Raj A. Malviya 1 And Brandon A.S. Ross 2

American Bar Association Section of Real Property, Trust and Estate Law: Subchapter J After Tax Reform: Ten Planning Considerations Raj A. Malviya 1 And Brandon A.S. Ross 2 1 Raj A. Malviya, J.D., LL.M. (Tax), is a partner in the Private Client practice group at Miller Johnson, and he practices in all areas of transfer tax and fiduciary income tax planning. Mr. Malviya is a past Fellow of the American Bar Association s Section of Real Property, Trust & Estate Law Section and is a Fellow of the American College of Trust and Estate Counsel (ACTEC). He is recognized in Best Lawyers of America, Michigan Super Lawyers, Chambers High Net Worth Guide, and he is an active member of the American Bar Association s Section of Real Property, Trust & Estate Law (RPTE) and the Income and Transfer Tax Group of RPTE and the Fiduciary Income Tax Committee of ACTEC. 2 Brandon A.S. Ross, J.D., LL.M. (Tax), is a Wealth Advisor in the D.C. office of JP Morgan Private Bank. He draws upon his experience as a practicing trusts and estates attorney with several large law firms in Florida and D.C. to guide clients through the estate planning process with their other advisors and to achieve their estate planning goals. Mr. Ross is a past Fellow of RPTE and is a current member of The Dennis I. Belcher Young Leaders Program through the ACTEC Foundation. He has been honored by the Probate & Property magazine of RPTE twice for excellence in writing on trusts and estates. He serves on the GST Committee for RPTE and as an Assistant Editor for the RPTE ereport. ABA Section of Real Property Trusts & Estates Law 1

I. Introduction This past year has proven to be action packed for estate planning and tax practitioners, thanks to the Tax Cuts and Jobs Act of 2017 ( TCJA ), the most sweeping change in Federal tax law since 1986. The TCJA may have been partially foreshadowed by the many post-80s transfer tax regimes leading up to it, such as the Taxpayer Protection Act of 1997 ( TPA ), Economic Growth and Tax Relief Reconciliation Act of 2001, Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010, and American Taxpayer Relief Act of 2012 ( ATRA ). The continued fluctuation in transfer tax exemption amounts, built-in sunsets, and the never-ending uncertainty of permanency have kept practitioners on their toes. With the current Federal transfer tax exclusion amount under the TCJA now in excess of an inflation-adjusted $10 million, scheduled at least through 2025, practitioners are increasingly focusing on income tax planning. A full-service trusts and estates practice presents many opportunities to navigate the income tax rules. In both the planning and administration context, practitioners must be familiar with the rules that govern nongrantor trusts, which are some of the most complex and nuanced rules in the Internal Revenue Code 3. The nongrantor trust rules are located in subparts A through D of Subchapter J of the Code and Regulations promulgated thereunder. There are many textbooks, treatises, and technical outlines available on nongrantor trusts. For an in-depth understanding of the subject matter, those types of resources should be consulted. This paper, however, is designed to be more of a practitioner overview of the fundamental rules when navigating the lifecycle of a nongrantor trust, while incorporating key planning considerations along the way. A. Organization of Subchapter J. II. Overview Subparts A through D of Subchapter J of the Code are titled: i. Subpart A: General Rules 4 ii. Subpart B: Simple Trusts 5 iii. Subpart C: Complex Trusts 6 iv. Subpart D: Accumulation Distributions 7 3 For purposes of this paper, all references to the Code shall mean the Internal Revenue Code of 1986, as amended. The authors would like to acknowledge the efforts of Angela M. Caulley, J.D., an associate in the Private Client practice group at Miller Johnson, for her review of multiple drafts of this paper and crosschecking and proofing the long list of authorities cited. 4 IRC 641 646. 5 IRC 651 652. 6 IRC 661 664. 7 IRC 665 668. ABA Section of Real Property Trusts & Estates Law 2

B. Nongrantor Trusts and Estates as Taxable Entities. This paper addresses trusts created to establish a traditional trustee-beneficiary relationship not so-called business trusts, which are created as a device to carry on profit-making business. 8 For purposes of applying Federal income tax rules, nongrantor trusts and estates are separate taxable entities; they file a U.S. Income Tax Return for Estates and Trusts (Form 1041), and they have a separate taxpayer identification number. 9 The taxable income of a nongrantor trust or an estate is computed the same way as income taxes for individuals, but with some modifications. 10 In effect, the fiduciary income tax rules bifurcate tax liability. For taxable income retained by the trust or estate, the entity calculates and generally pays the income tax under an entity regime of taxation. 11 However, when distributions of income are not accumulated, but instead are made to the beneficiaries, the trust or estate is generally treated as a conduit and the income distributed is taxed to the beneficiaries rather than the entity. 12 C. Fiduciary Income Tax Terminology. Some of the common terms used in the fiduciary income tax rules are as follows: i. Simple Trust. A simple trust is one that requires that all of the trust accounting income be distributed currently. It does not provide for any payment to or set aside for charitable purposes, and it does not actually distribute any trust principal during the year. 13 ii. Complex Trust. Any trust that is not a simple trust is a complex trust. 14 Trusts that do not require distributions of all income annually, or provide for charities, will always be complex. 15 Estates are also treated as complex. 16 iii. Trust Accounting Income. Trust accounting income, also known as fiduciary accounting income ( FAI ), is governed by the trust instrument and applicable local law. 17 Although it is not a tax concept, trust accounting income is important in determining whether the fiduciary, or the beneficiaries, pay tax on the trust s income. When subchapter J of the Code refers to income in connection with trusts and estates, the reference is to the definition of trust accounting income. 18 8 See Treas. Reg. 301-7701-4(b); Treas. Reg. 301.7701-2(a). 9 IRC 6012(a)(3)-(4). 10 IRC 643(b). Trusts and estates are defined as persons under IRC 7701(a)(1). Trusts and estates are also subject to the same alternative minimum tax liability as individuals. IRC 55. 11 IRC 641(a). 12 IRC 651 and 661. 13 Treas. Reg. 1.661(a)-1. 14 Id. 15 Id. 16 Id. 17 IRC 643(b); Treas. Reg. 1.643(b)-1. 18 IRC 643(b) (as applied to subparts A through D). ABA Section of Real Property Trusts & Estates Law 3

