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Sec. 643 prop. regs. redefine trust income.

In response to many states' adoption of the 1997 Uniform Principal and Income Act, the IRS issued proposed regulations permitting the inclusion of capital gains in distributable net income. The new rules, when final, will affect many different types of trusts; CPAs, attorneys and trustees may all incur additional responsibilities. This article examines the proposed regulations and offers planning suggestions.

On Feb. 15, 2001, Sec. 643 proposed regulations(1) were issued in response to state law changes to trust code income definitions. The new regulations' centerpiece is the ability to include capital gains in distributable net income (DNI) for trusts using the modern "power to adjust" or the "unitrust" concept embodied in the 1997 Uniform Principal and Income Act (UPIA). Fifteen states have already adopted versions of the UPIA; at least 15 more have either proposed (or plan to propose) similar legislation.(2) The proposed changes may soon affect more than three and a half million trusts and their advisers annually.(3)

The linchpin Code section most directly affected by these state law changes is Sec. 643; however, many other Code sections hinge on the Sec. 643 definition of fiduciary accounting income. These changes will affect all simple trusts, all complex trusts using trust income as a benchmark, and all qualified terminable interest property (QTIP) marital deduction trusts (1) in states that have adopted versions of the UPIA or (2) governed by the terms of a document that contains a power to adjust or a unitrust amount: They will also affect any charitable remainder unitrust (CRUT) in a state that has adopted a default unitrust definition of income (such as the New York proposal, before its recent amendment).(4) This article will analyze the proposed regulations and offer practical suggestions to trustees and their advisers.

Traditional Concepts of Fiduciary Income and DNI

Most state probate and trust codes are modeled after the 1962 Uniform Principal and Income Act.(5) Dividends and interest are income and allocated to the income beneficiaries; capital gains are corpus and allocated to principal beneficiaries. If no distributions are made to beneficiaries during a particular year, the taxable income remains a part of (and is taxed to) the trust. If distributions are made during the year, they will carry out some or all DNI under Secs. 651 and 661. Sec. 643(a) defines DNI as the trust's taxable income computed with certain modifications (i.e., excluding capital gains and including tax-exempt interest).

Under the current regime, distributions to beneficiaries carry out an estate's or trust's DNI--i.e., the fiduciary's taxable income with certain modifications (most notably, the exclusion of capital gains). Thus, beneficiary distributions (regardless of whether characterized as income or principal) carry out the estate's or trust's taxable income, leaving capital gains inside the trust for taxation at that level. In effect, the remainder beneficiary incurs the capital gain tax. This is fair; supposedly, the remainder beneficiary ultimately receives the benefit of the capital gains remaining in the trust on termination.

Modern Investment Portfolio Theory

This DNI carryout system worked fairly well, until the prudent-investor standard for managing trust assets allowed trustees to consider different types of investment alternatives that blurred the traditional distinction between income and principal.6 For example, trust portfolios may now include limited partnership interests, annuities, IRAs, options and other derivatives, regulated investment companies (mutual funds) and many other types of investment vehicles previously unheard of in a trust portfolio. Most state trust codes do not describe how to separate income from principal for such assets.

In addition to more modern investment vehicles, there is a growing trend to shift trust investments toward growth and equity strategies. This has an adverse effect on income beneficiaries, who traditionally are entitled only to dividends and interest. In response to the need to invest for growth, yet also protect the income beneficiary's interest, the National Conference of Commissioners on Uniform State Laws drafted the UPIA.

Its centerpiece is the Section 104 "power to adjust" between income and principal, which is granted if three conditions are met: (1) the trustee must be subject to the prudent-investor standard; (2) the computation of trust income must affect beneficiary distributions; and (3) the trustee must determine that full compliance with the first two criteria leads to noncompliance with his duty of impartiality among beneficiaries. Use of this power allows a trustee to allocate between income and principal if necessary to balance the interests of the income and remainder beneficiaries, regardless of the investment strategy.

Many states have revised their traditional definitions of income and principal to conform with this power, such as California.7 Other states, such as New York, have enacted either a power to adjust or an elective alternative "unitrust" concept of income for all trusts.8

Mismatch of Income Tax and Trust Distributions

While modern investment and distribution trends attempt to balance the income and remainder beneficiaries' rights, they play havoc with the existing income tax rules designed under traditional fiduciary standards. Under the old definition of fiduciary income, it made sense to tax an income beneficiary on income actually distributed, but not on capital gains retained by the trust. However, under the new power-to-adjust or unitrust distribution standards, income beneficiaries may obtain a tax windfall when they receive distributions reclassified by trustees as "income" but deemed "principal," and may be taxable to the trust as capital gains under Federal income tax rules.

