Income tax planning for trust and estate distributions.
The tax adviser to a trust or an estate is in an excellent position to offer more than tax compliance services to its fiduciaries and beneficiaries. He will often be able to reduce the overall income taxes payable by the trust or estate and its beneficiaries by providing timely advice as to when, how and to whom income and/or principal should be distributed. These tax savings often substantially exceed the tax adviser's total fee, including the portion attributable to compliance services.
This article will review many of the established planning tools and techniques, in order to alert tax professionals to, or remind them of, income tax planning tools that will be useful to their fiduciary clients during trust and estate administration.
To use these techniques effectively, the tax adviser must have a good working knowledge of the basic rules governing the income tax treatment of distributions made by trusts and estates. Therefore, before discussing planning techniques, the basic rules of taxation, which are set out in subchapter J of the Code (Secs. 641-692, governing the taxation of estates, trusts and beneficiaries) and the related regulations, will be reviewed.
It should be noted that a tax adviser cannot properly prepare a fiduciary income tax return, much less engage in tax planning for a trust or an estate, unless he is familiar with fiduciary accounting principles and the applicable state law. The latter requirement makes it essential for a tax accountant to establish a consulting arrangement with a lawyer who is especially competent in the field of trusts and estates.
The principles of the income taxation of trusts and estates and the related tax planning techniques will be broken down into the following 25 parts. Parts 1 through 13 are covered in this installment; parts 14 through 25 will be published in March.
1. General scheme for taxation of fiduciary income.
2. How simple trusts are taxed.
3. Tax character of distributions.
4. When beneficiary must report distribution.
5. Current distributions of complex trusts and
6. Charitable contributions.
7. Taxability of distributions of principal.
8. Taxation of current year's capital gains to beneficiary.
9. Treatment of net capital losses.
10. The "sixty-five day" rule.
11. The "separate share" rule.
12. The distributions deduction for alternative
13. Funding bequests with property in kind.
14. Distributions of interests in passive activities.
15. Distributions of income in respect of a decedent.
16. Phantom fiduciary taxable income.
17. Reducing and deferring taxes by distributing
18. Planning through distributions of principal.
19. Planning terminating distributions.
20. Distributions by complex trusts from accumulated
21. Taxation of multiple trusts.
22. Distributions of charitable remainder trusts.
23. Grantor trust taxation.
24. Distributions from foreign trusts.
In addition, since one example is often worth many words of explanation, the discussion will be illustrated with numerous examples.
1. General Scheme for Taxation
of Fiduciary Income
Estates and trusts are separate taxable entities. In general, income is initially taxed to either the estate/trust or to the beneficiaries, depending on the terms of the governing instrument and local law. To the extent income is distributed or distributable and the beneficiaries are taxed, the estate/trust is generally considered to be a conduit. To accomplish this result, the fiduciary is permitted to deduct the amount of distributed or distributable income and the beneficiary is required to include a corresponding amount in his gross income.
Ordinary trust income that is accumulated and is not initially taxed to the beneficiaries is, under present law, taxed to them on ultimate distribution (but see Part 20 in March).
2. How Simple Trusts Are Taxed
The regulations divide all trusts into two types - "simple" or "complex."(1) A simple trust is one that, under the terms of its governing instrument, is required to distribute all of its "income" currently and makes no distributions from principal or to charities.
The term "income," without modifications,(2) is defined in accordance with local trust law. For trust (and estate) accounting purposes, "income" receipts and payments are distinguished from those allocable to "principal." Thus, "income" normally consists of dividends, interest and other types of income earned as the result of the investment of trust principal. Gains realized on the sale of principal assets, however, generally constitute "principal" under local law.
In computing its taxable income, a simple trust is allowed a deduction for distributions to beneficiaries limited to the lower of - the amount of "income" required (under local law) to be distributed currently (IRDC), or - the amount of "distributable net income" (DNI).(3)
DNI is the trust's taxable income, with certain modifications specified in Sec. 643(a): * The personal exemption ($300 for a simple trust, $100 for a complex trust and $600 for an estate) is not allowed. * The deduction otherwise allowable for distributions to beneficiaries is not allowed. * Undistributed capital gains or losses allocated to principal are excluded. * Undistributed extraordinary dividends and taxable stock dividends allocated in good faith to principal are excluded.
Example 1: A simple trust, created on Feb. 17,19XX, realized the following income and expenses during its year ended Dec. 31, 19XX. Trust accounting Tax Income Principal Total Dividends $40,000 $ - $40,000 Interest 10,000 - 10,000 Capital gains 20,200 20,200 50,000 20,200 70,200 Trustee's commissions 5,000 3,000 8,000 Net $45,000 $17,200 $62,200 The deduction for distributions is $42,000, computed as follows: Lesser of: IRDC - required distributable income for trust accounting purposes $45,000 or DNI - $62,200 $20,200 capital gains $42,000 Note: The result of this computation is that principal expenses inure to the benefit of the income beneficiary.
Items that are not included in gross income are not eligible for the distributions deduction. Thus, in computing the actual distributions deduction, both IRDC and DNI are reduced by net tax-exempt income.
3. Tax Character of Distributions
Under the conduit approach, the trust beneficiary must include in gross income the amount the trust is allowed as a deduction for distributions.(4) The amount of the distributions deduction allowed to a simple trust will be taxed to the beneficiary whether or not the amount was actually distributed to him because the income was required to be distributed.
When reported on the beneficiary's tax return, the trust income retains the same character it had in the hands of the trust (e.g., dividend income, interest income, etc.).(5) Because the computation of DNI begins with the trust's taxable income, however, all deductions - including those chargeable to principal - are automatically taken into account and only the net amount is reportable by the beneficiary.
