than the income required to be distributed currently;

26 Simple Complex Trusts (cont.) A trust is a complex trust (and not a simple trust): For any year in which income is required to be accumulated; For any year in which the trustee has the discretion to accumulate or distribute income, even if the trustee actually distributes all of itsincomeforthatyear; For any year in which principal is distributed; and For any year in which a charitable contribution is made.

27 Simple Complex Trusts (cont.) A grantor trust is not treated as a separate taxpayer for federal income tax purposes. The income from a grantor trust is taxed to the grantor or, sometimes, to another person because he or she holds some interest in or control over the trust s assets. If the grantor or another person is treated as the owner of any portion of trust assets, then the trust is ignored for income tax purposes and the income, deductions, and credits attributable to that portion of the trust assets are taxed to the grantor. I.R.C. 678.

28 Distributable Net Income (DNI) Distributable net income (DNI) is central to the scheme of taxation for trusts and their beneficiaries. DNI is a tax concept that (1) measures the greatest amount that may be deducted by a trust because of distributions to beneficiaries and that may be reported by such beneficiaries as income, and (2) characterizes the income distributed for purposes of computing the distribution deduction and determining the items taxable to the beneficiaries. It is modified taxable income and often approximates gross accounting income less tax deductions.

29 Distributable Net Income (DNI) (cont.) DNI is equal to the following: (1) the taxable income determined without the distribution deduction or the personal exemption; (2) less the net capital gains; and (3) plus tax exempt income reduced by expenses (and any charitable deduction) allocated to such income.

30 Distributable Net Income (DNI) (cont.) Section 643 defines DNI to mean taxable income computed with certain modifications. These modifications are summarized below: (1) No distribution deduction is taken. (2) No personal exemption is taken. (3) Capital gains are not included, unless allocated to FAI or paid, credited, or required to be distributed to a beneficiary or paid or set aside for charitable purposes.

31 Distributable Net Income (DNI) (cont.) (4) Capital losses are not taken into account, except to the extent they reduce the amount of capital gains actually paid or credited to beneficiaries. (5) Tax exempt interest is included, net of disallowed deductions attributable to such interest.

32 Capital Gains and Losses Section 643(a)(3) provides the general rule that capital gains are not included in DNI. Capital gains and losses generally are allocated to principal and benefit (or disadvantage) the remainder beneficiaries of a trust. Thus, the trust (if it is not the final tax year in which the capital gain or loss is recognized) usually pays the tax on the net capital gain.

33 Capital Gains and Losses (cont.) But 643(a)(3) provides three exceptions to the general rule, namely, that capital gains will be included in DNI if they are: (1) allocated to FAI; or (2) allocated to principal and paid, credited, or required to be distributed to any beneficiary during the year ; or (3) allocated to principal and paid, permanently set aside, or to be used for [charitable] purposes specified in 642(c).

34 Distribution Deduction A non grantor trust is entitled to a distribution deduction for a tax year equal to all of its distributions for the year, limited by the amount and character of DNI, and subject to special rules for distributions made in kind that do not fall under 663(a). Section 661(a) establishes the tier system and governs this deduction. It provides that a complex trust is allowed a deduction equal to the sum of: 1. any amount of income for such tax year that must be distributed currently (including any amount required to be distributed that may be paid out of income or corpus to the extent such amount is paid out of income for such tax year); and 2. any other amounts properly paid or credited or required to be distributed for such tax year.

35 Distribution Deduction (cont.) Section 661(a) (1) defines the first tier payments as distributions of income that must be distributed currently. These first tier distributions are deductible to the trust to the extent of taxable DNI; that is, the DNI exclusive of tax exempt income..

36 Distribution Deduction (cont.) Second tier distributions are all amounts properly paid, credited or required to be distributed other than income that must be distributed currently. Second tier distributions include discretionary distributions of income or principal. These distributions also are deductible by the trust to the extent of taxable DNI.

37 Taxation of Distributions to Beneficiaries Distributions are taxed to beneficiaries to the extent they carry out taxable items of DNI. If distributions exceed DNI, then such excess amounts are not taxable to the beneficiaries. Special rules create priorities for the allocation of DNI to the distributions.

38 Taxation of Distributions to Beneficiaries (cont.) Section 662 creates tiers of beneficiaries. Special rules also determine the character of the distributions with respect to the allocation of income and deductions. Section 662 provides an allocation of DNI to the beneficiaries by calculating the respective amounts received or required to be distributed.

39 Taxation of Distributions to Beneficiaries (cont.) The significance of the tiers depends on whether the distributions exceed DNI. If the total distributions do not exceed DNI, the tiers are irrelevant amounts paid, credited, or required to be distributed carry out DNI dollar for dollar, each reflecting its proportionate share of the items of income and deductions in DNI, except to the extent of any special allocations. The remaining DNI that is not deemed distributed to the beneficiaries is taxed to the trust.

40 Taxation of Distributions to Beneficiaries (cont.) If the distributions exceed DNI, the tier of a distribution is crucial in determining the tax consequences to the beneficiary. Beneficiaries of first tier distributions are deemed to receive the DNI first. To the extent DNI exceeds the first tier distribution, second tier distributions are then allocated their pro rata share of the remaining DNI.

41 Taxation of Distributions to Beneficiaries (cont.) In comparing the amount of DNI to the distributions, there are several possibilities. First, the first tier distribution may equal or exceed DNI. In this case, the result for the firsttier beneficiaries would be the same as if the trust were a simple trust and had not made any second tier distributions.

42 Taxation of Distributions to Beneficiaries (cont.) Thus, where FAI is equal to or more than DNI and the trust is required to distribute all of the income, the first tier beneficiaries will be taxed on all of the DNI. This result is similar to what would occur if the trust were a simple trust, that is, the income beneficiaries of a simple trust are taxed on all of the DNI when the DNI is less than the FAI.

43 Example of DNI Computation Example: A special needs trust is established for a beneficiary. The terms of the trust allow the trustee to distribute income and principal at the trustee s discretion. The trust qualifies as a qualified disability trust. During the tax year the trust has the following items of income and expenses:

44 Example of DNI Computation (cont.) Dividends for domestic corporations $40,000 Taxable interest $20,000 Tax exempt interest $10,000 Long term capital gains $10,000 Trustee's commissions and miscellaneous expenses $ 5,000

45 Example of DNI Computation (cont.) The trust distributed $50,000 for the benefit of the beneficiary during the tax year. $1,000 of the trustee s fee is allocated to tax exempt income. The distributable net income determined under 643(a) amounts to $43,077.00, computed as follows:

46 Example of DNI Computation (cont.) Dividends from domestic corporations $30, Taxable interest $12, Nontaxable interest $10, Less: Expenses allocated thereto ($3,077.00) $6, Total $43,077.00

47 65 Day Rule 663(b) Election for Trust With respect to discretionary distributions, whether of income or principal, the year of payment by trust will generally be the year of deduction and will set the year for determining inclusion of the payment. But, if, within the first 65 days of the tax year of a trust an amount is properly paid or credited, and if the fiduciary makes a proper election, the distribution is treated as having been made on the last day of the preceding tax year.

48 65 Day Rule 663(b) Election for Trust (cont.) While the distribution must be made within 65 days of the new year, the election must be made no later than the deadline for filing the fiduciary income tax return for the tax year for which the distribution is treated as made, plus extensions. Because trusts must use the calendar year, the election deadline for trusts is April 15, plus any extensions. An election becomes irrevocable after the last day for making it.