iv. Distribution Deduction. A trust or an estate may either retain income or distribute it to beneficiaries, according to the terms of the trust instrument, and applicable state law. The trust is taxed only on the income it retains, 19 while the beneficiaries are taxed on the income distributed or required to be distributed. 20 The trust receives a deduction for the net income distributable to the beneficiaries. 21 v. Distributable Net Income. The concept of distributable net income ( DNI ) is unique to fiduciary income taxation. Logically, the distribution deduction should be limited to the taxable income of the trust. However, the deduction is based on DNI, which is derived under the rules of Code 643. To oversimplify, DNI is the taxable income of a trust, but only after a series of adjustments are made. 22 DNI serves as the overall limitation on the amount of distribution deductions available to a trust or an estate, as well as a limitation of the amount taxable to beneficiaries. 23 D. Compressed Income Tax Brackets. Compared to individual income tax brackets, fiduciary income tax brackets are compressed. The purpose of the compressed brackets is to prevent taxpayers from using trusts as a conduit to reduce income tax. The rate schedule that applies to taxable income for trusts and estates for 2019 is as follows: Not over $2,600 10% Over $2,600 up to $9,300 $260 plus 24% of the excess over $2,600 Over $9,300 up to $12,750 $1,868 plus 35% of the excess over $9,300 Over $12,750 $3,075.50 plus 37% of the excess over $12.750 24 In addition, at over $12,950 of income, trusts and estates are subject to the higher 20% capital gains rate 25 and may also be subject to the additional 3.8% net investment income tax ( NIIT ). A. Formula. III. Mechanics in Calculating Tax Form 1041 is constructed similarly to Form 1040: gross income minus deductions equals taxable income. The steps for the calculation are the same; however, the rules are different depending on whether the trust is simple or complex. 26 The instructions to Form 19 IRC 641; Treas. Reg. 1.641(b)-1. 20 IRC 652(a) and 662(a); see also IRC 61(a)(15). 21 Treas. Reg. 1.641(b)-1. 22 IRC 643(a). 23 IRC 651(b) and 661(a) (limiting distribution deduction); IRC 662(a)(1) and (2) (limiting the taxable amount of a distribution). 24 Rev. Proc. 2018-57; see IRC 1(j)(2)(E). 25 Rev. Proc. 2018-57; see IRC 1(j)(2(E). 26 E.g., compare IRC 651 with IRC 661 (specifying different deductions available to simple trusts and complex trusts). ABA Section of Real Property Trusts & Estates Law 4

1041 are extremely helpful to preparers calculating the tax due. The preparation and analysis of these tax forms, while critical in engaging in fiduciary income tax planning, are beyond the scope of this paper. The ordering of the steps below demonstrates a typical way to calculate taxable income of a nongrantor trust. B. Determine Trust Accounting Income. As noted above, trust accounting income is determined first by reference to the governing instrument and then to applicable state law. 27 Trust accounting income is focused principally on whether funds coming into the trust and expenses being paid from the trust are allocated to principal (corpus) or to income. According to the Uniform Principal and Income Act ( UPIA ), unless the governing instrument specifies otherwise, interest, dividends on investments, and short-term capital gains/losses are generally allocated to income whereas long-term capital gains/losses and return of principal are allocated to principal. 28 The same is also true for expenses. 29 Attorney and accounting fees, for example, are typically allocated 50% to income and 50% to principal. 30 Estate and income taxes are allocable to principal, but real estate taxes are allocable to income. 31 It is important to be familiar with the principal and income rules for each state, as they are not always intuitive. In general, net income is determined by totaling trust accounting income minus the disbursements made from income during the period, with other required adjustments to income. 32 After determining net income, the trustee then looks to the governing document to determine whether income is required to be distributed. When the income is required to be distributed, the beneficiary holds a mandatory income interest. 33 The most common example is a qualified terminable interest property trust ( QTIP ), which requires all net income be distributed to the surviving spouse. 34 Alternately, the trust may contain provisions which allow the trustee to exercise its discretion to accumulate or distribute income and principal according to the standards set forth in the document. These are referred to as discretionary distributions. A trust that is required to distribute net income and makes no principal distributions is a simple trust. 35 For such trusts, the mandatory 27 IRC 643(b); Treas. Reg. 1.643(b)-1. 28 See generally, Uniform Principal and Income Act ( UPIA ) 102(4) and (10). While beyond the scope of this paper, the practitioner should also become familiar with the classification of other types of distributions or receipts under the UPIA. For example, distributions from entities, receipts from contracts, realized gains or exchanges, terminating interests, and life insurance proceeds, are allocated to principal. See UPIA 401(c), 404, and 407. Deferred compensation arrangements, annuities, and similar payments may have varying classifications. See UPIA 409. Notably, applicable state law will govern classification and may provide a different result if the state has not adopted UPIA or a variation of it. 29 UPIA 501 and 502. 30 Id. 31 UPIA 505 and 506. 32 UPIA 102(8). 33 UPIA 102(7). 34 IRC 2056(b)(7)(B)(i)-(ii). 35 Treas. Reg. 1.661(a)-1. ABA Section of Real Property Trusts & Estates Law 5

