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Allocating Capital Gains to Distributable Net Income in Estates and Trusts: Achieving Optimal Tax Treatment FEBRUARY 13, 2018 Jeremiah W. Doyle, IV, Senior Wealth Strategist BNY Mellon Wealth Management, Boston jere.doyle@bnymellon.com Jacqueline Patterson, Partner Buchanan & Patterson, Los Angeles jpatterson@bplawllp.com
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.
Including Gains in Distributable Net Income Jeremiah W. Doyle IV, Esq. Senior Vice President BNY Mellon Wealth Management One Boston Place Boston, MA Jere.doyle@bnymellon.com Jacqueline A. Patterson, Esq. Buchanan & Patterson, LLP 1000 Wilshire Blvd. Suite 570 Los Angeles, CA 90017 jpatterson@bplawllp.com February, 2018 5
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 6
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 trusts and estates versus rates for individuals Estates and trusts reach 20% maximum rate for long-term capital gains, the 37% bracket for ordinary income (including short-term capital gains) and the 3.8% surtax at $12,500 of taxable income (2018) Individuals reach maximum rate for long-term capital gains and the 3.8% surtax at higher thresholds 7
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 8
Background - 2018 Fiduciary Income Tax Rates Over Not Over 0 2,550 10% 2,550 9,150 24% 9,150 12,500 35% 12,500 37% 9
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 10
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 11
Background - Income Taxation of Trusts and Estates DNI DNI acts as ceiling on entity s distribution deduction DNI acts as ceiling on amount beneficiary accounts for on his return Trust/Estate Beneficiary 12
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 13
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 14
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 37% + 3.8% surtax if taxable income exceeds $12,500 (2018) Long-term capital gains taxed at 20% + 3.8% surtax if taxable income exceeds $12,500 (2018) Planning point have gains taxed to beneficiary where gains would most likely be taxed at a lower tax rate 15
Including Capital Gains in DNI The Problem Where a beneficiary is entitled to distributions of principal, the beneficiary is not taxed in 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 16
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. 17
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 Regulations have: Two prerequisites and Three methods 18
Analyzing Regulation 1.643(a)-3(b) Two prerequisites capital gains included n 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 19
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 the 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 20
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. 21
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 The trustee allocates gains to income by a reasonable and impartial exercise of discretion granted by the trust instrument Solution if trust instrument is silent as to whether capital gains are allocated to income Decant Most states require trustee have significant discretion to distribute principal. 22
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 23
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 24
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Method 1-1.643(a)-3(b)(1) Two alternative ways capital gains can be allocated to income: Power adjust under UPIA Unitrust statute 26
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 capital gains 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 27
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 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 28
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. 29
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 30
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) 31
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 32
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 capital gain to income 33
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 taxexempt 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 capital gain to income 34
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. 35
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 K-1 with gains Trust DNI with p/ship gains Beneficiaries 36
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 is 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 37
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 38
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. 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. 39
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 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 40
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 of 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 41
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 42
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 43
Method 3-1.643(a)-3(b)(3) Actually distribute capital gains to a beneficiary Trusts with age attainment distribution provisions Example: Principal distribution required at stated ages (1/3 at 25, 1/3 at 30 and balance at 35), and asset must be sold to make the distribution. See Reg. 1.643(a)-3(e), Example 9. 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? 44
Method 3-1.643(a)-3(e) Example 7 Trust termination 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 45
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 46
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. 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 47
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 48
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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) 50
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 51
In-Kind Distributions Under 643(e) General rule: An estate or trust does not recognize gain or loss on the inkind 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). 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. 52
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 53
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 54
Resources Federal Income Taxation of Estates, Trusts and Beneficiaries, 3 rd 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, 3 rd Edition (RIA/Thompson/West) Income Taxation of Fiduciaries and Beneficiaries by Byrle M. Abbin, 2 volumes, 2017 Edition (CCH) 55
Thank You! 56