For example, if a trustee distributes a three-percent unitrust payment to a current income beneficiary when ordinary income represents only two percent of trust asset value, the income beneficiary will receive the last one-percent distribution tax-free. This happens because the trust's capital gains incurred during the year remain in the trust for taxation at that level. In a sense, the remainder beneficiary pays capital gain tax on a portion of the distributions paid to the income beneficiary.(9)

Sec. 643 Prop. Regs.

Recognizing these modern investment trends, changes in state law income definitions and the resulting income tax inequities, the IRS sought to overhaul Sec. 643's definition of fiduciary income as least as far back as its 2000 business plan. The proposed changes will affect any trust that relies on income to determine amounts properly payable to its beneficiaries and is subject to a power to adjust or unitrust amount under state law or its governing document; this includes simple trusts, complex trusts that measure distributions relative to trust income, QTIP trusts, CRUTs, pooled income funds and trusts grandfathered from generation-skipping transfer (GST) taxes. These changes are proposed to apply to trusts and estates, for tax years beginning on or after the date final regulations are published in the Federal Register.

These proposals affect not only fiduciaries in states that have already adopted the new state law income definitions, but trust instruments that contain unitrust payouts or fiduciary discretion to adjust income or principal.

While the IRS's original aim was to conform the Federal tax definition of income to the evolving state law definition, as the update of Sec. 643 progressed, it became obvious that other Code sections needed to be included in the project. Also at stake were marital, charitable and generation-skipping trusts, all of which rely on Sec. 643 for their definition of fiduciary income in determining their critical Federal tax consequences. Thus, the list of regulations requiring revision expanded, resulting in changes under Regs. Secs. 1.642(c)-2 (pooled income fund charitable set-asides), 1.643(a)-3 (capital gains included in DNI), 1.643(b)-1 (state law income definitions), 1.651 (a)-2 and 1.661 (a)-2(f) (in-kind distributions), 1.664-3(a)(1)(i)(b)(3) (CRUTs to provide their own definition of income), 20.2056(b)-5(f),-7 and 25.2523(e)-1 (income for marital trusts), and 26.2601-1(b)(4)(i)(D)(2) (GST-exempt trust modifications).

Including Capital Gains in DNI

Current income tax laws normally exclude capital gains from DNI, following state law that generally excludes such gains from trust accounting income. A review of the current rules on inclusion of capital gains in DNI will enable appreciation of the proposed changes.

Current Rules

Capital gains are generally excluded from DNI, except in three very limited situations. First, under Regs. Sec. 1.643(a)-3(a)(1), capital gains may be specifically included in income under local law or the governing instrument. This situation is rare; state laws (and most trust instruments) do not usually include capital gains in income. However, Letter Ruling 8728001(10) permitted trustees to use discretion granted them in the trust instrument to allocate some, but not all, of a trust's capital gains to income.

Second, capital gains otherwise allocable to corpus may be actually distributed to the beneficiaries. According to Regs. Sec. 1.643(a)-3(a)(2) and (3), this requires that a trustee have the appropriate authority under the trust instrument or state law. Rev. Rul. 68-392(11) provides that "appropriate authority" exists only when the distribution is "required by the terms of the governing instrument upon the happening of a specific event," such as the sale of a specific asset or trust termination.

Finally, capital gains may be included in DNI if they are actually used under the governing instrument's terms or in the practice followed by the fiduciary in determining the amount actually distributed to the beneficiary. In Rev. Rul. 68-392, the IRS warns that establishing a "practice followed by the fiduciary" requires more than one tax year. Moreover, the current regulations suggest that the exact net proceeds must be distributed to the beneficiary. What if the sales proceeds exceed the amount to which the beneficiary is entitled? Does the failure to distribute the exact proceeds from even one sale destroy the trustee's practice? Given the Service's harsh ruling position on these methods of including capital gains in DNI, few have chosen to rely on them.(12)

Proposed Standards

Recognizing that the current income tax rules were not designed for distributions under a power-to-adjust or unitrust standard, Prop. Regs. Sec. 1.643(a)-3 and (b)-1 would allow all or a portion of capital gains to be included in a trust's or estate's DNI if the allocation is made under state law or the governing instrument's terms, not inconsistent with local law. Thus, in states that have adopted the new power-to-adjust or unitrust version of income, capital gains may be included in DNI to the extent so allocated under the fiduciary's power to adjust or make a unitrust distribution.

