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New sec. 643 trustee capital gain and loss carryout regs.

Effective for tax years ending after Jan. 2, 2004, new capital gain and loss carryout rules (1) apply to all estates and trusts. Regs. Sec. 1.643(a)3(b) is a response to the large number of states that adopted the new "power to adjust" and "unitrust" definitions of income in their version of the Uniform Principal and Income Act of 1997 (UPIA). (2)

Under UPIA Section 104, a power to adjust allows the trustee to transfer amounts between trust income and principal, so that both classes of beneficiaries are allocated reasonable amounts of the total return (including both traditional income and capital appreciation) when a trust invests under the "prudent investor" rule. (3) A unitrust accomplishes the same result, but defines income as a fixed percentage of the trust assets determined annually. (4)

According to the regulations' preamble, the IRS was concerned that these new state laws would encourage settlors to begin defining income in ways that depart fundamentally from traditional trust income (the foundation on which Subchapter J was built). In addition, it was concerned that allowing existing trusts to default or "opt" into these new definitions of income would adversely affect their tax status as qualified terminable interest property trusts qualifying for the estate tax deduction, charitable remainder unitrusts, qualified S corporation trusts, grandfathered generation-skipping trusts or intentionally defective grantor trusts. Finally, the Service was bothered that without a change to the existing rules, an income beneficiary could receive tax-free distributions of, essentially, a portion of the trust's capital gain, while the remainder beneficiary pays the tax thereon. This item discusses the last concern.

Before the new regulations, capital gain was normally excluded from distributable net income (DNI), because most state laws excluded capital gain from trust income. Thus, such gain was taxed to the remainder beneficiary who actually received it. However, when income beneficiaries began to receive a portion of the capital gain through the trustee's power to adjust or a unitrust payment, the landscape changed.

Example 1: Trust T is a unitrust that pays beneficiary B 4% of the fair market value of its assets annually. C is the remainder beneficiary. Neither the trust instrument nor state law characterizes T's payment to B as capital or ordinary for tax purposes. T's assets are valued at $1 million; thus, it pays B $40,000: T has $30,000 dividends and interest and $50,000 long-term capital gain. Under the prior regulations, T's $40,000 payment to B would have carried out the $30,000 dividends and interest, and $10,000 tax-free principal; C would have borne the tax on the $10,000 capital gain B received.

Under Regs. Sec. 1.643(a)-3(b), however, 'if the trustee has authority over capital gains, T can include $10,000 of the capital gain in DNI and carry it out to B, a much fairer result. Although the regulation's concepts are simple and its examples helpful, the drafting is tortured. The exhibit on p. 734 contains a flowchart to help practitioners decipher the new rules.


Old Becomes New Again

The new regulations incorporate two of the prior rules. First, if either local law or the trust instrument includes capital gain in trust income, then capital gain is included in DNI. (5) Unfortunately, neither state law nor most trust documents provide that capital gain is income; thus, this rule is almost useless. The other old rule carried over to the new regulations allows a trustee to include capital gain in DNI if the trust instrument directs the trustee to distribute the sale proceeds of certain assets (i.e., "parcel X") or a portion of trust corpus (i.e., "one-half of corpus on attaining age 25"). (6) This occurs even though neither state law nor the trust document characterizes the payments as capital gain, because the settlor probably intended that result.

Discretionary Principal Distributions

One of the most welcome changes allows a trustee to include capital gain from an asset or class of assets in DNI if he or she has express authority, under either local law or the governing instrument, to (1) distribute principal and (2) deem those distributions as made from capital gain. (7) However, the trustee must be consistent in this decision from year to year (i.e., once he or she decides to include (or exclude) capital gain and losses in income, the decision is irrevocable).A practical problem is how to document a trustee's decision not to distribute capital gains. In addition, the new rule is not clear on the definition of a class, for which the trustee can make a different decision. For example, could a class be (1) all technology stocks, (2) only IBM stock or (3) only IBM stock purchased before 1950?

Unitrust Distributions

The trustee of a unitrust may also include capital gain in DNI if he or she has express authority, granted either under local law or the governing immanent, to (1) pay a unitrust amount and (2) deem such distributions as made from capital gain. (8) Many states provide the needed authority over capital gain in ordering rules that classify unitrust payments as made first from ordinary income, then from short-term capital gain, then from long-term capital gain and, finally, from principal. (9)

As long as the trustee has both types of authority discussed above, a unitrust payment may carry out capital gain to the extent the payment exceeds DNI computed without the capital gain. However, as with discretionary principal distributions, a unitrust trustee must be consistent with this decision from year to year. The preamble explains that the IRS requires consistency, because whether or not a payment includes a portion of capital gain does not affect the distribution amount, only the character. Thus, without a consistency requirement, a trustee's decision to allocate capital gain from year to year could be purely tax-motivated.

