For many estate planners, the complexities of the fiduciary income tax have not been terribly troubling, because Form 1041 audits have been historically few and far between. Yet with the federal applicable exclusion amount now at $5 million, the number of estates subject to federal estate tax will decrease substantially. With the potential decrease in resources needed to audit Form 706 (assuming the current regime stays intact beyond 2012) it seems likely that the Internal Revenue Service may shift its focus to a closer review of fiduciary income tax returns. Should this occur, the need for a deeper familiarity with the fiduciary income tax rules of Subchapter J of the Internal Revenue Code will increase.
At the broadest level, Subchapter J provides for the allocation of income and deductions between the trust and the beneficiaries. (The authors generally refer to trusts and trustees, though many of these concepts also apply to estates and their fiduciaries.) In this sense, the trust can be both a taxpayer and a conduit through which income and deductions flow out to the beneficiaries. This allocation and the role of the trustee in this allocation are conditioned by two fundamental concepts—fiduciary accounting income (FAI) and distributable net income (DNI)—that ultimately determine the tax accounting income (TAI) for the trust and the beneficiaries. As most practitioners are aware, these three concepts are fundamental to the mechanics of Subchapter J. They are far more complex, however, than some may recognize and often manifest themselves on Form 1041. This article offers a look at the “not-so-basic” basics.
Fiduciary Accounting Income
Unlike the concepts of DNI and TAI, which are governed by the IRC, FAI concepts are governed by state law. Unless otherwise specified in the governing instrument, state law determines whether a receipt or disbursement is allocated to income or principal for fiduciary accounting purposes. The authors refer to the Uniform Principal and Income Act of 1997, as amended in 2000 (UPIA), which most states have adopted in some form. Under the UPIA, income is defined as “money or property that a fiduciary receives as a current return from a principal asset,” and principal is defined as “property held in trust for distribution to a remainder beneficiary when the trust terminates.”
The UPIA’s basic philosophy is that the governing instrument controls whether a receipt or disbursement is allocated to income or principal. If the governing instrument is silent about the allocation and does not confer a discretionary allocation power on the trustee, the UPIA provides the default rules. Under UPIA § 103(a)(4), the ultimate default rule is that a receipt or disbursement is allocated to principal if both the governing instrument and the UPIA are silent about the allocation. This allocation rule complies with the trustee’s duty to administer the trust impartially, based on what is fair between the income and remainder beneficiaries. For example, allocating a receipt to principal will increase the income received by the income beneficiary in subsequent years and ultimately benefits the remainder beneficiaries on trust termination.
Notwithstanding the clear articulation of the definitions of income and principal, and the bright-line default rule to provide fiduciaries guidance on allocating between them, the complexities of fiduciary accounting can present a host of not-so-basic applications of the general rules. Set forth below are some of the more prominent applications.
Receipts from an Entity. Generally, money received from an entity is allocated to income. But money received from an entity is allocated to principal if it is received from the sale of all or a portion of the trust’s interest in the entity (for example, a capital gain), a total or partial liquidation of the entity, or short-term or long-term capital gain realized within an entity that is a regulated investment company or real estate investment trust. Property other than money received from an entity also is allocated to principal. In addition, a special rule applies to reinvested dividends. If a trustee elects to reinvest dividends in shares of stock of a distributing corporation, the new shares would be principal. Basically, making this election is equivalent to the trustee exercising the power to adjust from income to principal under its “equitable” power of adjustment. But, if the trustee makes the election for a reason other than the duty to administer the trust impartially—for example, to make an investment without incurring brokerage commissions—then the trustee should transfer money from principal to income in an amount equal to the reinvested dividends.
Receipts from an Obligation to Pay Money. Interest is allocated to income regardless of its taxability. In addition, the increment in value of a bond or other obligation bearing no stated interest, but payable at a future time in excess of the issue or purchase price, is allocated to income. Any amounts received from a sale or redemption of an obligation to pay money are allocated to principal.
Receipts from Rental Property. Generally, rent from real or personal property (even amounts received for renewal or cancellation of a lease) is allocated to income, and deposits, such as for security or rent, are allocated to principal. Particularly when the trust owns several parcels of real property, however, the trustee may elect to account separately for the rental activity from each separate parcel and to make certain adjustments for depreciation, as discussed below.