Even in states that have adopted the power to adjust principal and income under the UPIA, the authority to allocate capital gains to income is not automatically implied. One author strongly suggests that trustees wishing the power to allocate capital gains to income include a specific provision in the trust instrument to that effect. If a trustee invades principal to make a discretionary distribution, he should be specifically authorized to allocate capitol gains to that distribution.(13)

The proposed regulations would allow trusts in states that have not yet adopted the uniform laws to allocate capital gains to income, as long as the trust instrument gives the trustee the discretion to allocate and he exercises his discretion in a reasonable and consistent manner not inconsistent with local law. The governing instrument should specifically refer to the power to allocate capital gains, as opposed to merely principal alone.

Prop. Regs. Sec. 1.643(a)-3(e) provides 11 examples illustrating when and how capital gains may be allocated to DNI and distributed to a beneficiary. Examples 1 and 2 illustrate the allocation of capital gains under a discretionary power to adjust; Examples 9-11 deal with the distribution of capital gains as part of a unitrust payment. The overriding conclusion from these examples is that all or a portion of capital gains may be included in DNI to the extent that a trustee has discretion either under local law or the governing instrument (if not inconsistent with local law) to treat them as distributed to the beneficiary. The examples also highlight three traps.

Authority to allocate capital gains:

The first trap is that either state law or the trust instrument must specifically authorize the trustee to treat discretionary principal distributions as from capital gains. State laws that adopt the UPIA do not automatically provide authority to categorize a principal reallocation as coming from capital gains. This conclusion is warranted because the UPIA neither mentions capital gains nor expressly sanctions the practice of allocating capital gains to either unitrust or equitable adjustment distributions.

Some states have considered filling the statutory gap with an ordering rule that specifies that distributions are deemed first to come from ordinary income, then short-term capital gain, then long-term capital gain and finally, from return of principal. Prop. Regs. Sec. 1.643(a)-3(e), Example 9, contains a distribution under such a state ordering rule; Examples 1 and 2 illustrate a trustee who has been specifically granted the power to deem corpus distributions as capital gains either under local law or in the governing instrument.
Example 1: Under a trust's governing instrument, all income is to
be paid to A for life. The trustee has discretionary powers to
invade principal for A's benefit and to deem discretionary
distributions to be made from capital gains realized during the
year. During the trust's first tax year, it has $5,000 dividend
income, $5,000 partnership K-1 income and $10,000 capital gain
from the sale of securities. Under the governing instrument
and applicable local law, the trustee allocates the $10,000 capital
gain to principal.

During the year, the trustee distributes $5,000 to A, representing
A's right to trust income; in addition, the trustee distributes to
A $12,000, under the discretionary power to distribute principal.
The trustee intends to follow a regular practice of treating
discretionary distributions as being paid first from any net capital
gains realized by the trust during the year. The trustee evidences
this treatment by including the $10,000 capital gain in DNI on the
trust's Federal income tax return, so that it is taxed to A.

Total distributions to A for the year are $17,000 ($5,000 +
$12,000); total DNI is $20,000 ($10,000 + $10,000). How should
A be taxed?

Traditional trust accounting income $5,000
DNI (exclusive of capital gains)(16) 10,000
Capital gains 10,000
Required distribution(17) 5,000
Discretionary distribution 12,000

Possible beneficiary allocations:

 DNI excluding Nontaxable
 capital gains Capital gains principal Total

(1) $10,000 $7,000 0 $17,000
(2) $5,000 $10,000 $2,000 $17,000
(3) $8,500 $8,500 0 $17,000
(4) $7,000 $10,000 0 $17,000
Example 2: The facts are the same as in Example 1, except that the
partnership has a loss and DNI (exclusive of capital gains) is only
$3,000; capital gains are $20,000.

Traditional trust accounting income $5,000
DNI (exclusive of capital gains)(18) 3,000
Capital gains 20,000
Required distribution(19) 5,000
Discretionary distribution 12,000

Possible beneficiary allocations:

 DNI excluding Nontaxable
 capital gains Capital gains principal Total

(1) $3,000 $12,000 $2,000 $17,000
(2) $3,000 $14,000 0 $17,000
(3) $3,000 $12,000 $2,000 $17,000


Evidencing capital gain treatment:

Under Prop. Regs. Sec. 1.643(a)-3(b)(2), the second requirement to allocate capital gains to DNI is that the trustee must take express action to allocate the capital gains to income on the trust's books, records and tax returns. Examples 10 and 11 illustrate a trustee evidencing treatment of a capital gain allocation by including it (or not) in DNI on the trust's Federal income tax return. The trustee should also be careful to indicate in the trust accounting records whether the allocation is short-or long-term gain.(14)

Although the trust instrument itself. might not specify whether discretionary distributions should come first from short- or long-term gain, or contain a pro rata portion of each, it is doubtful that a trustee has the flexibility to change the ordering from year to year. Such a solely tax-motivated decision could violate the consistency requirement of Prop. Regs. Sec. 1.643(a)-3(b).