In determining the character of the components of "net" income, how are trust deductions allocated against the various components of "gross" income? The regulations provide specific rules for making the allocation: * Deductions directly related to specific types of income reduce the applicable income. For example, real estate taxes and mortgage interest are offset against rental income. * Any deduction not specifically related to a particular type of income is allocated among the various classes of income in any manner chosen by the trustee.(6)
Example 2: In Example 1, the income beneficiary should report $42,000 as income from the trust on his return. At the election of the trustee, the beneficiary may reflect $40,000 of dividend income and $2,000 ($10,000 - deductions of $8,000) of other income. The deductions allowed to the trust can be apportioned between the dividend and interest income in any manner (for example, in proportion to the amounts of gross income), at the trustee's option.
As a result of the DNI concept, the income beneficiary will usually receive the entire benefit of deductions paid from principal. To the extent that deductible principal disbursements are made for a tax year, he will receive income free of tax.
Example 3: The beneficiary in Example 1 is entitled to $45,000 of income (the amount of IRDC) for the year ended Dec. 31, 19XX. However, he will be taxed on only $42,000 - the amount of the distributions deduction allowed to the trust. The $3,000 difference represents the trustee's commissions chargeable to principal. It is because of the DNI concept that the income beneficiary receives the benefit of this principal deduction.
To the extent that they constitute taxable income, receipts that are allocable to principal for fiduciary accounting purposes are normally taxed to the trust or estate. For example, capital gains realized on principal investments are ordinarily taxed to the trust or estate.
Example 4: The $20,200 capital gain realized by the trust in Example 1 will be taxed to the trust. Although the capital gain constitutes a principal receipt, the expenses paid out of principal (trustee's commissions) do not reduce the amount of the capital gain that will be taxed to the trust. Instead, as shown in Example 3, these deductions inure to the benefit of the income beneficiary.
Under the conduit principle of fiduciary income taxation, other items flow through the trust or estate to the beneficiary. For example, depreciation and depletion deductions(7) are generally not allowed to the fiduciary of the property; instead, these deductions pass through to the beneficiary who is taxed on the income to which the deductions are attributable. Foreign income received by the trust or estate retains its character as foreign income in the hands of the beneficiary-distributee and he, not the fiduciary, is entitled to any credit allowable for foreign tax paid on such income.
4. When Beneficiary Must Report
If a trust or estate and its beneficiary use the same tax year, the beneficiary reports his taxable share of income in the same year that the fiduciary deducts the amount. When, however, an executor and the beneficiary use different tax accounting periods, however, the beneficiary includes in his gross income the amount of income taxable to him for the tax year(s) of the estate ending with or within his tax year.(8) In effect, the amounts reported on the fiduciary income tax return as taxable to the beneficiary are deemed distributed as of the last day of the trust's tax year.
There is a once-in-a-lifetime exception to this general rule. In the year of a beneficiary's death, any income actually received by him from a trust or estate up to and including the date of his death (limited, of course, to the DNI) is includible on his final income tax return.(9) In other words, the income of the trust or estate is not treated as distributed to the deceased beneficiary on the last day of the trust's or estate's year, but instead, to the extent paid to him before death, it is treated as distributed to him as actually paid.
Example 5: The income beneficiary of a calendar-year simple trust died on Nov. 11, 19XX. The trust received net income of $3,000 each month. Since each month's income was distributed to the income beneficiary on the tenth day of the month following receipt, $30,000 (10 months) of the 19XX net income was distributed to the beneficiary before his death.
Even though the beneficiary did not live until Dec. 31, 19XX (the last day of the trust's 19XX year), he will be taxed on all of the year's income that he actually received during the period he was alive - Jan. 1 to Nov. 11, 19XX. The decedent beneficiary's final income tax return will, therefore, include $30,000 of income from the trust.
Note that $3,000 received by the beneficiary on Jan. 10, 19XX, representing the trust's income for December of the prior year, was reported on his prior year's return since all the trust income was required to be distributed currently.
The income distributable to the deceased beneficiary for the period Nov. 1 to 11, 19XX, which was paid to his estate on Dec. 10, 19XX, represents. "income in respect of a decedent" under Sec. 691(a), and will be taxed to the estate.
5. Current Distributions of Complex
Trusts and Estates
By definition, all trusts that are not "simple" trusts are designated as "complex" trusts. Complex trusts include: * Trusts that are required to accumulate income. * Trusts that, under the governing instrument, may accumulate or distribute income at the discretion of the trustee. * Trusts that make a distribution from principal or make charitable contributions from income during the year, even though they are required to distribute all income currently.
In the year of termination, a simple trust is transformed into a complex trust, since terminating principal distributions are made. The general rules applicable to complex trusts also govern the taxation of estates.
The amount of the deduction for distributions allowed to a complex trust or an estate is limited to the lower of - the aggregate of IRDC and OAPC (other amounts paid or credited or required to be distributed), or - the amount of DNI.(10)
As in the case of simple trusts, beneficiaries of complex trusts and estates must include in their gross income the amounts for which the trust or estate received a deduction for distributions.(11) However, complex trusts and estates may make distributions to more than one beneficiary during a particular tax year, and some beneficiaries' rights to income may take precedence over others. Therefore, to provide priorities of taxability, the distribution rules establish what is known as the "tier" system.(12)
Under the tier system, the aggregate income that must be reported by the beneficiaries is allocated first to the beneficiaries who have rights to current income - that is, those beneficiaries to whom income is to be distributed currently under the terms of the governing instrument. The amount taxed to the first-tier beneficiary(ies) is the amount of IRDC, limited to DNI (computed without a charitable deduction). Such distributions are taxed to beneficiaries in the year required to be distributed.(13)
After allocating distributable income among the first-tier beneficiaries, any remaining amount of DNI is allocated among the "second-tier" beneficiaries. This tier consists of those beneficiaries who are paid or credited with OAPC for the tax year. Again, the amounts taxed to the second-tier beneficiaries cannot exceed the DNI, as reduced by first-tier distributions. Thus, charitable contributions inure to the benefit of second-tier beneficiaries. Second-tier distributions are taxed to the beneficiaries for the trust's or estate's year in which the distributions were made. Second-tier distributions include discretionary distributions of income and distributions of principal.