income interest will be the trust accounting income. If a trust permits a trustee to exercise discretion to accumulate or distribute income or principal, it is a complex trust. 36 C. Determine Trust Taxable Income. Once trust accounting income is determined, taxable income is determined. A trust s or an estate s taxable income is calculated in the same manner as the individual income tax rules, unless a different rule is provided under subchapter J of the Code. 37 Moreover, the adjusted gross income ( AGI ) of a trust or an estate is computed in the same manner as the AGI for an individual, with some modifications. 38 The rules surrounding the applicable deductions and how they interact are extremely nuanced, and they can be confusing due to some overlap. i. Categories of Deductions. The authors have organized the applicable deductions in the format of Categories 1 6 outlined below and in coordination with the attached Venn Diagram at Exhibit A. 39 a. Category 1. Deductions under Code 62(a). These are deductions used in arriving at AGI (above the line). Common deductions include: Trade or business expenses under Code 62(a)(1). 40 Losses from sale or exchange of property under Code 62(a)(3). 41 Management, conservation, and maintenance expenses attributed to property held for production of income that are attributable to property held for production of rents or royalties under Code 62(a)(4). 42 Reforestation expenses under Code 62(a)(11). 43 b. Category 2. Deductions under Code 63(d). These are itemized deductions (below the line) and include deductions other than the following: Standard deduction. 44 Those deductions in arriving at AGI (Category 1). 45 36 Id. 37 IRC 641(b). 38 IRC 67(e). 39 Exhibit A: Raj A. Malviya. All Rights Reserved. For a thorough discussion of the different deduction categories that apply to nongrantor trusts, see Blattmachr, Jonathan G., and Boyle, Ladson F., The Tax Act of 2017 Impacts Itemized Deductions and the Pass-Through of Excess Deductions, Probate Practice Reporter, Volume 30, Number 2. (February 2018). 40 IRC 162. 41 IRC 165. 42 IRC 212(2). 43 IRC 194. 44 IRC 63(a). 45 IRC 63(d)(1). ABA Section of Real Property Trusts & Estates Law 6

Personal exemption. 46 199A deduction. 47 c. Category 3. Deductions under Code 67(b). These are itemized deductions (below the line) that are specifically listed under Code 67(b) as being excluded from the definition of a miscellaneous itemized deduction under Code 67(b). In other words, an expense is generally a miscellaneous itemized deduction unless it is specifically excluded from the deductions listed under Code 67(b)(1) (12). Some common itemized deductions incurred in a trust or an estate administration include the following: Interest expenses. 48 Taxes (subject to the cap under the TCJA). 49 Charitable contributions 50 or amounts paid or permanently set aside for charity. 51 These deductions are only allowed if certain conditions are met. There are also charitable deduction opportunities available to trusts and estates that are not available to individual taxpayers. Subsection 10 of Section V of this paper provides a more in-depth discussion on the charitable deduction rules. Estate taxes paid on income in respect of a decedent. 52 Amortizable bond premiums. 53 d. Category 4. Deductions under Code 67(e)(2). These are deductions used in arriving at AGI (above the line). Trusts and estates are not permitted to take the standard deduction permitted by individuals, but they can take a personal exemption. The exemption amount depends on the type of trust. 54 Estates are permitted a $600 personal exemption. 55 Trusts required to distribute all of their income currently (simple trusts) are permitted a $300 personal exemption. 56 All other trusts are permitted a $100 personal exemption. 57 46 IRC 63(d)(2). 47 IRC 63(d)(3). 48 IRC 163. 49 IRC 164. 50 IRC 170. 51 IRC 642(c). 52 IRC 691(c). 53 IRC 171. 54 IRC 642(b). 55 IRC 642(b)(1). 56 IRC 642(b)(1)(B). 57 IRC 642(b)(1)(A). However, certain complex trusts may be permitted a $300 personal exemption. ABA Section of Real Property Trusts & Estates Law 7

Trusts and estates are also afforded a distribution deduction. 58 e. Category 5. Deductions under Code 67(a). These are not only itemized deductions (below the line), but they are miscellaneous itemized deductions by process of elimination. This is because Code 67(b) provides that the term miscellaneous itemized deductions means the itemized deductions other than the 12 deductions listed in Code 67(b)(1) (12) (e.g., interest, taxes, charitable contributions, medical expenses, estate tax paid on income in respect of a decedent). 59 As miscellaneous itemized deductions, they are deductible only to the extent that the aggregate of the deductions exceeds two percent of AGI. 60 i. Coordination with Code 67(e). Under Code 67(e), addressed under Category 6 below, the AGI of a trust or an estate for purposes of Code 67 is computed in the same manner as that of an individual, except that under Code 67(e)(1), the deductions for administrative costs paid or incurred by a trust or an estate that would not have been incurred if the property were not held in such trust or estate, are treated as deductions in arriving at AGI. ii. Historical Background. A brief review of the history of Code 67(e) and applicable guidance is important to fully understand how miscellaneous itemized deductions are categorized the way that they are. The Internal Revenue Service ( IRS ) first issued Proposed Regulations in 2007 providing that administrative costs would be fully deductible only to the extent that such costs were unique to a trust or an estate. In other words, if an individual could have incurred the specific expense at issue, then that expense would be a miscellaneous itemized deduction and subject to the two-percent floor. The interpretation of this statutory language and lack of clear guidance under the Proposed Regulations led to much uncertainty and litigation given that deductions described in Code 67(e) define the meaning of AGI and thus, are not miscellaneous deductions subject to the two-percent floor. Taxpayers generally argued that the IRS s interpretation of Code 67(e)(1) was overly restrictive and that situations could exist where certain trust or estate administration costs, even if not unique to a trust or an estate, did in fact constitute costs that would not have otherwise been incurred but for the holding of such property in a trust or an estate. 61 58 IRC 651 and 661. 59 IRC 67(b). 60 IRC 67(a). 61 A common example cited in tax controversy was a situation where the fiduciary duties of a trustee or executor under state law required engaging professional investment advisors; thus, making investment advisory fees, in some situations, includable under IRC 67(e) and not subject to the two-percent floor. ABA Section of Real Property Trusts & Estates Law 8

