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 two-part article reviews many of the established planning tools and techniques, in order to alert tax professionals to, or remind them of, income tax planning strategies that will be useful to their fiduciary clients during trust and estate administration.
The principles of the income taxation of trusts and estates and the related tax planning techniques have been broken down into the following 25 parts. Parts 1 through 13 were published in February; parts 14 through 25 are covered in this installment.
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
minimum tax. 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
income. 18. Planning through distributions of principal. 19. Planning terminating distributions. 20. Distributions by complex trusts from accumulated
income. 21. Taxation of multiple trusts. 22. Distributions of charitable remainder trusts. 23. Grantor trust taxation. 24. Distributions from foreign trusts. 25. Conclusion.
14. Distributions of Interests in Passive
Estates and trusts are subject to the same passive activity loss (PAL) deduction restrictions as are individual taxpayers.(60) Fiduciaries are not treated as flowthrough entities for PAL purposes.
For both individuals and fiduciaries, a PAL(61) generated by one particular activity must first be used to off set income from other passive activities. For tax years beginning in 1991 no deduction is allowed for a net PAL against any other type of income - active (nonpassive) trade or business income or portfolio income. Such PALs that are disallowed currently are trapped in the estate or trust and are "suspended" and generally carried forward (on a separate activity by activity basis) as PALs to future years. This provision requires taxpayers, including fiduciaries, to maintain complete records for each activity for all suspended losses.
Sec. 469(g)(1), however, provides that suspended PALS arising from a particular passive activity will be "triggered" (converted into an ordinary business loss fully deductible against nonpassive income) in the year in which a taxpayer disposes of his entire interest in the activity in a fully taxable transaction.
When an individual transfers an interest in a passive activity by a gift, the income tax basis of the transferred interest is increased by the amount of any suspended PALs. No deduction is allowed for such suspended PALs by the donor.(62)
When an individual's interest in a passive activity is transferred by death, a prior year's suspended PAL will be converted into an ordinary loss on the decedent's final income tax return, but only to the extent that it exceeds the step-up in the basis of the related property interest under Sec. 1014.(63)
Example 19: D died on Dec. 31, 1991. D had been a limited partner in the WXY Real Estate Partnership for 10 years prior to death. As of that date, D had a negative $200,000 income tax basis for his partnership interest. He had also accumulated unused suspended PALs for 1991 and prior years of $150,000. On Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, D's executor had valued the WXY partnership interest at $30,000.
How much, if any, of D's suspended PALS will be recognized on his 1991 final income tax return? What will happen to the balance of his suspended PALs?
None of D's unused suspended PALs will be recognized on his final Form 1040. The $150,000 suspended losses will be recognized only to the extent they exceed the step-up in the basis of his partnership interest. The step-up, however, is $230,000 (from a $200,000 negative partnership basis to a $30,000 basis under Sec. 1014). Therefore, no suspended PALs will be recognized on D's final return.
D's unused suspended PALs will expire at his death. The Code contains no provision enabling his estate to benefit from this carryover.
Sec. 469(j)(12) contains a special rule covering distributions of passive activities by estates and trusts:
If any interest in a passive activity is distributed by an estate or trust -
(A) the basis of such interest immediately before such distribution
shall be increased by the amount of any passive activity
losses allocable to such interest, and
(B) such losses shall not be allowable as a deduction for any
This provision completely ignores the rule enunciated in Sec. 469(g)(1). As previously discussed, that section provides that when a taxpayer disposes of his entire interest in any passive activity in a "fully taxable transaction," unused suspended PALs will be triggered, unless the disposition involves a related party.(64) Although a trustee and a trust beneficiary are related parties,(65) an executor and an estate beneficiary are not.
As discussed previously (in Part 13 of this article in February), distributions by an executor to fund a pecuniary bequest and distributions to fund a residuary or fractional bequest when a Sec. 643(e) election is made to realize a gain or loss are unquestionably "fully taxable transactions."
It seems clear, therefore, that the special limitation of Sec. 469(j)(12) should become operative only when an interest in a passive activity is distributed by an estate to a beneficiary and the general rules of nonrecognition of gain or loss on property distributions by executors apply, e.g. (see discussion in Part 13): 1. Distributions to fund a specific bequest. 2. Distributions to fund residuary or fractional bequests when the executor does not make a Sec. 643(e)(3) election to recognize a loss. 3. Distributions to fund certain types of fixed-dollar bequests that are not treated as fully taxable transactions (e.g., to satisfy a "fairly representative" or a "minimum worth" formula pecuniary bequest).
Example 20: On Jan. 1, 1994, D's executor (from Example 19) distributed to D's surviving spouse the estate's entire interest as a limited partner in the WXY Real Estate Partnership in partial satisfaction of a residuary (or fractional) marital bequest. The estate's interest in the WXY partnership had a $15,000 fair market value (FMV) on the date of transfer. (During the two years that the estate held the limited partnership interest, it had sustained an additional $20,000 of PALs, which, although they reduced the estate's adjusted basis of the partnership interest (to $10,000) were not, of course, deductible against other income on the estate's 1992 and 1993 Forms 1041, U.S. Fiduciary Income Tax Returns. On the date of distribution, Jan. 1, 1994, D's estate, therefore, had accumulated unused suspended PALs of $20,000.) The executor made no distributions to beneficiaries during 1994 other than the limited partnership interest. During the estate's 1994 calendar tax Year its only income was $50,000 of dividends received and it was entitled to no ordinary deductions.