Under the conduit theory, discussed above, the income items of complex trusts and estates retain the same character in the hands of the beneficiaries as they had in the hands of the trust or estate.(14) When there is more than one beneficiary, the income is allocated pro rata among the beneficiaries in each tier. And, like simple trusts, the beneficiaries of complex trusts and estates include in their gross income the amounts distributed or distributable to them by the trust for the tax year(s) ending with or within the beneficiary's tax year.(15) The special rule governing the taxation of distributions received by a deceased beneficiary of a simple trust in the year of death also applies to beneficiaries of complex trusts and estates.(16)
Example 6: H's will provided that the residue of his estate be divided equally between his widow and his children. The will further provided that $100,000 of income was required to be distributed currently each year to the widow. During 19XX the estate had net income (DNI) of $800,000. In 19XX the executor made the following distributions: Widow Children Income: Required $ 100,000 $ 0 Discretionary 300,000 400,000 Principal 27,000,000 8,000,000 Total $27 400 000 $8 400 000 The reduced principal distribution to the children resulted from the charge to their share of estate taxes paid of $19,000,000. How should the $800,000 DNI be allocated between the beneficiaries? The distributions would be taxed as follows: Total Widow Children (thousands omitted) 1st tier (IRDC) $ 100 $ 100 $ 0 2d tier - lower of: Distributions (OAPC) 35,700 27,300 8,400 DNI (76 1/2%/ 23 1/2%) 700 535 165 Taxable - 2d tier 700 535 165 Total taxable $ 800 $ 635 $ 165
Mrs. H argued that the result was inequitable and that, although she received only 50% of the estate's $800,000 income for the year, she was taxed on almost 80% (part of which actually had been distributed to her children).
The Court of Claims in Harkness(17) (on which this example is roughly based) concluded that in so taxing the beneficiaries, the IRS had properly interpreted the two-tier rules of Secs. 661 and 662.
6. Charitable Contributions
Separate rules govern trust and estate distributions to charitable organizations. Such distributions are not considered to be distributions to beneficiaries.(18) Normally, a trust or an estate can take a deduction for amounts paid to a charity if the governing instrument so provides.(19) There is no percentage limitation on the amount, as in the case of individual contributions to charity.
The deduction for charitable contributions is not limited to U.S. charities.(20) In addition, amounts permanently set aside for charitable organizations are allowable as deductions only in the case of an estate, or a trust that was created before Oct. 9, 1969.(21)
Example 7: Under the terms of a trust instrument dated 1967, the income must be distributed currently, 60% to a public charity and 40% to the grantor's son. In the year 2000, the trust is to terminate and the principal is to be distributed to the public charity. During its 19XX calendar year, the trust reported the following on its return: Dividend income $50,000 Capital gain 10,000 $60,000 The trust's 19XX charitable contribution deduction is $40,000, computed as follows: Income paid to charity (60% of $50,000) $30,000 Amount permanently set aside for charity (increase realized in trust principal) 10,000 $40,000
Of course, if the trust had been set up after Oct. 8, 1969, it could not deduct the $10,000 permanently set aside for charity. This gain would be taxed to the trust. In contrast, an estate is entitled to a charitable contribution deduction for amounts set aside regardless of the date of creation.
7. Taxability of Distributions of Principal
As discussed in Part 5, a complex trust or estate is entitled to a deduction for both IRDC to beneficiaries and for OAPC. Thus, items of principal that are paid or credited or required to be distributed can, under certain circumstances, carry with them income tax consequences.
Not all distributions of principal to beneficiaries will result in taxable income. Sec. 663(a)(1) specifically provides that any amount of principal that, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of specific property or a specific sum of money (which is payable in not more than three installments) is not deductible by the trust or taxed to the beneficiary. If the will or other governing instrument does not specify a time for the payment of the gift or bequest, any payments are treated as required to be paid in a single installment.(22)
Example 8: A will provides for the distribution of a specific bequest of principal securities to a legatee. The distribution of the specified securities would not involve any tax consequences.
Similarly, the payment, pursuant to a trust instrument, of $10,000 of principal in one lump sum when a beneficiary, for example, reaches age 21, will come within the exception and will be neither deductible by the trust nor taxed to the beneficiary.
In order to qualify under this exception, however, the identity of the specific property or the amount of the specific sum of money "must be ascertainable under the terms of a testator's will as of the date of his death, or under the terms of an inter vivos trust instrument as of the date of the inception of the trust."(23)
Example 9: A trust instrument requires income to be distributed currently to daughter D. She is also to receive distributions of $10,000 of principal at age 21, $10,000 at age 35 and $40,000 at age 40. When D reaches 40, the remaining principal is to be paid to son S and the trust is to terminate.
Only the payments of principal to D will not carry tax consequences. Although the principal payable to S might be considered a specific sum of money, it was not ascertainable when the trust was created since it will consist of a residual amount that cannot be predetermined.
Part 18, in March, will point out how planning for the distributions of principal can result in substantial tax savings. Part 13, below, will discuss the often unusual income tax consequences of funding gifts and bequests with property in kind.