iii. Knight Decision and Proposed Regulations. After many years of litigation and uncertainty on the classification of these types of expenses, the U.S. Supreme Court ruled on the issue in Knight v. Comm r. 62 The Knight case dealt with the deductibility of advisory fees incurred by a trust. The Court held that fees paid to an investment advisor by an estate or nongrantor trust generally were classified as miscellaneous itemized deductions subject to the twopercent floor under Code 67(a) because no evidence was presented to support the conclusion that the investment advisor charged the trustee anything extra than it would have charged an individual with similar investment objectives. The Knight Court took a somewhat expansive approach, 63 and held that the proper reading of the statutory language with respect to whether the expense would not have been incurred if the property were not held in such trust or estate requires an inquiry into whether a hypothetical individual who held the same property outside of a trust would customarily or commonly incur such expenses. The Court reasoned that the language of Code 67(e)(1) necessarily involved a prediction of what would happen if the property were held by an individual rather than a trust, and that predictions are based on customary or common occurrences. The Court went on to hold that expenses customarily or commonly incurred by individuals are subject to the two percent floor. iv. Final Regulations. Subsequent to the Court s decision in Knight, the IRS issued various notices to provide interim guidance on the treatment of investment advisory fees that were bundled as a single fee to the fiduciary. 64 The IRS then issued revised Proposed Regulations in 2011 and withdrew the 2007 Proposed Regulations. 65 The 2011 Proposed Regulations, with minor revisions, were adopted in the long-awaited Final Regulations, which took effect on May 9, 2014. 66 v. Deductions under Code 642. These deductions arise out of various investment or business contexts and are separate from specific deductions listed under Code 642 in Category 4. In general, unless deduction are specifically listed under Code 62, are exempted from being miscellaneous itemized deductions under Code 67(b)(1) (12), or are included in the grouping of those 62 Knight v. Comm r, 552 U.S. 181 (2008). 63 The Court cited prior decisions such as Scott v. U.S., 328 F.3d 132 (4 th Cir. 2003) and Mellon Bank, N. A. v. U.S., 265 F.3d 1275 (Fed Cir. 2001). 64 See Notice 2008-32; Notice 2008-116; Notice 2010-32; Notice 2011-37. 65 Prop. Reg. 1.67-4. 66 Treas. Reg. 1.67-4. The IRS subsequently amended these regulations on July 16, 2014, to extend the effective date of the final regulations to tax years beginning after December 31, 2014. Treas. Reg. 1.67-4(d). ABA Section of Real Property Trusts & Estates Law 9

deductions taken in arriving at AGI under Code 67(e) (see Categories 1, 4, 5 and 6), they are treated as miscellaneous itemized deductions. Common deductions under Code 642 include: Net operating losses under Code 172 (with exception of those passing out to beneficiaries in final year of administration). 67 Deprecation under Code 167(d) and 611(b). 68 Amortization under Code 169 and 197. 69 f. Category 6. Deductions under Code 67(e)(1). These are deductions used in arriving at AGI (above the line) for expenses that are unique to a trust or an estate. In other words, these are expenses that would not have been incurred if the property were not held in a trust or an estate. i. Coordination with Code 67(a). As previously mentioned above under Category 5, Knight held that the proper reading of Code 67(e) is whether the expense would not have been incurred if the property were not held in such trust or estate requires an inquiry into whether a hypothetical individual who held the same property outside of a trust would customarily or commonly incur such an expense. 70 If an expense is unrelated to the existence, validity, or administration of the trust or estate, it is considered a cost incurred commonly or customarily by individuals; therefore it is categorized as a miscellaneous itemized deduction subject to the two percent floor. 71 ii. Final Regulations: Expenses Unique To Trusts and Estates. These are the Final Regulations adopted by the Knight decision and provide that ownership costs constitute costs that are commonly or customarily incurred by a hypothetical individual owner of such property and, accordingly, are subject to the two-percent floor. 72 In determining whether the cost would be commonly or customarily incurred by a hypothetical individual owning the same property, the 67 IRC 642(d). 68 IRC 642(e). Importantly, the depreciation deduction is apportioned between the trust or estate and the beneficiaries on the basis of the trust income allocable to each, unless the governing instrument or local law requires or permits the trustee to maintain a depreciation reserve. Thus, if all of the trust accounting income is to be distributed to the beneficiary, the depreciation deduction is allocated in full to the beneficiary, and no part of it is deductible by the trust. If the trustee is required to maintain a reserve for depreciation, that amount must be allocated to the trust. The treatment of depreciation for trust accounting purposes may be entirely different than its treatment for income tax purposes. Unless the governing instrument or state law requires depreciation to be considered and charged against income, it will be ignored in the accounting system and will not be charged to income for trust accounting purposes. Treas. Reg. 1.642(e)-1. 69 IRC 642(f). 70 Knight v. Comm r, 552 U.S. 181 (2008). 71 Treas. Reg. 1.67-4(b)(1). 72 Treas. Reg. 1.67-4. ABA Section of Real Property Trusts & Estates Law 10