The flowchart illustrates a curious result obtained by a literal reading of the regulations that was probably not intended, based on the preamble. The trustee of a unitrust authorized under state law must be consistent in allocating capital gain to the unitrust payment year to year. However, when the unitrust is authorized only in the document, the trustee may allocate capital gain reasonably and impartially, a more flexible standard (discussed below).

Power to Adjust

A trustee wishing to exercise a power to adjust must have the authority to do so, granted either by local law or the governing document. In addition, to deem any part of a payment to the income beneficiary as being made from capital gain, the trustee must also have express authority over capital gain, granted by local law or in the trust document. (10) The power to include capital gain in DNI is not implied in the UPIA; thus, unless a state statute or the trust document expressly adds a power over capital gain, the trustee may not treat any portion of an adjustment as capital gain. Texas appears to be the only state that has provided the needed authority over capital gain in its power-to-adjust statute. (11) Trusts created in all other states will need to rely on authority contained in the trust instrument. While this is not good news for existing irrevocable trusts, those drafting new trust instruments should Consider adding a provision that gives the trustee "the power to allocate all or part of a capital gain to trust income."

Although a trustee who allocates capital gain to trust income with a power to adjust must do so "reasonably and impartially," the regulations neither define nor illustrate this concept. The preamble explains that the capital gain allocation should be part of the trustee's overall plan to balance the beneficiaries' interests under the UPIA, consistent with the settlor's intent. Because a trustee who exercises the power must use judgment and be impartial among the beneficiaries, and the allocation of capital gain is just one part of this decision, he or she should be given the flexibility needed to carry out capital gain in some years and not others.

Capital Losses

Regs. Sec. 1.643(a)-3(d) requires a trustee to net capital loss against capital gain before determining how much to include in the trust's DNI. However, netting is not required when a capital gain is actually distributed (i.e., a parcel of land) or used to determine the amount paid to a beneficiary (i.e., one-half of corpus on attaining age 25). It is not clear whether the regulation actually prohibits a trustee from netting capital losses before carrying out the gain from sale proceeds actually distributed or used in determining a payment, or whether the trustee has a choice. Capital losses were not as plentiful when the regulations were first drafted as they are now, and no commenter requested clarification on this issue.

The anti-netting rule for the capital gain actually distributed or used in calculating the amount payable to a beneficiary is either a great planning opportunity or a real trap.

Example 2: Trustee Y sells stock at a loss to offset a capital gain (from the sale of a parcel of land) that must be distributed to beneficiary D. Y may be surprised to find that he needlessly generated that loss, if he must retain it in the trust rather than net it against the capital gain carried out to D. On the other hand, Y may be glad to have it if the trust has other capital gain to offset it.

65-Day Election

Presumably, the new capital gain carryout rules also apply to distributions made during the first 65 days of a trust's tax year, that the trustee elects to treat under Sec. 663(b) as having been made on the last day of the previous tax year. If so, the 65-day election presents significant new opportunities for trustees who exercise the power to adjust or who have the authority to make discretionary principal distributions and the authority they need over capital gain. The election allows a trustee 65 days of hindsight to carry out some extra capital gain to the income beneficiary (who may have the loss to offset it). This decision requires the trustee to consider both the trust's and the beneficiary's capital gain and loss position and ordinary tax bracket.


The new rules do not resolve all the issues that can arise in allocating capital gain. For example, Secs. 1245 and 1250 recapture and Sec. 1231 losses are part of the gain or loss on a capital asset sale, yet they are treated as ordinary income and included in DNI. In addition, the new regulations do not address whether the trustee has the authority to include capital gain from a passthrough entity. However, once deciphered, the new rules go a long way toward granting trustees the tools they need to better match trust distributions and the related tax obligation than did the old rules. In the meantime, the IRS has verbally indicated that it is ready to publish rulings addressing unresolved issues brought to its attention.

(1) TD 9102 (12/30/03).

(2) Uniform Principal and Income Act of 1997, available at bll/ulc/upaia/2000final.htm.As of September 2005, 41 states and the District of Columbia had adopted it.

(3) The "prudent investor" rule is codified in the Uniform Prudent Investor Act (1995), Section 2, available at upia94.htm.

(4) See Sec. 664(d)(2).

(5) See Regs. Sec. 1.643(a)-3(b)(1) and (e), Example (4).

(6) See Regs. Sec. 1.643(a)-3(b)(3) and (e), Examples (6), (7), (9) and (10).

(7) See Regs. Sec. 1.643(a)-3(b)(2) and (e), Examples (1)-(3) and (5).

(8) See Regs. Sec. 1.643(a)-3(b)(1) and (e), Examples (11)-(14).

(9) See, e.g., TX Property Code [section] 116.007.

(10) See Kegs. Sec. 1.643(a)-3(b)(1). The regulations contain no examples of allocating capital gain under a power to adjust.

(11) See TX Property Code [section] 116.005.

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Author:Cantrell, Carol A.
Publication:The Tax Adviser
Date:Dec 1, 2005
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