8. Taxation of Current Year's
Capital Gains to Beneficiary
Gains from the sale or exchange of capital assets realized by a trust or an estate are ordinarily excluded from DNI. In addition, capital gains are not ordinarily treated as included in any payment or distribution to any beneficiary. There are three exceptions to this general rule.(24) 1. When capital gains are allocated to income (rather than principal) under the terms of the governing instrument or local law and are allocated by the fiduciary on its books or by notice to the beneficiary. 2. When, pursuant to the practice followed by the fiduciary, capital gains are allocated to principal and actually distributed to the beneficiaries during the tax year.(25) 3. When capital gain is used (pursuant to the terms of the governing instrument or the practice followed by the trustee) in determining the amount that is distributed or required to be distributed.
Example 10: A trustee has a discretionary power under the trust instrument to invade principal for the benefit of the income beneficiary. During the tax year the trust realizes a $10,000 capital gain. The trustee does not allocate the gain to the beneficiary on the trust's books. However, the trustee follows a regular practice of distributing the exact net proceeds of the sale of trust property to the beneficiary each year. Therefore, the capital gain would be includible in DNI; the trust would get a deduction for the distribution; and the beneficiary would be taxable on the current year's capital gains.
9. Treatment of Net Capital Losses
A net capital loss realized by a trust or an estate in a year other than the year of termination(26) cannot be "distributed" to a beneficiary during that year. As in the case of individuals, a net capital loss is deductible against ordinary income to the extent of a maximum of $3,000 (limited of course to taxable income). The excess net capital loss is then available as a carryforward to subsequent years, and can be used to offset future capital gains. To the extent that the carryforward is not so used, it is deductible annually against ordinary income up to a maximum amount of $3,000 each year.
Example 11: A complex trust reports the following 19XX transactions: Ordinary income (net of deductions) $20,000 Short-term capital loss 5,000 Discretionary distributions of income to beneficiary 19,400
The trust's 19XX taxable income, before the deductions for the capital loss and its exemption, is $600 ($20,000 - $19,400 deduction for distributions to beneficiary); $600 of the capital loss is therefore deductible in 19XX, reducing taxable income to zero. (The maximum capital loss deduction allowable in any year is $3,000.) The unused $4,400 will be available as a short-term capital loss carryover in 19XY and later years to offset future capital gains or ordinary income.
It does not matter whether the capital loss is sustained on the sale of income property or principal assets. A net capital loss in any year is always allocated to the entity; it cannot pass through to the beneficiary except in the year of termination of the trust or estate (see Part 19 in March).
10. The "Sixty-Five Day" Rule
Generally, for a complex trust to take a distributions deduction for OAPC, the amount must be paid or credited to the beneficiary during the trust's tax year. A trustee may elect, however, to treat any portion of a distribution to a beneficiary made within the first 65 days of the trust's tax year as if it had been paid or credited to the beneficiary on the last day of the preceding tax year.(27) This election,(28) which must be attached to the fiduciary income tax return, is made on an annual basis, and becomes irrevocable after the due date of the return, including extensions. The "sixty-five day" rule does not apply to estates or to simple trusts.
The election can be valuable, for example, when a trustee has the discretion to distribute or accumulate income and wishes to distribute all of the trust's income for a particular year. As a practical matter, however, it may be difficult to determine the trust's total income until after year-end when the books can be closed. Thus, the trustee can use the election to distribute "retroactively" the undistributed balance of income for a preceding year by treating the first payments made (within 65 days) in a trust's tax year as the preceding year's income.
11. The "Separate Share" Rule
For certain purposes, the substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts.(29) This "separate share" rule applies to both simple and complex trusts. Although most of the income tax provisions applicable to complex trusts also govern the taxation of estates, there is no similar separate share rule for estates. The following example demonstrates the purpose of this separate share rule.
Example 12: M creates a trust for her two children, S and D. Each has a 50% separate interest in the trust. The trust instrument provides that income is to be accumulated until each beneficiary reaches age 21. when each child reaches that age, the accumulated income is to distributed and, thereafter, income is required to be distributed currently.
In 19XX, S becomes 21 while D is still under 21. The trust income accumulated before S reaches age 21 totals $40,000. The trust's DNI for 19XX totals $4,000.
Under the separate share rule, S is taxed on only $2,000 of the trust's 19XX income, the DNI applicable to his separate share. The remaining $2,000, which represents D's one-half share, must be accumulated for her benefit. Without the separate share rule, S would be taxed on the full $4,000 of the current year's income.
Under the separate share rule, the DNI is computed separately for each share. This rule is not elective;(30) if separate shares exist, the rule must be applied. Moreover, application of the rule does not depend on whether the trust's books are maintained separately and the assets are actually segregated.(31)
12. The Distributions Deduction for AMT
Estates and trusts have to compute DNI and the distributions deduction twice - once under the regular income tax rules and again by applying the provisions of the alternative minimum tax (AMT).(32) In order to compute the income distributions deduction for AMT purposes, the fiduciary must first compute the estate's or trust's "distributable net alternative minimum taxable income" (DNAMTI).(33)
The fiduciary's DNAMTI concept and the DNAMTI income distributions deduction calculation for AMT purposes are the analogs of the distributable net income (DNI) concept and income distributions deduction computation needed to determine the amount of the estate's or trust's regular income tax liability. The concept constitutes the essence of the conduit principle underlying the income taxation of estates and trusts.
DNI will often differ from DNAMTI for reasons unrelated to AMT preference items. And since the fiduciary's AMT income distributions deduction must be calculated on Schedule H of Form 1041, U.S. Fiduciary Income Tax Return, and the beneficiaries' shares of DNAMTI must be entered on their Schedules K-1 (Form 1041), many estates and trusts that have no AMT tax preference items (but only adjustment items) will nevertheless have to prepare Schedule H of Form 1041.