type of product or service rendered to the trust or the estate is determinative. 73 The Final Regulations address several types of costs typically incurred in a trust or an estate administration. In addition to analyzing those costs, the Regulations provide that costs incurred in defense of a claim against the estate, the decedent, or the nongrantor trust that are unrelated to the existence, validity, or administration of the trust or estate are considered costs incurred commonly or customarily by individuals and are therefore subject to the two percent floor. 74 Ownership costs are defined as costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. Examples of expenses that would not have been incurred if the property were not held in a trust or an estate (i.e., these are not miscellaneous itemized deductions subject to the two-percent floor) include: Tax preparation fees for the following returns: estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent s final individual income tax return. 75 Note that gift tax returns filed after the donor s death are not on this list. Investment advice beyond the amount that normally would be charged to an individual investor because the investment advice is rendered to a trust or an estate rather than to an individual or attributable to an unusual investment objective or the need for a specialized balancing of the interests of various parties. 76 Appraisal fees to determine the fair market value of assets as of the decedent s date of death (or the alternate valuation date), to determine value for purposes of making distributions, or as otherwise required to properly prepare the estate s or trust s tax returns, or a generation-skipping transfer tax return. 77 Certain fiduciary fees and expenses that are not commonly or customarily incurred by individuals. These include, but are not limited to: probate court fees and costs, fiduciary bond premiums, legal publication costs of notices to creditors or heirs, the cost of certified copies of the decedent s death certificate, and costs related to fiduciary accounts. 78 73 Treas. Reg. 1.67-4(a) and 1.67-4(b)(1). 74 Treas. Reg. 1.67-4(b)(1). 75 Treas. Reg. 1.67-4(b)(3). 76 Treas. Reg. 1.67-4(b)(4). 77 Treas. Reg. 1.67-4(b)(5). 78 Treas. Reg. 1.67-4(b)(6). ABA Section of Real Property Trusts & Estates Law 11

iii. Unbundling Professional Fees. The Regulations provide that a bundled fee must generally be unbundled and allocated between costs that are subject to the two-percent floor (miscellaneous itemized deductions) and those that are not. 79 A bundled fee is a single fee, such as a fiduciary s commission or fee, attorney s fee, or accountant s fee, that encompasses costs that are subject to both categories. 80 To reduce the administrative burdens in unbundling costs, the Regulations provide that if a bundled fee is not computed on an hourly basis, then only the portion of the cost attributable to investment advice is subject to the two-percent floor. 81 This carveout was designed to allow equal treatment for taxpayers who pay investment fees to a third-party investment advisor and those who pay investment fees as part of an overall bundled fiduciary fee. Given that a component of most advisory fees is based on the fair market value of assets under management (and not on an hourly basis), a trustee paying for such fees would only need to make an allocation of its bundled fiduciary fee to comprise of those costs attributable to investment advice. Legal and accounting fees tend to be easier to allocate, since they are generally computed on an hourly basis outlining the underlying services rendered. The level of detail involved in an unbundling exercise is not prescribed in the Regulations or in any ruling. Rather, the Regulations simply provide that any reasonable method may be used to allocate a bundled fee, including, without limitation, the allocation of a portion of a bundled fiduciary fee to investment advice. 82 iv. Suspension of Miscellaneous Itemized Deductions under TCJA. The proper classification of deductions under Categories 5 and 6 above is important, since the TCJA added new Code 67(g), which suspends miscellaneous itemized deductions through 2025. 83 Therefore, if an expense incurred in the administration of an estate or nongrantor trust cannot be categorized under Code 67(e) because it is one customarily or commonly incurred by individuals, it will be categorized as a miscellaneous itemized deduction and not deductible through 2025 under the new law. 79 Treas. Reg. 1.67-4(c)(1). 80 Id. 81 Treas. Reg. 1.67-4(c)(2). 82 Treas. Reg. 1.67-4(c)(4). The regulations provide the following nonexhaustive factors to offer guidance in connection with determining whether an allocation is reasonable: (1) the percentage of the value of the corpus subject to investment advice; (2) whether a third-party advisor would have charged a comparable fee for similar advisory services; and (3) the amount of the fiduciary s attention to the trust or estate that is devoted to investment advice as compared to dealings with beneficiaries, distribution decisions, and other fiduciary functions. Id. 83 See 11045 of the TCJA; IRC 67(g). ABA Section of Real Property Trusts & Estates Law 12