How will the distribution of the limited partnership interest be reported on the estate's 1994 fiduciary income tax return? What income will be reportable by Mrs. D as the result of the distribution? What will be her income tax basis of the WXY limited partnership interest?
The determination of the estate's taxable income for 1994, the income reportable by Mrs. D and the tax basis of the limited partnership interest in her hands will depend on whether D's executor chooses to make a Sec. 643(e)(3) election.
Sec. 643(e)(3) election No Yes Estate's Form 1041: Dividend income 50,000 50,000 Capital gain realized on distribution of limited partnership interest 0 5,000(c) Suspended PALs triggered on taxable transfer 0 (20,000) Total income 50,000 35,000 Less deduction for distributions, lower of: DNI 50,000 30,000(d) Distribution 15,000(a) 15,000(e) Lower 15,000 15,000 35,000 20,000 Less personal exemption 600 600 Taxable income 34,400 19,400 Income taxable to surviving spouse 15,000 15,000 Mrs. D's income tax basis for WXY partnership 30,000(b) $15,000(f) (a) Lower of estate's new $30,000 basis ($10,000 basis + suspended PALs of $20,000, per Sec. 469(j)(12)) or $15,000 FMV. (b) New adjusted basis $30,000. (c) $15,000 FMV- $10,000 adjusted basis. (d) $35,000 income - $5,000 capital gain. (e) $15,000 FMV. (f) $10,000 basis + $5,000 gain realized.
The distribution of the WXY partnership interest to Mrs. D to partially fund a "true worth" formula pecuniary bequest rather than a residuary bequest would produce essentially the same results as under the Sec. 643(e)(3) election, as shown above.
Since a passive activity involves the conduct of a trade or business, triggering unused suspended PALs as the result of distributing interests in passive activities to fund either a pecuniary bequest or a residuary or fractional bequest (coupled with a Sec. 643(e)(3) election by the executor) may create a net operating loss (NOL)(66) in a particular year. Any excess unused NOL for that year may be carried back(67) or by election by the executor carried forward.(68)
An unused NOL existing at the termination of the estate passes to the beneficiaries succeeding to the property of the estate.(69)
There are not many postmortem planning options available to the executor. However, here are a few: * A higher valuation of a passive activity interest on Form 706 will of course result in an increased adjusted income tax basis. A lower valuation, on the other hand, may leave suspended PALs in excess of the Sec. 1014 basis step-up, which can possibly result in a deduction on the decedent's final income tax return. * During administration, the executor can, of course, look for a "risk-free" investment in a passive activity that produces income, which can be used to offset the continuing PALs from the decedent's interest. Or he can attempt to sell the inherited interest - if he can find a buyer - to trigger any suspended PALs arising during the period of administration. * An executor, as previously discussed, can distribute the interest in the passive activity to partially fund a pecuniary bequest or make a Sec. 643(e)(3) election to recognize a loss on the funding of a residuary or fractional bequest. Either of these actions should trigger any of the interest's suspended PALs in the year of distribution and may even result in an NOL, which, if not usable by the executor, can be carried out to the estate beneficiaries on termination of administration.
Although trustees normally encounter the same income tax consequences as executors when funding gifts with appreciated property in kind, the distribution of depreciated property to fund a pecuniary gift or a residuary gift (coupled with a Sec. 643(e)(3) election) will not result in the recognition of loss by a trustee. This is because a trustee and a trust beneficiary, as previously noted, are considered to be related parties.(70)
Finally, although proposed regulations have been promised on the specific application of the passive activity rules to fiduciaries and beneficiaries, more than six years have passed without any guidance from the Treasury or the IRS. Meanwhile, the author's suggestions for handling the disappearing suspended PALs of decedents and executors carry out the clear intent of the statute.
15. Distributions of Income in Respect of a
Income in respect of a decedent (IRD), essentially accrued income at the date of the decedent's death, is a peculiar type of property. It constitutes part of the decedent's gross estate for estate tax purposes and is also subject to income tax on receipt by the recipient,(71) generally the executor. The character of IRD to the receiver is determined by reference to the income's character in the hands of the decedent.(72)
IRD does not get a stepped-up income tax basis at death. Sec. 1014(c) specifically excludes IRD property from the regular basis rules applicable to property acquired from a decedent. Thus, for example, partnership IRD income would ordinarily have a zero basis to the recipient; it would be fully taxed as if the decedent were still alive and received it. Because IRD generally constitutes the most important property right in the estate of a member of a legal, accounting or other professional personal service partnership, it is essential that its receipt be the subject of thorough income tax planning.(73)
When the right to receive IRD passes outside the probate estate: 1. The recipient (e.g., surviving spouse under community property rules or a designated beneficiary) reports as gross income all IRD received.(74) 2. The survivor may also be entitled to an income tax deduction for any applicable estate tax and generation-skipping transfer tax (GST).(75) 3. The decedent's basis (if any) in the property is carried over to the beneficiary.
When the right to receive IRD passes to the probate estate: 1. Currently received IRD will be taxed to the estate unless distributed currently to a beneficiary. 2. If current IRD is distributed currently: (a) The estate will be entitled to a Sec. 661 deduction for distributions (limited to distributable net income (DNI)), and (b) The distribution will retain its basis and IRD character in the hands of the beneficiary, who may be entitled to an applicable deduction for estate and GST tax. Note: These general rules apply only to the distribution by the estate of current IRD receipts. The distribution of the right to receive future payments of IRD can result in completely different income tax treatment.