Examples of items that are not technically AMT preference items (i.e., adjustment items), but which will cause a beneficiary's share of DNAMTI to vary from the amount of his share of DNI, include a variety of deductions and losses allowed for regular tax purposes, but not for AMT purposes. These include state and local income and property taxes,(34) "miscellaneous itemized deductions" in excess of 2% of adjusted gross income (AGI),(35) any allowed portion of excess investment interest and "personal" interest cost36 and any passive activity losses(37) allowed in computing the fiduciary's regular income tax. And, of course, any AMT preference or other adjustment item incurred by the fiduciary would also cause DNI and DNAMTI to differ.
As previously discussed, in order to compute the income distributions deduction for regular income tax purposes, the trustee of a simple trust must determine (1) the amount of IRDC and (2) DNI. The trustee's distributions deduction(38) is equal to the lower of these two amounts.
On the other hand, the fiduciary of a complex trust or an estate calculates the allowable regular income tax deduction for distributions to beneficiaries(39) as the lower of (1) the aggregate of IRDC and OAPC or (2) DNI. These computations should be made on Schedule B on page 2 of Form 1041.
For AMT purposes, the formulas required to determine the amount of the distributions deductions (and the beneficiary's share of income(40)) are similar, except that the applicable amount of DNAMTI should be substituted for the amount of DNI. For example, the AMT formula to calculate the allowable distributions deductions for a simple trust would be the lower of IRDC or DNAMTI, and for a complex trust or estate the lower of the aggregate of IRDC and OAPC or DNAMTI. Note: the amounts of "income required to be distributed currently" and "other amounts paid or credited," as concepts under local law - not tax law, are generally identical(41) whether the distributions deduction is being determined for regular tax or AMT purposes. It is the amounts of DNI and DNAMTI that will normally differ.
These computations are made on Part II of Schedule H on page 4 of Form 1041.
Example 13: A simple trust having one beneficiary reports the following income and deductions for 19XX: Dividend income $100,000 Deductions: Trustee's income commissions $ 5,000 State income taxes paid on capital gains (charged to principal) 35,000 $40,000 How should the trust's DNI, DNAMTI and the related income distribution deductions for 19XX be computed? The deductions would be calculated as follows: Regular income tax AMT Dividend income $100,000 $100,000 Deductions for expenses and taxes 40,000 5,000 DNI/DNAMTI 60,000 95,000 IRDC 95,000 95,000 Distributions deduction - lower $ 60,000 $ 95,000
Note: The result would be the same if aggregate AMT preference items replaced the amount of state income tax payments, as would the substitution of other deductions disallowed for AMT purposes such as passive activity losses, personal and excess investment interest, "miscellaneous itemized deductions" exceeding 2% of AGI, etc.
The amounts of the fiduciary's income distributions deductions allowed under Secs. 651 and 661 for both regular income tax and AMT purposes are the identical amounts that must be reported as gross income under Secs. 652 and 662 by the beneficiary of the estate or trust. When there is more than one beneficiary, DNAMTI is allocable among them in the same manner as income was allocated for regular income tax DNII purposes. Each beneficiary's share of both DNI and DNAMTI must be shown on the Schedule K-1 (Form 1041).
Example 14: The beneficiary of the simple trust in Example 13 would receive a 19XX Schedule K-1 (Form 1041) from the trustee that would reflect the following: Income for minimum tax purposes $95,000 Income for regular tax purposes 60,000 Adjustment for minimum tax purposes 35,000
The difference between these two amounts is reportable by the beneficiary as an adjustment for computing his 19XX AMT on Form 6251, Alternative Minimum Tax - Individuals (or on Schedule H of Form 1041, if the beneficiary is an estate or another trust).
13. Funding Bequests With Property In Kind
For income tax purposes, all gifts and bequests can be categorized into the following types: 1. Gifts and bequests of specific property. 2. Pecuniary (fixed-dollar) gifts and bequests:
a. simple (nonformula) pecuniary, or
b. formula pecuniary. 3. Fractional and residuary gifts and bequests.
The income tax consequences of funding each of these types of gifts and bequests with appreciated (or depreciated) property in kind can differ tremendously. For example, the distributions by an executor or trustee of such property in kind can, only in certain instances, do the following: 1. Trigger a gain or loss (based on the difference between the fair market value (FMV) of the property and its adjusted tax basis). 2. Permit the fiduciary to qualify for a Sec. 661 deduction for distributions to beneficiaries based on the FMV of the property distributed in some instances, and the adjusted basis of the property in others. 3. Subject the distributee/beneficiary to income tax on ordinary estate or trust income under Sec. 662 (limited to DNI). 4. Result in a step-up (or step-down) in the adjusted basis of the property in the hands of the beneficiary to its FMV on distribution.
This part will discuss and illustrate the general income tax consequences of funding gifts and bequests with stocks and other types of securities and capital assets. The income tax consequences of funding bequests with interests in passive activities (Part 14) and with income in respect of a decedent (Part 15) will be covered in March.