v. New Code 67(g) and Interaction with Code 67(e). For a short period of time after the enactment of Code 67(g), some practitioners were uncertain whether Code 67(g) affected the deductibility of expenses categorized under Code 67(e)(1). This uncertainly likely stemmed from the first sentence of Treasury Regulation 1.67-4(a), which refers to expenses categorized under Code 67(e) as exception[s] to the two-percent floor in miscellaneous itemized deductions However, by definition, an expense that falls under Code 67(e) is one that is initially treated as a deduction in arriving at AGI not an exception to miscellaneous itemized deduction treatment. 84. vi. IRS Issues Clarification. The IRS clarified any uncertainty by issuing Notice 2018-61, which states that the Treasury Department and the IRS believe that the suspension by Code 67(g) of the deductibility of miscellaneous itemized deductions under Code 67(a) does not affect the deductibility of payments described in Code 67(e)(1). 85 Notice 2018-61 further reinforces the Knight holding and Final Regulations promulgated thereunder, stating that an expense that commonly or customarily would be incurred by an individual (including the appropriate portion of a fiduciary s bundled fee) is not a payment described in Code 67(e)(1) and therefore, is a miscellaneous itemized deduction not deductible by a trust or an estate during the suspension of such deductions previously allowable under Code 67(a). 86 Notice 2018-61 further states that an expense that commonly or customarily would be incurred by an individual (including the appropriate portion of a fiduciary s bundled fee) is not a payment described in Code 67(e)(1) and, therefore, is affected by Code 67(g) and is not deductible by a trust or an estate during the suspension of the deductions previously allowable under Code 67(a). 87 84 See IRC 67(e), flush language Determination of adjusted gross income in case of estates and trusts. This has been an area of confusion for quite some time. Perhaps this uncertainty could have been avoided if the regulation read something along the lines of IRC 67(e) provides that costs paid or incurred in connection with the administration of an estate or a nongrantor trust that would not have been incurred if the property were not held in such estate or trust shall be allowed in determining adjusted gross income, or something similar. The authors commend ABA member and ACTEC Fellow, Austin Bramwell, who has highlighted this issue and solutions for clarification on several occasions through teaching, continuing legal education, and committee work. For example, see Bramwell, Austin, Select Treasury Guidance Projects: What to Expect, Spring Symposia, American Bar Association Real Property Trust and Estate Law Section, May 10, 2018; Bramwell, Austin and Kaufman, Beth, Select Treasury Guidance Projects: What to Expect, ACTEC Fall Meeting, October 26, 2018. 85 Notice 2018-61. 86 Id. 87 Id. ABA Section of Real Property Trusts & Estates Law 13

D. Tax Credits. A trust or an estate may claim the foreign tax credit to the extent not allocable to the beneficiaries. 88 E. Determine DNI. DNI is a term of art created by the tax law to serve a narrow, but important, role in the income taxation of trusts and estates. The primary function of DNI is to place a limit on not only the amount of the trust s or estate s distribution deduction, but also on the amount and the character of current income attributable to the income beneficiaries for taxation in the current year. DNI is essential to the calculation of taxable income because it limits the amount of the distribution deduction. 89 Code 643 defines DNI as the taxable income of the trust or estate computed with the following modifications. 90 The modifications to DNI under Code 643 are outlined below. i. Distribution Deduction under Code 651 and 661. The distribution deduction is effectively added back to taxable income. 91 This modification is really just structural to allow for the distribution deduction, which is limited to the taxable portion of DNI, to function as intended. ii. iii. Deduction for Personal Exemption. The personal exemption is added back to taxable income. 92 This upward adjustment ensures that DNI is larger than taxable income, meaning that a larger distribution deduction is available to the entity for current income distribution. Similarly, a larger amount is subject to inclusion in the taxable income of the beneficiaries of the trust or estate who received distributions, in each case because DNI is a cap on each. The net effect is to only reduce tax consequences to the entity it does not benefit the beneficiaries, who have their own personal exemptions. Capital Gains (Losses). Capital gains (losses) are generally excluded (subtracted) from DNI to the extent they are allocated to corpus and are not paid, credited, or required to be distributed to a beneficiary or paid to or set aside for charity. 93 This adjustment ensures that items of taxable income that are allocated to fiduciary accounting principal and not currently distributed will effectively reduce DNI and, correspondingly, reduce the maximum distributions deduction, thereby causing the gains to be taxed to the entity in years when accumulated and not distributed. Several exceptions to this rule apply, which are outlined in Section IV of this paper below. Capital gains are included as part of DNI in the final tax year of a trust or 88 IRC 642(a) and 901. 89 IRC 651(b) and 661(a). 90 IRC 643(a)(1)-(6). 91 IRC 643(a)(1). 92 IRC 643(a)(2). 93 IRC 643(a)(3). There are exceptions, which are mentioned later in this paper, to this rule. Also, the fiduciary income tax rules governing non-domestic (foreign) trusts generally include capital gains in DNI. This paper only mainly domestic nongrantor trusts, but there is a brief discussion at Section F below on foreign nongrantor trusts. ABA Section of Real Property Trusts & Estates Law 14

an estate. 94 In recognition that modern portfolio theory focuses on total return, many states have adopted laws that permit a trustee to convert the trust to a unitrust. 95 iv. Extraordinary Dividends and Taxable Stock Dividends. Extraordinary dividends and taxable stock dividends are excluded from DNI if they are received by a simple trust and not distributed. This is because these types of dividends are allocated to corpus by the fiduciary in good faith and in accordance with the governing instrument and local law. 96 v. Tax-Exempt Interest and Income from Foreign Trusts. Tax-exempt interest and income from foreign trusts are included (added back) in DNI, but both types of interest are reduced by any amounts disallowed by Code 265 and by the share of the charitable deduction allowed by the trust or estate. 97 This add-back serves to permit this form of tax-favored income to pass through to the beneficiaries by increasing DNI, and thus, increasing both the distribution deduction and the amount subject to inclusion at the beneficiary level. When tax-exempt income is included in DNI, a proportionate share of the expenses of the trust not allocable to particular items of income must be allocated to tax-exempt income and are not deductible. 98 The net tax-exempt income must be allocated to the beneficiaries if distributions are made. 99 vi. vii. Exclusions from DNI. Certain specific distributions cannot carry out DNI. For example, any amount which, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of a specific sum of money, or of specific property which is paid or credited all at once or in not more than three installments, shall be considered a gift or bequest of money or specific property. 100 DNI Calculation. In summary, DNI is calculated under Code 643(a) as follows: Start with taxable income Add back the distribution deduction Add back the personal exemption Subtract out capital gains or add back capital losses allocable to principal (except for in the year of termination) 94 Treas. Reg. 1.643(a)-3(b). 95 See Treas. Reg. 1.643(a)-3(b)(1). Applicable state law should be consulted to determine whether conversion to a unitrust income interest is possible, either by statutory procedure or petition. 96 IRC 643(a)(4). 97 IRC 643(a)(5)-(6). 98 Treas. Reg. 1.643(a)-5(a). 99 Id. 100 IRC 663(a)(1). ABA Section of Real Property Trusts & Estates Law 15