Sec. 691(a)(2) provides that when the right to receive future IRD is "transferred," the estate will generally include in gross income the right's FMV on the date of transfer.
The term "transfer" in the case of an estate includes a "sale, exchange or other disposition," but excludes the distribution by the estate to fund a specific or residuary legatee.(76)
As previously discussed, IRD is specifically excluded from the Sec. 1014 "step-up (down)" in basis rules. Most IRD normally has a zero income tax basis. The income triggered on an "included" transfer will ordinarily constitute ordinary income based on the FMV on the date of distribution of the right to receive the future payments of IRD.(77) Nevertheless, the transfer of capital gain IRD (e.g., gain portion of proceeds received after death of an installment sale made by the decedent) will trigger capital gain, not ordinary income.
The executor can fund - a specific bequest, or - a residuary or fractional bequest with the right to receive future payments of IRD without triggering income to the estate. The estate will receive no deduction for the distribution and the legatee will report no income on the transfer of the right. The legatee will report IRD income only when received and will be entitled to any applicable deduction for estate and GST tax.
The funding of a pecuniary (fixed-dollar) bequest with the right to receive future payments of IRD, however, will trigger income to the estate to the extent of the present value of the right to receive the future payments, even though most of the funds may not be received for many years to come (for example, death benefit payments resulting from the death of a partner). in such a case: 1. The estate should be entitled to a distributions deduction for the value of the right distributed, and 2. The legatee of the pecuniary bequest should receive a stepped-up basis equal to the FMV of the right to receive the future IRD payments.(78)
Example 21: J, a partner in a law (or CPA) firm, died in December 1990. To partially fund a pecuniary marital deduction bequest, in 1991 the executor of J's estate distributed to her surviving spouse, B, the right to receive over 10 years $400,000 in future payments due under the firm's partnership agreement as death benefits (including her interest in accounts receivable and work-in-process). On the distribution date, the discounted FMV of the right to these future payments, based on a 10-year payout, was $300,000. The estate had no other net taxable income for 1991. How much income and what type of income would be generated on the distribution, and to whom and when would it be taxed?
The value of the right to receive these IRD payments would be triggered(79) and reportable(80) as partnership income by J's estate in 1991 in the amount of $300,000. In turn, the estate should be entitled to a distributions deduction for the same amount (assuming no other DNI), and B would have to report and become taxable on the $300,000 distribution in 1991, even though only $40, 000 (the first of 10 annual payments) was received by him in 1991. Depending on the amount of B's other taxable income, his Federal income tax on the distribution could amount to as much as $93, 000 (at the top 31% ordinary income tax bracket) or as little as $88,875 (filing as a single individual, having no other taxable income).
Query: Where would B get the necessary funds to pay this whopping tax bill (to say nothing of any additional 1991 state income taxes due)?
Planning for the receipt of IRD is fairly obvious; Avoid passing IRD through the probate estate; and, when possible, specifically designate the beneficiary to receive the IRD directly. If IRD will have to pass through the probate estate, provide that the right to receive such payments is to be used to fund a specific bequest, or a fractional (or residuary) bequest.
If the will (by design or inadvertence) can result in the distribution of the right to receive future IRD payments to fund a pecuniary bequest, consider one of the following plans: 1. Try to keep the estate in administration until all IRD payments have been received. If each IRD amount received is immediately distributed to the surviving spouse or other pecuniary legatee, the estate will receive a Sec. 661 deduction and the recipient will be taxed on such income, which will retain its IRD character. 2. If the IRD is to pass to a pecuniary marital bequest, the surviving spouse may wish to disclaim the bequest and, instead, exercise any available right of election under state law.
When future IRD payments are to be used to fund entirely, or in part, a qualified terminable interest property (QTIP) or other marital deduction trust, the trustee should generally be given broad powers to invade trust principal (since IRD is generally corpus, not income, under state law), so that the IRD, when received. can be transferred to the surviving spouse.
Take advantage of the deduction for any GST and estate taxes applicable to the IRD.
16. Phantom Fiduciary Taxable Income
For years beginning in 1991, estates and trusts (and individual taxpayers) are no longer allowed to deduct any part of the following items for income tax purposes: 1. PALs (except for the special deduction of up to $25,000 for active real estate activities).(81) 2. Personal or consumer interest.(82) 3. Excess investment interest expense.(83) 4. "Miscellaneous itemized deductions" subject to the 2% of adjusted gross income (AGI) floor.(84)
The disallowance of these items can play havoc with the regular subchapter J rules when such losses and expenses are charged to the income account for state law fiduciary accounting purposes.
Example 22: A simple trust created in 1980 received $100,000 of dividend income during its year ended 12/31/9X. No capital gains were realized. The trustee incurred the following expenses and loss in 199X, all of which were charged to income for fiduciary accounting purposes:
Trustees' income commissions $5,000 Net loss realized on real property rentals acquired in 1980 (PAL) 15,000 Total 20,000
In computing the trust's 199X taxable income, the trust's 199X Form 1041 would reflect:
Dividend income 100,000 Net rental loss $15,000 Less PAL disallowed 15,000 Allowed loss 0 Trustees' commissions paid 5,000 5,000 DNI 95,000 Less deduction for distributions, lower of: Income required to be distributed currently (IRDC) 80,000 DNI 95,000 Lower 80,000 15,000 Less personal exemption 300 "Phantom taxable income" $14,700
In this case, income tax levied on such "phantom income" would be charged to the trust's income account for fiduciary accounting purposes.