* Funding specific bequests
No gain or loss is triggered when the specific property is transferred, even though the value of the property on the distribution date is higher or lower than its adjusted basis. The estate or trust cannot claim a deduction for the distribution - it is a gift or bequest of specific property excluded under Sec. 663(a)(1). The recipient succeeds to the estate's or trust's income tax basis for the property.(42)
Example 15: In 19XX, an executor distributed stock having an income tax basis of $175,000 in partial satisfaction of a specific bequest to the surviving widower. The value of the stock on the distribution date was $230,000. No other distributions were made to other beneficiaries during the year. During 19XX the estate's only income consisted of $80,000 of dividends received and it had paid no deductible expenses. The executor (or his accountant) must determine the estate's taxable income for 19XX, the income reportable by the widower and the income tax basis of the stock distributed in the hands of the surviving spouse. The estate's 19XX fiduciary income tax return would show: Dividend income $80,000 Total income 80,000 Less deduction for distributions, lower of: DNI $80,000 Distribution 0 Lower 0 80,000 Less personal exemption 600 Taxable income $79,400
The surviving spouse would report no income from the estate for 19XX. The income tax basis of the stock distributed in the widower's hands would be $175,000, its basis to the estate.
* Funding pecuniary bequests
The inclusion in a will or trust instrument of a bequest or gift of a flat fixed-dollar (pecuniary) amount, in trust or otherwise (for example, a bequest to a surviving spouse of $1 million, or a bequest in trust to children for $600,000 to "sop up" the unified credit), may not be advisable for a number of obvious tax and nontax reasons. Nevertheless, this type of gift or legacy may be encountered.
Whether the funding of such a gift or bequest with cash will result in a deduction to the estate, and income to the beneficiary, depends on whether the bequest qualifies as "a gift or bequest of a specific sum of money or of specific property" under Sec. 663(a)(1): 1. If under the terms of the governing instrument it is to be paid in three or fewer installments, any payment to the legatee will not constitute an "other amount paid or credited" (OAPC), which will carry out DNI. 2. If under the terms of the will or other instrument it is to be paid in four or more installments, each payment (even if in fact it is paid in a lump sum) will be deemed OAPC and will carry out DNI to the legatee.(43) 3. If under the terms of the will, "no time of payment ... is specified.... [it is] considered as required to be paid or credited in a single installment."(44)
The funding of such a fixed dollar gift or bequest with appreciated (or depreciated) capital asset property valued at the date of distribution will result in the realization by the trust or estate of a capital gain (or loss).(45) Such a bequest is treated as a cash bequest equal to the property's FMV, followed by a deemed sale of the property to the beneficiary for cash.
The beneficiary will receive a stepped-up basis equal to the property's FMV on the transfer date.(46)
If ordinary income property is distributed to satisfy a fixed-dollar obligation, ordinary income will be triggered. For example, the distribution of the right to receive future Sec. 691 income in respect of a decedent (IRD) in satisfaction of a pecuniary bequest will trigger a capital gain or ordinary income to the estate, depending on the type of IRD.(47) Depreciation recaptured under Sec. 1245 or 1250 will also result in a distribution of ordinary income.
Example 16: Assume the same facts as in Example 15, except that the stock distributed was in partial satisfaction of a non-formula (simple) pecuniary marital bequest, rather than a specific bequest. No number of payments was specified in the will. The will provided that the pecuniary amount of the bequest was to be satisfied with cash or property valued at the date of distribution (the so-called true worth funding approach). The estate's 19XX fiduciary income tax return would show: Dividend income $ 80,000 Capital gain realized on the distribution ($230,000 - $175,000) 55,000 Total income 135,000 Less deduction for distributions, lower of: DNI $80,000 Distribution 0 Lower 0 135,000 Less personal exemption 600 Taxable income $134,400
The widower would report no income from the estate for 19XX. The income tax basis of the stock distributed to him would be $230,000, its FMV on distribution.
If, however, the will provided that the simple pecuniary bequest was to be satisfied in four or more installments, the surviving spouse would be taxed on $80,000 of estate income for 19XX, the estate's distributions deduction (and the surviving spouse's reportable income) would be limited to the estate's $80,000 of DNI. The tax basis of the stock distributed would still be $230,000 in the hands of the widower.
The provisions of the governing instrument will determine the income tax consequences of funding formula pecuniary gifts and bequests. * In a true worth pecuniary gift or bequest, property distributed in kind is valued at the distribution date. This is the most commonly used funding approach. State law generally provides that the FMV of the property on the distribution date is used to measure the extent to which a distribution satisfies the pecuniary amount, absent a specific valuation provision in the governing instrument.(48) Unless specifically noted, the discussion in this article, and the examples used, presume that the pecuniary bequest is funded with property valued at the date of transfer - the true worth pecuniary gift or bequest. * In 1964, the IRS issued Rev. Proc. 64-19,(49) which effectively outlawed the use of the adjusted income tax basis of property distributed in kind to measure the funding of a pecuniary bequest by denying the estate tax marital deduction for such a bequest. The ruling did, however, give rise to two permitted alternatives to the true worth funding approach: 1. A fairly representative pecuniary gift or bequest under which each asset is generally valued for funding purposes at its basis for Federal income tax purposes, provided that the assets used to satisfy the bequest are "fairly representative" of the depreciation or appreciation of the estate's assets as a whole, and 2. A minimum worth pecuniary gift or bequest under which each asset is valued for funding at the lesser of its distribution date value or its Federal income tax basis, if the total value of the assets distributed is equal to the amount of the marital deduction.