Trustee's consistency requirement:

The third requirement for inclusion of capital gains in DNI is consistency. In Prop. Regs. Sec. 1.643(a)-3(e), Example 2, a trustee has the power and intends to follow a regular practice of treating discretionary distributions as made from capital gains. The example points out that the trustee must, in future years, treat all discretionary distributions as made first from any realized capital gains. Thus, a trustee should think carefully about the decision to allocate discretionary distributions to capital gains. Once that authority is exercised, it must be followed consistently every year thereafter, rather than changed at will each year. This mandate is not surprising; the aim of the proposed regulations is to more nearly align the income taxation with the actual distributions made, rather than to promote planning opportunities.

DNI vs. Fiduciary Income

In all 11 examples in Prop. Regs. Sec. 1.643(a)-3(e), the trust's DNI exactly equals its fiduciary accounting income before any equitable or unitrust reallocation. In these examples, distributions of a trust's ordinary income carry out the ordinary income included in DNI; any excess distributions designated as capital gains by the fiduciary neatly carry out capital gains.

However, state law income and DNI are almost never equal. In many (if not most) instances, there are varying degrees of difference between state .law definitions of income and DNI. For example, differences occur with trust ownership of partnerships or S corporations, annuities, stock options, IRAs and other deferred compensation arrangements. It is unclear how the proposed regulations will treat distributions of fiduciary income that are more than or less than DNI when a trustee has allocated a portion of capital gains to income.

The roles in effect prior to the Sec. 643 proposed regulations treat distributions of fiduciary income in excess of DNI as tax-free. Will the new rules provide the same treatment, except to the extent that distributions are specifically earmarked as capital gains? The AICPA has requested clarification of this matter in comments to Treasury. Edited portions of the AICPA comments-containing specific examples of when DNI and ordinary fiduciary income are not perfectly aligned--are reproduced below.(15)

DNI Exceeds Trust Income

When trust accounting income is less than DNI (e.g., there is K-1 passthrough income, but no partnership distributions), the question arises as to the character of any equitable, unitrust or discretionary distribution in excess of traditional trust accounting income when a trust also has capital gains. It essentially becomes an ordering problem: Discretionary distributions could carry out (1) remaining DNI (exclusive of capital gains) before carrying out any of the capital gains; (2) capital gains, bypassing the remaining DNI (exclusive of capital gains) in the trust and any excess from nontaxable principal; (3) DNI proportional to the character of its components (including capital gains); or (4) capital gains, with any excess discretionary distributions from any remaining DNI (exclusive of capital gains); see Example 1.

Trust Income Exceeds DNI

Likewise, when trust income exceeds DNI (e.g., the trust has tax-deferred annuities or allocates deductible expenses to corpus), the question arises as to the character of distributions of remaining trust income in excess of DNI (exclusive of capital gains), plus discretionary distributions. Such excess distributions could (1) carry out nontaxable distributions before any discretionary distributions carry out capital gains; (2) immediately carry out capital gains to the extent thereof; or (3) carry out DNI (including capital gains) proportional to the character of its components (including capital gains).

As Examples 1 and 2 illustrate, the ordering of the carryout will sharply affect the allocation of the tax burden between the income beneficiary and the remainder interest holders. Hopefully, there will be guidance along these lines before the final regulations are published. If not, the message may be that the Service has gone as far as it intends to on guidance; the rest is up to the trustee and practitioners to draft accordingly or take a reasonable position.

65-Day Elections

Currently, a trustee may elect under Sec. 663(b) to treat all or a portion of distributions made during the first 65 days of a trust's tax year as having been made on the last day of the prior tax year. This is purely a tax election and has no effect on a trustee's classification of income or principal on trust books and records. The election is limited to the trust's income under Regs. Sec. 1.643(b)-1 (or DNI, if greater).

The 65-day election has not been an issue with simple trusts, which are required to distribute all their income currently. However, certain complex trusts that use income as a measure for distributions may find renewed interest in this election. Presumably, the election will apply to discretionary distributions of capital gains; AICPA comments have requested verification.(20) Assuming the 65-day election will apply to capital gain distributions, it may make a significant difference whether distributions during the first 65 days are treated as current or prior-year distributions.

Example 3: T, the trustee of a complex trust, may distribute up to, but no more than, the trust's income each year; T made a $10,000 distribution in the first 65 days of the trust's 2000 tax year. Further, T has a regular practice of treating discretionary distributions as capital gain. In 1999, all the trust's accounting income and DNI were carried out, but there is a $100,000 capital gain from the sale of B. In 2000, there is expected to be little or no capital gain. If T elects to treat the $10,000 as a 1999 distribution, it will carry out $10,000 of 1999 capital gain. Without the election, the $10,000 will carry out 2000 DNI.