Phantom taxable income can also arise based on differences between the income tax law and state principal and income statutes. For example, the percentage depletion allowance for oil and gas interests for Federal income tax purposes is generally 15% of gross income; under the Texas Principal and Income (P&I) Act it is 27 1/2%, and under the Illinois P&I Act it is 22%.
Example 23: The only 19XX income of a Texas simple trust consisted of $100,000 of oil and gas royalty receipts; $27,500 of these receipts were credited to the principal account for fiduciary accounting purposes. The trust had no other income or expenses.
In computing the trust's taxable income for 19XX, the trust's 19XX Form 1041 would show:
Oil and gas receipts $100,000 Less depletion (@ 15%) 15,000 85,000 Less deduction for distributions, lower of: DNI $85,000 Required distributions (72 1/2% X $100,000) 72,500 Lower 72,500 12,500 Less personal exemption 300 "Phantom taxable income" $12,200
Under these facts, the income tax levied on the trust's taxable income would be charged to the principal account for fiduciary accounting purposes.
17. Reducing and Deferring Taxes by
Estates are normally not required to distribute income currently to beneficiaries. However, judicious distributions to beneficiaries can result in overall savings of tax to the estate and beneficiaries.
The compaction of tax brackets has also upset the old conventional wisdom that estates, as separate taxable entities (not subject to the throwback rules), should generally accumulate income that can then be distributed tax free to the beneficiaries on termination.
Example 24: For the year 1992 an estate and beneficiary had the following:
Estate's DNI $30,600 Beneficiary (joint return)'s taxable income 25,000
If the executor distributed $20,000 to the beneficiary before year-end, a $1,977 overall income tax saving can be gained:
Without distribution With distribution Taxable Taxable income Tax income Tax Estate $30,000 $8,505 $10,000 $2,332 Beneficiary 25,000 3,750 45,000 7,946 Total $55,000 $12,255 $55,000 10,278
Since estates are still permitted to adopt a fiscal tax year (other than a calendar year), the tax on income distributed by a fiscal year estate can still be deferred, and even reduced. Thus, if the executor (in Example 24) had not used a calendar tax year but had, instead, initially adopted a fiscal year ending January 31 and deferred the distribution until January 1993, the beneficiary would report it on his 1993 calendar-year return (due on Apr. 15, 1994), even though the major portion of the distribution represented income earned by the estate during 1992 (11 months of the estate's fiscal year ending Jan. 31, 1993).
Since all trusts are now required to use a calendar tax year, the ability to defer tax to the beneficiary of a discretionary or sprinkling trust has been foreclosed. Although income can still be "shifted" to such trust beneficiaries, the overall income tax savings normally will be relatively small because of the present compacted tax rates. However, when income tax rates are raised in future years, as they undoubtedly will be, greater overall tax savings will be possible.
In certain types of trusts, substantial savings can be achieved through the judicious distribution of income. For example, in the case of a sprinkling trust in which the trustee has the discretion to distribute income to one or more members of a named group, disproportionate distributions can be made to different beneficiaries in different years. Beneficiaries in low tax brackets can be favored (within the boundaries set by the trust instrument) at the expense of beneficiaries in higher tax brackets, and the overall income tax for the family group can be substantially minimized.
18. Planning Through Distributions
Substantial tax benefits can also be achieved through the proper use of the rules governing distributions from principal. For example, a trustee or executor with discretionary powers may purposely distribute principal to a low tax bracket beneficiary in order to spread the taxable income and reduce the overall effective tax rate. As noted in Part 5 (in February), a distribution of principal generally gives rise to a distributions deduction for the trust or estate and taxable income for the beneficiary. If the distribution is a payment of specific property or a specific sum of money payable in three or fewer installments, however, the distribution will not have income tax consequences. These types of nontaxable principal distributions also have a place in tax planning.
Unplanned distributions of principal by an estate should be avoided. For example, if there is no specific bequest of the decedent's personal effects or of a "family" car in the will, or in the event of intestacy, delivery of the personal effects or car to the surviving spouse-residuary beneficiary is technically a distribution of estate income (limited to DNI).