Subtract out extraordinary dividends and taxable stock dividends allocable to corpus for a simple trust Add back tax-exempt income F. Different DNI Rules for Foreign Nongrantor Trusts. The DNI of a foreign nongrantor trust is computed in the same manner as the DNI of a domestic nongrantor trust, with several modifications. A foreign nongrantor trust s DNI includes (1) gross income from sources outside of the United States 101 ; (2) capital gains, regardless of whether allocated to income or principal 102 ; and (3) gross income from sources within the United States without regard to certain income exempted under a treaty by Code 894. 103 While a thorough discussion of foreign nongrantor trusts is well beyond the scope of this paper, practitioners must still be able to recognize whether a trust is a foreign trust and if it is, the application of what are known as the throwback rules, which attempt to remove income tax incentives for accumulating trust income in foreign trusts. Failure to recognize whether a foreign trust exists and to understand the implication of the throwback rules could lead to punitive results, given the remarkable texture of the rules and how they interact with the concepts of DNI and FAI. To aid practitioners in issue-spotting, below is a summary of the general rules that govern classification of trusts, foreign or domestic, and the throwback rule regime. i. Overview of Foreign Nongrantor Trusts and Throwback Rules. Decades ago, trust income was taxed in lower brackets than individual income. As a result, trustees minimized income tax by accumulating, and subjecting to tax at lower rates, income and later distributing principal to beneficiaries. In response to this behavior, Congress enacted what are known as the throwback rules under Code 665 through 668. 104 The TPA repealed the throwback rules with respect to distributions made from most domestic trusts, 105 but they continue to apply to (1) foreign trusts; (2) trusts created before March 1, 1984 that would be treated as multiple trusts under Code 643(f); and (3) except as otherwise provided in Regulations, domestic trusts that used to be treated as foreign trusts. 106 The throwback rules are complex, rely on the coordination and application of several nuanced terms, and can plant tax landmines if not managed properly. If a foreign nongrantor trust makes distributions in excess of the trust s DNI for a particular year, the U.S. beneficiaries who receive the distributions may be affected under the throwback rules. When in effect, the throwback rules likely require U.S. beneficiaries to include such distributions in their gross incomes, to calculate their U.S. income tax on such distributions under a complex set of computations 101 IRC 643(a)(6)(A). 102 IRC 643(a)(6)(C). 103 IRC 643(a)(6)(B). 104 IRC 665 668. 105 P.L. 105-34, 507(a)(2). See IRC 665(c)(1). 106 IRC 665(c)(2). ABA Section of Real Property Trusts & Estates Law 16

designed to mimic a retroactive distribution, and to be subject to a significant amount of interest on these taxes. 107 ii. Domestic vs. Foreign Trust Classification. Until 1996, key factors such as the identity of the trustees, the residence of the beneficiaries, the location of the trust administration and trust assets, and the governing law of the trust were all weighed in determining whether a trust would be treated as a foreign or domestic trust. The characterization of a trust as foreign or domestic was clarified by provisions of the Small Business Job Protection Act of 1996, the related proposed Regulations issued in June of 1997, and the TPA. The rules are now clearer and much more objective a trust is automatically a foreign trust unless it satisfies both a court test and a control test. 108 a. Court Test. In determining whether a trust satisfies the court test, consideration must be given to all of the terms of the trust instrument. To satisfy the control test, the U.S. court must have the authority to render judgments or orders, or resolve issues regarding the trust s administration. 109 Moreover, the U.S. court must have the authority regarding substantially all of the issues regarding the trust s administration. 110 A trust may satisfy the court test even if a U.S. court and a foreign court both have primary supervision over the trust. 111 The Regulations contain several safe harbor provisions for certain trusts to satisfy the court test. One in particular involves registering the trust in a U.S. probate court pursuant to a state statute that has provisions identical or similar to those of the Uniform Probate Code. 112 b. Control Test. Similar to the court test, the criteria for satisfying the control test are set forth in the Treasury Regulations. The term control means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. To determine whether U.S. persons have control, it is necessary to consider all persons, not only the trust fiduciaries, who have authority to make a substantial decision of the trust. 113 A substantial decision means a decision that is not simply ministerial, and include decisions such as: 107 IRC 665 668. 108 IRC 7701(a)(30)(E). 109 Treas. Reg. 301.7701-7(c)(3)(iii). 110 Treas. Reg. 301.7701-7(c)(3)(iv). 111 Treas. Reg. 301.7701-7(c)(4)(i)(D). 112 Treas. Reg. 301.7701-7(c)(4)(i)(A) and (C). 113 Treas. Reg. 301.7701-7(d)(iii). ABA Section of Real Property Trusts & Estates Law 17