Trustees anticipating this election should continue making protective distributions during the first 65 days of the tax year. In fact, trustees who reallocate principal to capital gains may now be required to actually make those distributions within 65 days and make a timely Sec. 663(b) election for those capital gains to carry out to a beneficiary for the tax year in which they arose.

CPAs considering this election need to be aware that it may now carry out capital gains, but only to the extent the trustee has reallocated capital gains to income under a state statute or a governing instrument's provisions. Now, both the trustee and tax preparer should consider the beneficiary's capital gain or loss position, as well as his ordinary income tax bracket.

Prop. Regs. Sec. 1.643(b)-1

"Not Inconsistent with Local Law"

When Regs. Sec. 1.643(b)-1 was drafted in 1956, it contained a caveat that"trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for this purpose" As an example, the regulation described a trust that provided that all its income should be distributed, yet proceeded to define interest and dividends as principal.

Prop. Regs. Sec. 1.643(b)-1 retains the original "depart fundamentally" warning, yet further provides that "an allocation ... to income will be respected if ... made ... pursuant to a reasonable and consistent exercise of discretionary power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law." (Emphasis added.) The lone previous example has been eliminated.

The italicized language seems to overlook the fact that in nearly all states, the governing instrument controls the definitions of principal and income; state law definitions merely function as default rules when the trust document is silent or ambiguous. The AICPA Trust Income Task Force (Task Force) has asked the IRS in comments to clarify when a trust instrument allocation will be ineffective under state law.(21)

State Law Unitrust Amounts

According to Prop. Regs. Sec. 1.643(b)-1, a local law definition of trust income will be respected as reasonable if state law provides for the income beneficiary to receive a unitrust amount of between three and five percent of the trust assets' annual fair market value (FMV). However, unitrust amounts on either side of the safe-harbor range are not automatically ignored for tax purposes.(22) Apparently, this range was designed to reign in certain states (e.g., California and New York) that suggested a broader, two-to-seven-percent unitrust payout.(23) Ironically, the current New York law contains a four-percent unitrust rate.(24)

Although the proposed regulations do not mention unitrust payouts based on a "smoothing" rule, neither do they appear to prohibit one. A smoothing rule uses a fixed percentage of an average FMV of trust assets to determine the unitrust amount. The state legislatures considering a unitrust definition of income are drafting smoothing rules.(25) Its primary purpose is to avoid excessive volatility in the annual distribution amount. The AICPA has asked the IRS in comments to confirm that reasonable smoothing rules will be accepted within the safe harbor.

State Law Power to Adjust

Similarly, Prop. Regs. Sec. 1.643(b)-1 approves as reasonable allocations between income and principal made pursuant to a trustee's exercise of an adjustment power granted under state law. In states that have adopted the UPIA, adjustments between income and principal are permitted under UPIA Section 104(a) when (1) the trustee invests the trust assets under the state's prudent-investor rule; (2) the trust describes the amount to be distributed to a beneficiary by referring to the trust's income; and (3) the trustee, after applying the state statutory rules governing income and principal allocations, cannot administer the trust impartially.

Governing Instrument Provisions

Finally, in states that have not yet adopted the UPIA, the allocation of capital gain to income will be respected if the allocation is made pursuant to a reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or the governing instrument, if not inconsistent with local law. A "consistent" exercise means once an allocation to capital gain is made, it is followed every year thereafter, as illustrated in Prop. Regs. Sec. 1.643(a)-3(e), Example 2.

Prop. Regs. Secs. 20.2056(b)-5, -7 and 25.2523(e)-1, (h)-2

QTIPs and Other Marital Trusts

Of prime importance to all trusts intended to qualify for the estate and gift tax marital deduction is the requirement to pay the spouse all of the trust's income each year, as provided in Regs. Secs. 20.2056(b)-5(f) and 25.2523(e)-1 (f). Most drafters of marital trusts hesitate to become too creative with the definition of income in the trust document, and instead defer to the state law definition. Thus, income for most marital trusts designed to qualify for the marital deduction is determined under the traditional notions of dividends and interest defined by state law.

However, there are questions about whether state law is still a safe default for marital trusts in states that have adopted the UPIA's power to adjust or a unitrust version thereof. The chief concern, of course, is whether the spouse can be "entitled to all the income" from a trust in a state that permits equitable adjustments or unitrust distributions.