"Trapping distributions" can often be used by trustees and executors to reduce the overall income taxes of the entities and the beneficiaries. A trapping distribution involves a transfer of principal by an estate or trust to another trust, in which DNI is removed, but without current taxation of the income beneficiary of the distributee trust. The DNI is "trapped" in the second trust because it constitutes a receipt of principal, rather than "income." Principal is not required to be distributed to the income beneficiary. This technique is possible because of differences in state law and the rules of subchapter J (see Part 7 in February).(85)
A trapping distribution of highly appreciated property can severely reduce the amount of DNI carried out to the beneficiary unless the Sec. 643(e)(3) election is made. Although under the present highly compacted income tax rates the use of a trapping distribution has lost a great deal of its former luster as a tax-planning technique, tax rate increases in 1993 and future years may see much of the lost benefits restored. * Sec. 643(e) planning As discussed in Part 13 (in February), the Sec. 643(e)(3) election grants to the fiduciary the option of not only recognizing gain or loss on property distributions, but also of choosing whether the fiduciary or the beneficiary will report such gains or losses. Further planning opportunities are available to the fiduciary because of his ability to time the recognition of the gain or loss. This election unquestionably constitutes a very flexible planning device. There are many planning considerations flowing from the provisions of Sec. 643(e). The fiduciary can take into account the estate's or trust's and the beneficiary's gain (or loss) status and tax bracket before deciding whether to make the election. For example: 1. The fiduciary may consider making the election to trigger gains at the estate or trust level to offset previously recognized losses. 2. The fiduciary may make the election to insure the effectiveness of the carryout of the maximum amount of DNI on a trapping distribution. 3. An executor may make the election to trigger a loss in order to offset previously realized gains. 4. The fiduciary may decide not to make the election and distribute low basis/high present value property to a beneficiary, thus giving the beneficiary the opportunity to sell the property and realize a planned advantageous gain, either to offset a prior loss or have the gain taxed at a lower rate than it would have been to the estate or trust. 5. The executor or trustee may decide to forgo the election when distributing high basis/low current value assets in order to enable the beneficiary to realize a needed loss on subsequent sale.
The fiduciary may also decide not to make the election in order to defer or even eliminate a future gain on appreciated property when - the beneficiary has no current intention of selling the property, or - the beneficiary is seriously ill or of advanced age. On the beneficiary's death, the property will get a tax-free step-up in basis under Sec. 1014 to its then FMV.
An executor who partially funds a residuary or fractional bequest with an interest in a passive activity should make the Sec. 643(e)(3) election in order to trigger a deduction against nonpassive income for any unused suspended PALS applicable to the interest transferred (see Part 14).
Even though the Sec. 643(e)(3) election applies to all distributions in a tax year, the executor, if he wishes, can sell certain property to effect gains or losses and, in addition, also make property distributions without making the Sec. 643(e)(3) election when he wants the beneficiary to be able to recognize gain or loss on the property distributed.
Wills and trust instruments should be drafted with the election in mind. Clauses should be inserted to: 1. Permit the fiduciary to exercise the election or not, in his sole discretion, without adjustment being required among beneficiaries. 2. Grant the fiduciary the power not only to make distributions in kind, but also to make non-pro rata distributions so as to be able to distribute low basis/high current value property to some beneficiaries and high basis/low current value assets to others.
While an estate will be able to recognize a loss on the distribution of depreciated property if the executor makes the election, Sec. 267(b)(6) prohibits the allowance of loss on sales (even deemed sales) between a trustee and a trust beneficiary. Trustees distributing depreciated property in kind should not make the Sec. 643(e)(3) election.
19. Planning Terminating Distributions
In the final year of an estate or trust: * No income is taxed to the entity; all income (including capital gains) is taxed to the beneficiaries. * No personal deduction is allowed to the estate or trust. * Net capital losses in excess of $3,000 cannot be deducted on the final return against other income; any balance of losses over $3,000 is transformed into a capital loss carryover.
The final distributions of a trust or an estate must be carefully planned: Only in the termination year can a beneficiary receive the benefit of the excess of the trust's or estate's deductions (other than the personal exemption and charitable contribution deductions) for that year over its income.(86) The excess of deductions in any other year is completely lost-neither the fiduciary nor the beneficiaries can take advantage of them.
The termination of a trust or estate usually results in abnormally large expenses-fiduciaries' termination commissions and legal and accounting fees. These expenses often exceed the final year's income. To insure that the remaindermen receive the benefit of any excess deductions, it is usually necessary for the terminating distributions to be made in the same year in which the termination expenses are paid.
Example 25: Following the death of the income beneficiary in 19XX, a calendar-year simple trust was being wound up. The trust received income of $5,000 a month. The trustee, T, could reasonably complete termination of the trust in late 19XX or early in the following year 19XX.
Because of the long period of the trust's existence, the size of the principal and the complexities involved in the accounting, the legal and accounting fees totaled $100,000. T's termination commissions also totaled $100,000. The attorney and accountants requested payment in 19XX. T, for income tax reasons of his own, did not want to receive his commissions until 19XX.
T paid the professional fees in December 19XX. On Jan. 28, 19XX, the day T made his final distributions of income and principal, effectively terminating the trust, he paid himself the commissions due. (Any constructive receipt problem that the trustee may have is not considered here.)
The trust's tax returns show the following income and deductions:
Calendar-year 19XX return: Income (DNI) $60,000 Legal and accounting fees paid 100,000 Excess of deductions over income $(40,000) Result: $40,000 of excess deductions are wasted. Short period (1/1/XY to 2/28/XY) final return: Income $10,000 Trustee's commissions paid 100,000 Excess of deductions over income $(90,000) Result: The remainderman was entitled to a deduction of only $90,000 on his income tax returns. Query: Can T be surcharged because of the wasted $40,000 of deductions in 19XX?
A fiduciary should consider paying administration expenses currently (if possible, under local law) and not waiting until termination. The fiduciary may also wish to keep an estate or trust open in its final year to generate sufficient income to offset more deductions.
The beneficiary will also be able to "take over" in the year of termination: 1. Any unused net operating loss (NOL) carryforward of the estate or trust, and 2. Any unused capital loss carryforward.
The beneficiaries receiving the aforementioned tax benefits are normally the remaindermen, not the income beneficiaries.