Whether and when to distribute income or corpus; The amount of any distributions; The selection of a beneficiary; Whether a receipt is allocable to income or principal; Whether to terminate the trust; Whether to compromise, arbitrate, or abandon claims of the trust; Whether to sue on behalf of the trust or to defend suits against the trust; Whether to remove, add, or replace a trustee; Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust s residency from foreign to domestic, or vice versa; and Investment decisions. However, if a U.S. person hires a foreign investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the U.S. person if the U.S. person can terminate the investment advisor s power to make investment decisions at will. 114 The control test can be a trap for practitioners who are not versed in the intricacies of these rules. For example, under the control test, a trust may be a foreign trust even if it was created by a U.S. person, all of its assets are located in the U.S., and all of its beneficiaries are U.S. persons. All it takes is one foreign person who has control over only a substantial type of trust decision as outlined in the Regulations. iii. Accumulation Distribution. The throwback rules apply only if a foreign nongrantor trust makes what is called an accumulation distribution. An accumulation distribution is one made pursuant to Code 661(a)(2), to the extent such distribution exceeds the trust s DNI for the year, reduced by trust accounting income required to be distributed currently. 115 Consequently, income that is currently distributable is not subject to the throwback rules. Moreover, distributions that do not exceed trust accounting income in the year made are not accumulation distributions. 116 iv. Undistributed Net Income. An additional measuring stick that limits the amount of an accumulation distribution subject to tax is called undistributed net income 114 Treas. Reg. 301.7701-7(d)(ii). 115 IRC 665(b). 116 Treas. Reg. 1.643(b)-1. ABA Section of Real Property Trusts & Estates Law 18

( UNI ). A trust s UNI for any year is equal to the amount that DNI exceeds the sum of: (1) trust accounting income required to be distributed; (2) any other amount properly paid or credited or required to be distributed; and (3) any taxes imposed on the trust that are attributable to its DNI. 117 The above definitions (and limitations) allow for planning opportunities. If a foreign nongrantor trust has no UNI, then no tax will be imposed on its accumulation distributions. v. Applying the Throwback Rules. Once a foreign nongrantor trust has UNI, it remains in the trust until it is distributed. When the total distributions from a foreign nongrantor trust for a tax year exceed FAI, the distributions will first be deemed to carry out current year DNI until exhausted and second will be deemed to come from UNI, on a first-in, first-out basis (as an accumulation distribution) carried forward from prior years until UNI is exhausted. 118 Once all DNI and UNI have been exhausted, the balance of any distributions for the tax year is deemed to be a nontaxable distribution of principal. 119 vi. Throwback Computations. The throwback rule computations for a beneficiary are lengthy and well beyond the scope of this paper. Conceptually, the throwback rules treat an accumulation distribution as though it had been distributed to a beneficiary in the year in which the trust income was historically earned. 120 These rules provide that distributions, and the taxes paid on the accumulated income, are taxed to the beneficiary at the beneficiary s tax bracket for the years in which income was accumulated, and there is a nondeductible interest charge imposed on the tax due by the beneficiary on the accumulated income per annum from the date the income was originally earned by the trust. 121 The interest charge is pegged to the rate applicable to underpayment of tax and is compounded daily. 122 The combination of the throwback tax and interest charge can result in a tax as large as the distribution itself because the longer UNI accumulates in a trust, the higher the interest charge. G. Determine Distribution Deduction. Once DNI has been calculated, the distribution deduction and taxable income can be calculated. i. Simple Trusts. For simple trusts, the trust receives a distribution deduction for the amount of income that is required to be distributed currently, limited to the amount of DNI. 123 ii. Complex Trusts. For complex trusts, the trust receives a distribution deduction for the amount of income required to be distributed currently and for any other 117 IRC 665(a). 118 IRC 665(a); Treas. Reg. 1.665(a)-1A(b). 119 IRC 665(b) and 666. 120 IRC 667(a). 121 IRC 665 668. 122 IRC 668(a)(1). ABA Section of Real Property Trusts & Estates Law 19

iii. amounts of income or corpus properly paid, credited or required to be distributed, but limited to DNI. 124 Tax Exempt Portion. No deductions are allowed for an item of DNI that is not part of the trust s gross income; therefore, the trust must subtract from its distribution deduction that portion of any distributions considered to be taxexempt. 125 H. Distribution in Kind of Appreciated Property. A trust or an estate will realize income when it distributes appreciated property in satisfaction of a pecuniary bequest. 126 The trust or estate is treated as if it sold the property to the beneficiary at its fair market value. Gain may be recognized when funding a pecuniary marital bequest. A distribution of appreciated property that is not in satisfaction of a pecuniary bequest will not result in gain or loss unless the fiduciary so elects. 127 I. Income in Respect of a Decedent ( IRD ). Items that would have been income to a decedent, but were not recognized before death, retain their character and are income when received by the estate or beneficiary of the item. 128 The recipient of IRD does not receive a stepped-up basis in the item as a result of the decedent s death. 129 The recipient is entitled to a Federal (but not state, if applicable) income tax deduction for the estate tax attributable to the inclusion of the item in the decedent s gross estate a deduction in respect of a decedent. If a fiduciary receives IRD and distributes it to a beneficiary in the year of receipt, the beneficiary will receive both the IRD and the deduction. J. Alternative Minimum Tax. Trusts and estates are subject to the same alternative minimum tax ( AMT ) liability as individuals. 130 Trusts and estates compute their AMT liability on Schedule I of Form 1041. K. Tax Year Reporting. In general, a trust uses a calendar year for its tax year, but can elect to be treated as an estate by making a certain election known as a 645 election, which is discussed in Section V of this paper. 131 An estate may report on calendar or fiscal year basis. A fiscal year may end on the last day of any month, but can extend no longer than 12 months. 123 IRC 651. 124 IRC 661(a). As explained above, this deduction is limited to distributable net income. 125 IRC 651(b) and 661(c). 126 Treas. Reg. 1.1014-4(a)(3). 127 IRC 643(e)(3) and 663(a)(1). 128 IRC 691. 129 IRC 1014. 130 IRC 55. 131 IRC 644(a) and 645. In practice, the IRS automatically puts an estate on a fiscal year (in determining the 1041 due date). An estate can essentially file on a calendar year end by filing a short year return. ABA Section of Real Property Trusts & Estates Law 20