Marital Trusts Must Adhere to State Law

The proposed regulations provide that a spouse's interest satisfies the income standard set forth in Regs. Secs. 20.2056(b)-S(f) and 25.2523(e)-1(f) if (1) the spouse is entitled to income as defined under a state statute that provides for reasonable apportionment of the total mast return between the income and remainder beneficiaries; and (2) it meets Prop. Regs. Sec. 1.643(b)-1's requirements. As the examples under Prop. Regs. Sec. 1.643(a)-3(e) make clear, reasonable apportionment can be accomplished through a state law unitrust definition of income or by giving the trustee a power under state law to adjust between income and principal. However, state law must be controlling.

The Task Force's comments to the IRS requested that the regulations eliminate the requirement that the definition of income for marital trusts be supplied by state law. Instead, trusts intending to qualify for the estate and gift tax marital deduction should be permitted to use a conforming power to adjust or unitrust concept of income. For this purpose, "conforming" should be defined in the proposed regulations as:

... consistent with the power to adjust in the Uniform Principal and Income Act (1997) section 104 or with the three to five percent unitrust safe harbor described in [sections] 1.643(b)-1 (a), or any validly enacted state law versions thereof.

This scope limitation should allow trusts in all states the range of drafting freedom they need, while not undermining the intended purposes of Prop. Regs. Secs. 20.2056(b)-5, -7 and 25.2523(e)-1 and (h)-2. However, in conversations with Brad Poston, IRS Attorney, Sec. 643 Project Coordinator, it is not likely that the IRS will retreat from its requirement that income be defined by a state law statute. Looking solely to the individual document leaves the income definition too lax for the IRS'S comfort.

Prop. Regs. Sec. 1.664-3

CRUTs

A CRUT is a split-interest trust that provides for a specified distribution to one or more noncharitable beneficiaries for life or a term of years, with an irrevocable remainder interest held for the benefit of a charitable organization. Under Sec. 664(d)(2), the amount distributed to the noncharitable beneficiaries is a fixed percentage (not less than five percent and not more than 50%) of the trust assets' annual FMV. Alternatively, under Sec. 664(d)(3), the unitrust amount may be the lesser of this fixed percentage amount or trust income (with or without a make-up amount). For this purpose, "trust income" means income as defined by Sec. 643(b) and the applicable regulations.(26)

CRUTs that default to the state law definition of income in states that have adopted a unitrust definition of income of less than five percent will lose their CRUT qualification. The New York EPTL-SCPA Legislative Advisory Committee proposal to change N.Y. Estates, Powers and Trusts [sections] 11-2.5 to a four-percent default unitrust for all new trusts was an example of this problem. However, because the unitrust-default concept proved to be the most controversial aspect of the New York proposal, it was later changed to a conscious choice, in the final version enacted on June 19, 2001.(27)

Document Must Supply Its Own Income Definition

To prevent any potential problems from state law definitions of trust income less than the required five-percent mandatory minimum, the proposed regulations require a CRUT in a state with a default unitrust income definition to contain its own definition of income. This causes problems in drafting appropriate language that will maintain the trust's exempt status. The Task Force commented on this, as follows:

1. The IRS should provide a model definition of CRUT income for these CRUTs for incorporation in the sample forms of trust published in Rev. Proc. 90-31(28) (and currently scheduled to be updated, according to Notice 2000-37(29)).

2. There is currently no grandfathering provision in the proposed regulations to protect existing CRUTs that refer to Sec. 643(b) for the default definition of income. In states that have adopted a unitrust definition of income, the mandate that each CRUT document provide its own definition of income consistent with the five-percent minimum payout under Sec. 664(d) (2) (A) would be fatal to the exempt status of most (if not all) CRUTs existing in that state. The IRS could not have intended this result. The proposed regulations should allow existing trusts a period to reform their documents and provide a definition of income in compliance with the new requirements.(30)

CRUTs Denied Discretion to Adjust

Capital gain attributable to appreciation in the value of a trust asset after the date it was contributed to (or purchased by) a CRUT may be allocated to income under local law and the terms of the governing instrument, but not via a discretionary trustee power. This provision has caused dissent in the planned-giving community.(31)

The general feeling is that it is discriminatory to grant all trustees except unitrustees the discretion to allocate capital gains to income; this is not an area likely to be abused. Also, given the limited choice of allocating 100% of capital gains to income or principal (with no discretion for partial allocations), a trustee will likely choose to allocate them to the current income beneficiary rather than the charity, inevitably producing a smaller interest for charity. Thus, most commentators feel that CRUTs should be given the discretion to allocate capital gains to income, even if on a limited basis (such as through an independent special trustee).