Part 14 discussed the distribution of interests in passive activities by an executor or trustee. As noted there, it is clear that distributions to fund a "true value" pecuniary bequest, or distributions to fund a residuary bequest when the fiduciary makes a Sec. 643(e) election to realize a gain or loss are both fully taxable transactions. If the estate's or trust's entire interest in a passive activity is so distributed, gain (or loss) will be realized and any unused suspended PALS pertaining to such interests should be triggered and be available to offset all types of income.
The special limitation of Sec. 469(j)(12) should become operative only when an interest in a passive activity is distributed by an estate to a beneficiary and the general rules of nonrecognition of gain or loss on property distributions by executors apply. For example: 1. On a distribution to fund a specific bequest. 2. On distributions to fund residuary (or fractional) bequests when the executor does not make a Sec. 643(e)(3) election to recognize loss. 3. On distributions to fund certain types of pecuniary bequests (e.g., to satisfy a "fairly representative" or "minimum worth" formula bequest).
However, the distribution of a depreciated interest in a passive activity by a trustee will not trigger such suspended PALs until the year such interest is acquired from the beneficiary in a fully taxable transaction by a person unrelated under Sec. 267(b) or 707(b)(1).
Unused investment tax credits on termination are converted into a deduction on the final fiduciary income tax return.(87) Also, an executor (as well as a trustee) has the ability to elect under Sec. 643(g) to "distribute" to the estate's beneficiaries excess estimated tax payments in the tax year "reasonably expected to be" the year of termination.
An estate should not be kept open for an unreasonable length of time or good tax planning may be endangered. Regs. Sec. 1.641(b)-3(a) provides that an estate will be deemed terminated when all of its assets have been distributed except for a reasonable amount that is set aside in good faith for the payment of unascertained or contingent liabilities and expenses. The case of Berger(88) illustrates the constructive termination of an estate due to unreasonable delay.
Example 26: B died on Nov. 1, 1976. Her will, which had been executed two weeks previously, left specific bequests and a life interest in the residue to her surviving spouse. It also left 45% of the estate's residue to various relatives and 55% to charity. On Aug. 1, 1978, the probate court entered an order approving an accounting by the executor. In the order, the court found that all assets had been collected and that the U.S. and illinois estate taxes and, except for the residuary assets, all bequests had been paid.
In 1982, the executor sold a large portion of the residue, realizing a capital gain of $140,650. The estate's 1982 Federal fiduciary income tax return reflected the capital gain and claimed a "set aside" charitable deduction for 55% of the gain under Sec. 642(c)(2).
The Tax Court held that the administration of the estate had been unduly prolonged and that it had been terminated for Federal income tax purposes before 1982. Since it was, in effect, operating as a residuary trust created after Oct. 9 1969, the court concluded that the estate was "not entitle to a deduction for the taxable portion of the capital gain which [was] permanently set aside for charitable purposes."(89)
20. Distributions by Complex Trusts From
A distribution to beneficiaries by a complex trust in excess of the current year's DNI, that is, from accumulated income, is generally described as an accumulation distribution.(90)
Under the throwback rules: * An accumulation distribution is taxed to the beneficiary in the year of distribution. * Accumulation distributions are generally subject to an unlimited throwback of ordinary income accumulated after 1968. There is, however, an exception for income accumulated before the beneficiary reaches age 21. * A FIFO (first-in, first-out) rule is used to determine in which trust years the income was accumulated. * The distribution is "grossed up" by the allocable share of income tax paid by the trust on the distribution. * The conduit principle of trust taxation generally is not applicable, and the beneficiary's tax is computed on this amorphous income under a revised "shortcut" method. * A credit is allowed to the beneficiary for income taxes paid by the trust, limited however to the beneficiary's tax on the distribution; no refunds are possible.
The throwback rules do not apply to distributions from estates and trusts that are required to distribute all income currently, except for accumulations in a year in which the trust received "outside income," e.g., income in respect of a decedent.
The aborted Revenue Act of 1992 would have exempted amounts distributed by most domestic trusts from the "throwback rules" for tax years beginning after Dec. 31, 1992.(91) Hopefully, in the not too distant future, such a provision will be enacted. It will be a true simplification step. However, under the proposal, accumulation distributions made by foreign trusts would continue to be subject to the throwback rules.
21. Taxation of Multiple Trusts
Under the throwback rules, severe penalties are levied on beneficiaries of multiple accumulation trusts. A penalty is imposed when a beneficiary receives an accumulation distribution from more than two trusts with respect to the same prior tax year, subject to a $1,000 de minimis rule.(92) The "gross up" for taxes paid by the trust is not permitted. In addition, the credit for the income taxes paid by the trust on such income is lost. Further, no exception from the throwback rules is allowed for income accumulated before age 21 on distributions received from more than two trusts.(93)
According to Sec. 643(f),(94) under regulations to be prescribed by the Treasury, two or more trusts that are not accumulation trusts will be treated as one trust for income tax purposes if: 1. The trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and 2. A principal purpose of such trusts is the avoidance of income tax. 3. In applying these tests, a husband and wife are treated as one person. No regulations have as yet been issued by the Treasury for this penalty provision.
22. Distributions of Charitable Remainder Trusts
Two types of charitable remainder trusts can be set up - the charitable remainder annuity trust and the charitable remainder unitrust. Although a complete discussion of the concepts underlying these trusts and the application of the relevant Code provisions and regulations is beyond the scope of this article,(95) a general discussion of the unusual income tax consequences of distributions by these trusts to their noncharitable beneficiaries is in order.