When an executor distributes property in kind in satisfaction of a true worth pecuniary gift or bequest: 1. The transfer constitutes a sale or exchange. 2. Gain or loss is recognized by the estate to the extent that the property's FMV on the transfer date exceeds or is less than the amount of the bequest. 3. Since the legatee is considered, in effect, to have purchased the property on the "deemed sale," he gets a stepped-up basis equal to the property's FMV on the transfer date.(50)
Nevertheless, Treasury regulations state that such a fixed dollar pecuniary formula bequest "is neither a bequest of a specific sum of money or of specific property" (emphasis added) within the meaning of Regs. Sec. 1.663(a)-1 because "[t]he identity of the property and the amount of money specified ... are dependent both on the exercise of the executor's discretion and on the payment of administration expenses and other charges, neither of which are facts existing on the date of the decedent's death." In addition, "[i]t is immaterial that the value of the bequest is determinable after the decedent's death before the bequest is satisfied (so that gain or loss may be realized by the estate in the transfer of property in satisfaction of it)."(51)
Therefore, a distribution to fund such a gift or bequest will carry out income to the beneficiary. The amount of the income distribution will be equal to the FMV of the property distributed, limited to DNI.
If the Sec. 2032 alternate valuation election can be made, no gain will be recognized on the distribution of appreciated property to fund bequests within the six-month period.
Example 17: Assume the same facts as in Example 15, except that the stock distributed was in partial satisfaction of a true worth formula pecuniary marital bequest, rather than a specific bequest. The estate's 19XX fiduciary income tax return would show: Dividend income $ 80,000 Capital gain realized on the distribution of property ($230,000 - $175,000) 55,000 Total income 135,000 Less deduction for distributions, lower of: DNI $ 80,000 Distribution 230,000 Lower 80,000 55,000 Less personal exemption 600 Taxable income $ 54,400
The surviving spouse in 19XX would report $80,000 in income from the estate. The income tax basis of the stocks in the hands of the widower would be $230,000, their FMV on distribution.
As previously noted, Examples 16 and 17 were prepared based on a true worth pecuniary funding approach. If either the fairly representative or minimum worth pecuniary approach had been used, the distribution would not have triggered a gain although use of the minimum worth approach could result in a loss. However, these possible income tax benefits must be weighed against the possibility that use of a fairly representative pecuniary gift or bequest tends to overfund or underfund the marital deduction, while a minimum worth approach can, under certain circumstances, endanger the qualification of the residue for the estate tax marital deduction and even the deductibility of a charitable bequest for estate tax purposes.
When an executor transfers depreciated property in satisfaction of a true worth pecuniary formula bequest, the estate realizes a capital loss. The legatee receives a "step-down" in the income tax basis of the property received.
A net capital loss realized by an estate in any tax year (other than the year of termination) cannot be "distributed" or passed through to the beneficiaries in that year.(52) A loss realized on a distribution by a trustee of depreciated property to a trust beneficiary is disallowed under Sec. 267(b)(6). it may not be completely lost, however. If the beneficiary later sells the property at a gain, such gain will not be recognized to the extent of the prior nondeductible loss.(53)
* Funding residuary bequests
A distribution in satisfaction of a fractional or percentage share formula gift or bequest is a distribution of a portion of the residue and, as such, does not qualify as a gift or bequest of specific property or a specific sum of money.(54) Therefore, such a distribution will always carry out income to the beneficiary (limited to DNI).
The Code essentially provides that when an estate or trust distributes property in kind, a gain or loss is not normally recognized unless the distribution is in satisfaction of a pecuniary (fixed-dollar) gift or bequest. When no gain or loss is recognized, the beneficiary's income tax basis of the property is the estate's or trust's adjusted basis.(55)
The executor or trustee can, however, make an irrevocable affirmative election (under Sec. 643(e)(3)) to have the gain or loss recognized on the distribution to the beneficiary of a fractional or residuary gift or bequest, as if the property had been sold to the beneficiary at its FMV on the distribution date.
When property is distributed in kind, the amount to be taken into account in computing the "other amount paid or credited" when the Sec. 643(e)(3) election is not made is the lesser of the basis of the property in the beneficiary's hands or its FMV when distributed. When the election is made, the amount of OAPC is the property's FMV on distribution.(56)
Example 18: Assume the same facts as in Example 15, except that the stock distributed was in partial satisfaction of a residuary (or fractional) marital bequest, rather than of a specific bequest. The determination of the estate's taxable income for 19XX, the income reportable by the widower and the income tax basis of the property distributed in his hands would depend on whether the executor chooses to make a Sec. 643(e) election: Sec. 643(e)(3) election No Yes Dividend income $ 80,000 $ 80,000 Capital gain realized on distribution of stock 0 55,000 Total income 80,000 135,000 Less deduction for distributions, lower of: DNI 80,000 80,000 Distribution 175,000 230,000 Lower 80,000 80,000 0 55,000 Less personal exemption 600 600 Taxable income (600) 54,400 Income taxed to the surviving spouse 80,000 80,000 Widower's income tax basis for stock $175,000 $230,000
The Sec. 643(e)(3) election is an annual election and once made, is revocable only with IRS consent. The election applies to all distributions made during the estate or trust's tax year; it cannot be made on a separate distribution basis.(57)
If the trustee or executor does not make the Sec. 643(e)(3) election, the holding period of the property in the hands of the trust or estate is "tacked on" to that of the beneficiary.
If a trustee (not an executor) distributes depreciated property, he should not make the election since the loss on the "deemed sale" will be disallowed.(58) Further, when a trust distributes depreciable property, Sec. 1239 denies capital gain treatment to the trust on any gain when the trustee makes a Sec. 643(e)(3) election.
When there are multiple beneficiaries of the residue of an estate, the property of the estate may need to be distributed in fractional (or percentage) shares. Unless the will authorizes the executor to divide or partition the estate's assets in a non-pro rata manner (e.g., all of A Corp. stock to one beneficiary, all of B Corp. stock to another), the IRS has ruled(59) that distributions other than in fractional shares will be treated as taxable exchanges among the beneficiaries.
The Sec. 643(e)(3) election is a very flexible tax planning device. See Part 18 in March for illustrations.