Prop. Regs. Sec. 26.26011-(b)(4)(i)(D)(2)

Modifications to Pre-Sept. 25, 1985 GST-exempt Trusts

Prior to the proposed regulations, the transfer tax consequences of a change in the definition of trust income of a grandfathered GST-exempt trust was uncertain. Even the final GST regulations, Regs. Sec. 26.2601-1(b) (i) (A)-(D),(32) did not specifically address the effect of income modifications under Sec. 643(b) among their safe-harbor provisions. They did, however, suggest certain modifications that would not cause a trust to lose its exempt status, including modifications that do not shift a beneficial interest in the trust to a lower-generation beneficiary.

Going one step further, Prop. Regs. Sec. 26.2601-1(b)(4)(i)(D)(2) provides that the administration of a pre-Sept. 25, 1985 trust in conformance with a state law that defines income as a unitrust amount, or permits equitable adjustments between income and principal to ensure impartiality, and that meets the requirements of Prop. Regs. Sec. 1.643(b)-1(a), will not be treated as a modification that shifts a beneficial interest to a lower-generation beneficiary, or increases the amount of a GST. Two examples of permitted GST-safe modifications to income are provided in which trust provisions are inadvertently modified by state law changes, one to a unitrust concept and the other to permit equitable adjustments.

Prop. Regs. Secs. 1.651 (a)-2 and 1.661 (a)-2(f)

Distributions in Kind

Distributions of property by an estate or trust generally do not, by themselves, trigger gain or loss. Such property distributions carry out DNI equal to the lesser of the property's basis or its FMV. The beneficiary inherits the same basis as that of the estate or trust. An exception exists for distributions of property in satisfaction of a right to receive a specific dollar amount or a right to receive specific property other than that distributed. In that case, under Regs. Sec. 1.661(a)-2(f), gain or loss is recognized by the estate or trust as if the property had been sold to the beneficiary at its FMV. In all other cases, an estate or trust may elect under Sec. 643(e)(3) to recognize gain or loss as if the property had been sold to the distributee at its FMV. In that event, the distribution carries out DNI equal to the FMV of the property; the beneficiary obtains a new basis equal to FMV.

The proposed regulations add another category of property distributions that will automatically be treated as a deemed sale. The use of property to satisfy distributions of income as defined under Sec. 643(b) (if income is required to be distributed) will also cause the estate or trust to recognize gain or loss. However, the Sec. 267(b) (6) related-party rules will prevent such losses from being currently recognized, except to the extent losses are incurred by an estate in funding a pecuniary bequest under Sec. 267(b)(13). Therefore, care must be taken in selecting property (or batches of property) to distribute in lieu of cash, to prevent gains from being recognized, while losses are deferred.

The Task Force comments requested that the IRS provide examples of deemed sales under both a unitrust and a power-to-adjust income distribution in the new regulations. It also requested that exceptions be made to the disallowance of related-party losses for distributions of property under a unitrust or power-to-adjust distribution. Further, the Task Force sought clarification on how to treat groups of assets included in a single in-kind distribution.33 For example, would gains be recognized, but losses disallowed? Or, would gains and losses first be netted before application of the related-party rules? It is uncertain whether the IRS will agree to tackle the related-party rules in connection with this project.

Prop. Regs. Sec. 1.642(a)-2

Pooled Income Fund Set-asides

The regulations clarify that pooled income funds may not receive a charitable contribution deduction for capital gains set aside if it would be possible, under the fund's governing instrument or local law, at any time for an income beneficiary to receive a portion of these capital gains. This could occur, for instance, if the beneficiary's right to income could be satisfied by the payment of either a fixed percentage of the trust property's annual FMV or any amount based on unrealized appreciation in the value of trust property. Judging from comments sent to Treasury thus far, there seems to be little controversy surrounding this proposal.

Conclusion

The Service has accommodated the new state law "power to adjust" and "unitrust" definitions of income with exceptional speed and friendliness. However, because these definitions affect a great number of trusts, professionals in all disciplines will need to take greater care. Attorneys drafting new trusts may want to override some of these state law provisions; at a minimum, they should be aware of the tax effect on existing trusts that default to the new state law changes. CPAs will need to be careful in making tax elections and computing DNI when it is no longer determined under the traditional notions. Trust officers may need to evaluate the adequacy of their accounting software under new rules and to play a greater role in tax planning and decisions. While these new changes are welcome, they will definitely raise the bar of responsibility for all trust professionals.
EXECUTIVE SUMMARY

* The proposed
changes will affect any
trust that (1) relies on
income to determine
amounts properly
payable to beneficiaries
and (2) is subject
to a power to adjust or
unitrust amount.

* The Service has
accommodated the
new state law definitions
of income with
exceptional speed and
friendliness.

* Trust officers may
need to evaluate the
adequacy of their
accounting software
under the new rules
and play a greater role
in tax planning and
decisions.

For more information about
this article, contact Ms.
Cantrell at (713) 667-9147 or
ccantrell@bvccpa.com.