Charitable remainder trusts are generally accorded exempt status for income tax purposes.(96) Distributions made by these trusts to their noncharitable beneficiaries are characterized in a completely different manner from distributions by ordinary trusts. Distributions to noncharitable beneficiaries are deemed to come from the following five sources, in the order indicated: 1. From ordinary income, to the extent of the trust's current and previously undistributed ordinary income. 2. From current or undistributed short-term capital gains. 3. From current or undistributed long-term capital gains. 4. From tax-exempt income, to the extent that the total distributions exceed current and accumulated ordinary income and capital gains. 5. From trust principal.
The beneficiary must report the annuity or unitrust amount in his tax year in which the distribution was required, even though the actual distribution may not occur until after the close of the trust's tax year.
A trust distribution of property in payment of a fixed annuity trust or unitrust amount is treated, in effect, as a sale at FMV. To the extent that the value of the property distributed exceeds its basis, a capital gain will be realized. This gain will not be taxed to the trust, which is exempt. The gain could affect the tax liability of the noncharitable beneficiary, however; once all ordinary income is deemed distributed, further distributions will be deemed to come from capital gains, including those generated by distributions in kind.
23. Grantor Trust Taxation
The general rules governing the income taxation of trusts and their beneficiaries do not apply when the grantor or creator is treated as the "owner" of the trust. To the extent that the grantor or other person is treated as the owner of a "grantor trust,"(97) he will be taxed on its income. This principle applies even though the income is accumulated or is paid to other income beneficiaries. Moreover, grantor trusts may be recognized as separate entities under state law, but they are not recognized as separate entities for income tax purposes.
The following types of trusts are treated as "grantor trusts": * Trusts with prohibited powers: The grantor (or his spouse) who holds a "prohibited power" as defined in Sec. 672. * Reversionary trusts: The grantor (or his spouse) retains a reversionary interest that enables him to recover the possession or enjoyment of property transferred (or income therefrom) if at the inception of the trust, the value of that reversionary interest exceeds 5% of the trust's value.(98) * Grantor controlled trusts: The grantor retains control of the beneficial enjoyment of trust income or principal(99) or retains certain administrative powers usable for his benefit.(100) * Revocable trusts: The grantor reserves the power to terminate the trust and take back the trust principal.(101) * Income benefit trusts: The grantor or his spouse can or does benefit from the trust income.(102) * Trusts controlled by persons other than the grantor: The trustee, beneficiary or other person has the power to take the trust principal or income or use it to pay his legal obligation for support or maintenance.(103) * Certain foreign trusts: The corpus of a foreign trust is transferred, in part or in whole (directly or indirectly), by a U.S. person and the trust has a U.S. beneficiary. The U.S. transferor is taxed currently on the foreign trust's income when the funds are being accumulated for a U. S. beneficiary.(104)
The income of any of these types of trusts will be taxed to the grantor or other substantial owner to the extent of his ownership. The "owner" of the trust reports on his income tax return all trust income, deductions and credits to the extent of his interest in the trust, as though the trust did not exist. Although the trust must file a fiduciary income tax return, it is essentially an information return, rather than a return for a separate taxable entity.(105)
24. Distributions From Foreign Trusts
The Code contains a number of provisions that restrict the use of foreign trusts, and greatly reduce, if not eliminate, any tax advantages that these trusts afforded in the past.(106)
As explained in Part 23, when a U. S. person transfers principal, directly or indirectly, to a foreign trust, which has a U. S. beneficiary, the trust is subject to the grantor trust rules. The U.S. transferor is taxed currently on the income of the foreign trust when the funds are being accumulated for the U.S. beneficiary.
When the foreign trust income is not taxed to the grantor (for example, when the foreign trust was established by a nonresident alien), income from a foreign trust is generally subject to the general rules applicable to domestic trusts. U.S. beneficiaries are taxed on the trusts' worldwide income(107) at the time the income is distributed. Treaty exemptions are disregarded in taxing income from U.S. sources to U.S. beneficiaries and 100% of net capital gains must be included in DNI.
Although distributions of accumulated income, when not taxable to the grantor, are subject to the regular throwback rules (described in Part 20), the U.S. beneficiaries pay a substantial penalty in the form of nondeductible interest charges on the U.S. income taxes on the accumulation distributions, at the rate of 6 % a year simple interest.(108)
This article has reviewed and illustrated the basic principles underlying the income taxation of trusts and estates and their beneficiaries, emphasizing the importance and timing of distributions. A tax adviser must fully appreciate the tax consequences of trust and estate distributions and must be aware of the available planning techniques and timing considerations that can result in very significant overall tax savings for every beneficiary, both income and remainderman. It is hoped that this presentation of these basic rules and techniques will serve as a refresher for those familiar with them and prove informative to those who are not.
Income tax planning during trust administration, which usually involves judicious distributions of income and principal to beneficiaries, can often result in large tax savings to the trust and its beneficiaries, as a group. Tax planning during estate administration can also produce substantial income tax savings, thereby increasing the portion of the estate that passes to the surviving spouse and other beneficiaries.