See the chart on page 127 for a summary of the income tax consequences of funding the various types of gifts and bequests with appreciated/depreciated property in kind valued at the date of distribution.
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(1) Subpart B of subchapter J (Secs. 651 and 652) refers to trusts that distribute income currently. Subpart C (Secs. 661 through 664) refers to estates and trusts that may accumulate income or that distribute principal. The regulations refer to these as "simple trusts" (Regs. Sec. 1.651(a)-1) and "complex trusts" (Regs. Sec. 1.661(a)-1), respectively. (2) Regs. Sec. 1.643(b)-1 defines the term "income," "when not preceded by the words 'taxable', 'distributable net', 'undistributed net', or 'gross', ... [as] the amount of income of ... [a] trust ... determined under the terms of its governing instrument and applicable local law." (3) Sec. 651. (4) Sec. 652. (5) Sec. 652(b); Regs. Sec. 1.652(b)-2; Rev. Rul. 81-244, 1981-2 CB 151. (6) Regs. Sec. 1.652(b)-3. (7) Secs. 167(d) and 611(b)(3). See also Regs. Secs. 1.167(h)-1(b) and 1.611-1(c)(4). (8) Sec. 652(c); Regs. Sec. 1.652(c)-1. The fiduciary must inform the beneficiary of the amount and character of income he should report, using Schedule K-1 of Form 1041, U.S. Fiduciary Income Tax Return. (9) Regs. Sec. 1.652(c)-2. (10) Sec. 661(a). (11) Sec. 662(a). (12) Sec. 662(b). (13) Regs. Sec. 1.662(b)-2. (14) Sec. 662(b). (15) Sec. 662(c). (16) Regs. Sec. 1.662(c)-2. (17) The decision in Rebekah Harkness, 469 F2d 310 (Ct. Cl. 1972)(30 AFTR2d 72-5754, 72-2 USTC [para]9740), specifically upheld the constitutionality of the pertinent regulations under Secs. 661 and 662. (18) Sec. 663(a)(2). (19) Sec. 642(c)(1). The deduction is normally allowed for charitable contributions paid during the trust's or estate's tax year. However, if the charitable contribution is paid on or before the last day of the trust's or estate's next tax year, the fiduciary can elect to treat the contribution as having been made during the year preceding the year of payment. (20) Sec. 642(c)(1). (21) Sec. 642(c)(2). (22) Regs. Sec. 1.663(a)-1(c)(1)(iii). (23) Regs. Sec. 1.663(a)-1(b). (24) Regs. Sec. 1.643(a)-3(a). (25) But the IRS has ruled that this exception will not apply in the initial year of a trust or estate. IRS Letter Ruling (TAM) 8324002 (2/16/83). (26) The trust remainderman will succeed to the trust's unused net capital loss carryover in the year of termination of the trust. Sec. 642(h). See Part 19 in March. (27) Sec. 663(b). (28) See Regs. Sec. 1.663(b)-2. (29) Sec. 663(c). (30) Regs. Sec. 1.663(c)-1(d). (31) Regs. Sec. 1.663(c)-l(c). (32) Barnett, "No Haruspex Needed to Demystify the Fiduciary," 24th Annual U. Miami Institute on Estate Planning, Ch. 5 (1990), for an in-depth discussion of the AMT as it affects estates, trusts and beneficiaries, including planning possibilities. (33) The term "distributable net alternative minimum taxable income" is not in the Code but is used by the IRS on tax forms (e.g., Schedule H of Form 1041, and the Instructions thereto). For AMT purposes, DNAMTI corresponds to the term "distributable net income" (DNI) used in computing the Sec. 651 and 661 deductions allowed the fiduciary for distributions to beneficiaries for regular income tax purposes. (34) Sec. 56(b)(1)(A)(ii). (35) Sec. 56(b)(1)(a)(i). (36) Sec. 56(b)(1)(c). (37) Sec. 58(b). (38) Sec. 651. (39) Sec. 661. (40) Secs. 652 and 662. (41) Although the amounts of IRDC and OAPC as fiduciary accounting concepts will always be identical for both regular income tax and AMT purposes, each of these items must be reduced by adjusted tax-exempt income when the respective actual income distributions deductions are determined. And since there is one type of municipal bond interest that is exempt from regular income tax, but taxable for AMT purposes (i.e., interest on private activity municipal bonds issued after Aug. 7, 1986), the amount of distributions made to beneficiaries (IRDC and OAPC) will differ for regular tax and AMT purposes. DNI and DNAMTI will also differ by the amount of such interest income since it constitutes an AMT adjustment item under Sec. 57(a)(5). (42) Under Sec. 1014, the uniformity of basis rule. (43) Regs. Sec. 1.663(a)-1(a) and b)(2)(iv). (44) Regs. Sec. 1.663(a)-1(c). (45) Regs. Sec. 1.1014-4(a)(3). (46) Id. (47) See the discussion in Part 15 in March. (48) See Casner, Estate Planning, [Subsections]13.10.1 (5th ed. 1988). (49) Rev. Proc. 64-19, 1964-1 (Part 1) CB 682. (50) Regs. Sec. 1.1014-4(a)(3). (51) Regs. Sec. 1.663(a)-1(b), because the amount is not ascertainable as of the date of death. (52) Sec. 642(h). See the discussion in Part 9, supra. (53) Sec. 267(d). (54) Regs. Sec. 1.663(a)-1(b)(2)(iii). (55) Sec. 643(e)(1). (56) Sec. 643(e)(2). (57) Sec. 643(e)(3). (58) Under Sec. 267(b)(6). (59) Rev. Rul. 69-486, 1969-2 CB 159.
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|Title Annotation:||part 1|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1993|
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