Editor's note: Ms. Cantrell chaired the AICPA's Trust, Estate, and Gift Tax Technical Resource Panel's Trust Income Task Force.

Author's note: The author wishes to thank Task Force members Evelyn Capassakis (Chair of the Trust, Estate, and Gift Tax Technical Resource Panel), Byrle Abbin, Barbara Bond, Robert Blume, Suzanne Scriven, George Strobel and Eileen Sherr (AICPA Technical Manager).

(1) NPRM KEG-106513-00 (2/15/01).

(2) See Uniform Law Commissioners, Introduction & Adoption of Uniform Acts, available at www.nccusl.org/uniformact_factsheets/uniformacts-fs-upia.htm (last modified in 2001; provides the status of (1) all current uniform laws adopted by the states and (2) new uniform law drafting projects).

(3) See IR-2001-40 (3/30/01).

(4) See NY EPTL-SCPA Legislative Advisory Comm., Fifth Report (4/7/98)(hereinafter cited as "EPTL Report") and Supplement to Fifth Report of the EPTL-SCPA Legislative Advisory Committee (5/26/00)(hereinafter cited as."EPTL Supplement") (recommending that the New York State Legislature enact additions to Estates, Powers, and Trusts Law Article 11, Part 2, to change the definition of trust accounting income).

(5) See Spalding, "Put Your Trust in Trustees," 186 J. of Accountancy 69 (November 1998)(compiling a list of states and comparing which versions (if any) of the Uniform Principal and Income Acts and the Uniform Prudent Investor Act they have adopted).

(6) See Restatement (Third) of Trusts: Prudent Investor Rule, [subsections] 227-229 (1992).

(7) See Cal. Prob. Code [sections] 16,336.

(8) N.y. Estates, Powers, and Trusts Law [sections] 11-2.4 (6/19/01).

(9) See Rosepink, "The Total Return Trust--Where And How To Tax Capital Gains," 137 Trusts & Ests. 12 (October 1998) (analyzing current uncertainties on the taxation of capital gains distributed under a unitrust standard of income).

(10) IRS Letter Ruling 8728001 (11/21/86).

(11) Rev. Rul. 68-392, 1968-2 CB 284.

(12) See Rosepink, note 9 supra.

(13) See Kasner, "Capital Gains: A New Definition for Income and Principal?," Tax Notes Today (3/5/01)(commenting on the drafting implications of the. Sec. 643 proposed regulations).

(14) Id.

(15) AICPA, "Proposed Regulations Under IRC Section 643 Regarding the Definition of Income," Tax Notes Today (5/18/01).

(16) In Examples 1 and 2, DNI is presumed to exclude capital gains; capital gains are added back to illustrate the proposed regulations' effect.

(17) "Required distributions" are assumed to be those required under the terms of the governing instrument before the trustee exercises discretion to allocate additional amounts to income.

(18) See note 16, supra.

(19) See note 17, supra.

(20) See note 15, supra.

(21) Id.

(22) Annual Winter Estate Planning Practice Update (American Law Network Live Nationwide via Satellite)(2/15/01)(live comments of Beth S. Kaufman, Jeffrey N. Pennell, Lawrence P. Katzenstein, Pam Schneider and Malcolm A. Moore during open panel discussion on Sec. 643 proposed regulations).

(23) Telephone interview with Brad Poston, IRS Attorney, Sec. 643 Project Coordinator (4/18/01) (explaining the reasons for the IRS early start on the Sec. 643 regulatory project).

(24) See note 8, supra.

(25) See Wolf, "Bob Wolf's Commentary on Proposed Regs.," Steve Leimberg's Newsletter (2/26/01).

(26) Regs. Sec. 1.664-3(a)(1)(i)(b) (as amended by TD 8791, 12/9/98).

(27) See EPTL Report, note 4 supra.

(28) Rev. Proc. 90-31, 1990-1 CB 539.

(29) Notice 2000-37, IRB 2000-29, 118.

(30) See AICPA, note 15 supra.

(31) See Schultz, "Unitrust Capital Gain Discretion Prohibited in Proposed Regulations," Pepperdine University Center for Estate and Gift Tax Planning Gift Law e-Newsletter (2/19/01), available at www.pepperdine.edu/estateandgift/ PEPNET.htm (noting the adverse effect on charitable remainder trusts).

(32) TD 8912 (12/20/00, corrected 2/21/01).

(33) See AICPA, note 15 supra.
Carol Cantrell, CFP, CPA/PFS
Shareholder
Briggs & Veselka Co.
Member BKR International
Bellaire (Houston), TX
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Author:Cantrell, Carol
Publication:The Tax Adviser
Geographic Code:1USA
Date:Aug 1, 2001
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