(60) Sec. 469(a)(2)(A). (61) See Abbin, "To Be [Active] or Not to Be [Passive]: That is the Question Confronting Fiduciaries and Beneficiaries Trying to Apply the Passive Activity Loss (PAL) Rules," 23rd Annual U. Miami Institute on Estate Planning, Ch. 3 (1989), for an excellent and comprehensive discussion of the passive activity loss limitation rules and how they apply to estates and trusts. (62) Sec. 469(j)(6). (63) Sec. 469(g)(2). (64) Under Sec. 267(b) or Sec. 707(b)(1). (65) See Sec. 267(b)(6). (66) Under Sec. 172. (67) See Sec. 172(b)(2). (68) See Sec. 172(b)(3). (69) See Sec. 642(h)(1). (70) Under Sec. 267(b)(6). See prior discussion. (71) Sec. 691(a)(1). (72) Sec. 691(a)(3). (73) See Barnett, "IRD - The Atomic Bomb in the Estate of the Professional Partner," 18th Annual U. Miami Institute on Estate Planning, Ch. 18 (1984). (74) Sec. 691(a)(1). (75) Sec. 691(c). (76) Regs. Sec. 1.691(a)-4(b). (77) Regs. Secs. 1.691(a)-3(a) and -4(a). (78) See Regs. Sec. 1.1014-4(a)(3). (79) Sec. 691(a)(2). (80) Sec. 736(a). (81) See Sec. 469(i)(4). (82) Under Sec. 163(h). (83) Under Sec. 163(d). (84) See Sec. 67(a). (85) See Caroline P. Van Buren, 89 TC 1101 (1987), and Rebekah Harkness, 469 F2d 310 (Ct. Cl. 1972)(30 AFTR2d 72-5754, 72-2 USTC [paragraph]9740). For a discussion of the Harkness case, see the text accompanying note 17 in Part 5 of February's installment. (86) Sec. 642(h). However, this deduction constitutes a "miscellaneous itemized deduction" and as such is subject to the 2% of AGI floor in computing the beneficiary's income tax. (Sec. 67.) (87) Sec. 196(b). This deduction is subject to the 2% of AGI floor, (88) Est. of Helen Barrow Berger, TC Memo 1990-554, from which the following example is adapted. See also Old Virginia Brick Co., Inc., 369 F2d 276 (4th Cir. 1966)(18 AFTR2d 5750, 66-2 USTC [paragraph] 9708). (89) Berger, id., at 90-2706-90-2707. (90) Subpart D of subchapter J of the Code (Secs. 665 through 668) covers the treatment of excess or accumulation distributions by trusts. This subpart was extensively revised by the Tax Reform Act of 1976. For a comprehensive discussion of the taxation of distributions of accumulated income, including illustrative examples, see Barnett, "Accumulation trusts and the '76 Act - simplification at a price," 7 The Tax adviser 654 (Nov. 1976). See Exhibit I of that article (at 659) for a comprehensive table of the effective dates for the provisions of the 1976 and prior laws. (91) HR 11, The Revenue Act of 1992, would have added a new. Sec. 665(f) to the Code, which would have provided that accumulation distributions by domestic trusts are not subject to the throwback rules if they are "qualified trusts." Qualified trusts are all trusts other than (a) a foreign trust or (b) a trust created before Mar. 1, 1984, unless the taxpayer establishes that the trust would not be aggregated under Sec. 643(f) (see the discussion in Part 21) if such section applied to the trust. (92) Sec. 667(c). (93) See Secs. 665(b) and 667(c). (94) Sec. 643(f), effective for tax years beginning after Mar. 1, 1984. A trust created prior to that date will be subject to consolidation only to the extent of transfers of trust principal made after Mar. 1, 1984. (95) The legislative purpose of the provisions applicable to charitable remainder trusts is to ensure that tax deductions (for income, estate and gift tax purposes) for charitable remainders will be allowed only if the remainderman-charity is assured of receiving property with a value that bears some relationship to the allowable deduction. The statute carries out this purpose by providing for relatively specific limitations on the amounts payable to noncharitable beneficiaries. See Sec. 664 and the related regulations. (96) Sec. 664(c). If a charitable remainder trust has unrelated business income (see Sec. 512), however, it will be subject to income tax on all of its income as a complex trust. See Regs. Sec. 1. 664- 1 (c). (97) Subpart E of subchapter J of the Code (comprising Secs. 671 through 679) governs the income taxation of trust income "attributable to grantors and others as substantial owners." (98) Sec. 673, applicable to irrevocable trusts created after Sept. 25, 1985 and to trusts that were revocable on that date. The "grantor trust" rules, however, do not apply to the income portion of a pre-Sept. 26, 1985 irrevocable trust in which the grantor's reversionary interest in the principal will (or may reasonably be expected to) take effect more than 10 years after the trust was established (a so-called Clifford or "short-term" trust). (99) Sec. 674. (100) Sec. 675. (101) Sec. 676. (102) Sec. 677. (103) Sec. 678. (104) Sec. 679. (105) The income, deductions and credits attributable to the grantor's interest should not be reported on the Form 1041, but instead, should be shown on a separate statement attached to that form. There is an exception for a revocable trust when the grantor or spouse is a trustee. For this type of trust, created after 1981, no Form 1041 is to be filed. Instead, all income, deductions, etc., are reportable directly on the grantor's Form 1040. Regs. Sec. 1.671-4. (106) For example, in addition to the special income tax provisions discussed here, Sec. 1491 levies a 35% tax on the transfer of property by a U.S. person to a foreign estate or trust. (107) See Sec. 643(a)(6). (108) Sec. 668(a).
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|Title Annotation:||part 2|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 1993|
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