Separate Accounting. Under UPIA § 403, a trustee that operates certain business activities can elect to account for those activities separately, regardless of whether they are conducted through a separate legal entity. These activities include traditional business activities, such as manufacturing, service and retail, farming, raising and selling livestock, management of rental properties, and extraction of natural resources and timber. The election gives the trustee greater flexibility for fiduciary accounting purposes. For example, a trustee that accounts separately can determine the extent to which cash receipts are held back from income for working capital, repairs, depreciation, and other business needs. This flexibility, however, is limited if a trustee sells business assets other than in the ordinary course of business. In this case, the trustee must allocate the proceeds to principal to the extent that the proceeds are no longer required for the conduct of the business. In addition, the election does not permit a trustee to account separately for a traditional securities portfolio to avoid the other provisions of the UPIA.
General Expenses. The basic rule for general trust disbursements is that such disbursements are allocated half to income and half to principal, including, but not limited to, trustee compensation, investment advisory fees, accountings, and judicial proceedings. Specific rules apply beyond these basics, however.
For example, the trustee should allocate exclusively to income all of the ordinary expenses (other than those mentioned above that get allocated only half to income) incurred in connection with the administration, management, or preservation of trust property and the distribution of income, such as interest, ordinary repairs, regularly recurring taxes assessed against principal such as real property taxes, expenses of any matter that primarily concerns the income interest, and regularly recurring insurance premiums covering the loss of a principal asset or the loss of income from or use of the asset. For insurance premiums, the term recurring is intended to separate premiums that are continuous (for example, premiums for flood insurance) from premiums that are occasional, each of which covers the loss of a principal asset. On the other hand, “nonrecurring” premiums, such as title insurance premiums, would be allocated to principal.
Alternatively, certain expenses are generally allocable exclusively to principal. These include any of the trustee’s compensation calculated on principal as a fee for acceptance, distribution, or termination, all disbursements made to prepare property for sale, all payments on the principal of a trust debt, and expenses of any matter that primarily concerns the remainderman (for example, a proceeding to construe the trust or to protect the trust or its property). Also, all transfer taxes, including estate, inheritance, and generation-skipping transfer taxes, and penalties are allocated to principal.
Federal Income Taxes. Taxes that are incurred for the receipt of income (for example, interest income) should be allocated to income and taxes that are generated from principal (for example, capital gains) should be allocated to principal. Note that receipts allocated to income or principal should be reduced by the amount distributed to a beneficiary from income or principal for which the trust received an income tax deduction. For income taxes when a trust owns an interest in an entity, if the trust’s share of the entity’s taxable income exceeds the total income and principal receipts, then such tax should be allocated to principal. In addition, under UPIA § 506, a trustee can make adjustments (unless the governing instrument states otherwise) to offset the shifting of economic interests or tax benefits between income and remainder beneficiaries. This power to adjust for tax purposes should not be confused with the trustee’s power to adjust under UPIA § 104, which applies to any inequity arising from the allocation of receipts and disbursements.
Depreciation. The UPIA permits the trustee to make transfers from income to principal to create a reasonable reserve for depreciation. The trustee, however, cannot exercise this power for an asset that is either used or available for a beneficiary’s enjoyment or personal use (for example, personal residence), during the administration of an estate, or if the trustee has elected to use separate accounting. The amount of the depreciation taken for income tax purposes is presumed reasonable in determining the reserve. A depreciation reserve could benefit the remainder beneficiaries by shifting a portion of the cash distributions from income to principal and, therefore, from the income beneficiary to the remainder beneficiaries. The depreciation reserve provides the trustee a method to ensure that all beneficiaries are treated fairly and thereby comports with the trustee’s duty of impartiality.
Distributable Net Income
DNI is the mechanism through which the IRC translates the trust’s taxable income into the terms of FAI, so as to properly allocate taxable income and deductions between the trust and its beneficiaries. In conjunction with the distribution deduction and income inclusion rules of IRC §§ 651 and 652 and IRC §§ 661 and 662, DNI determines how a trust’s items of FAI ultimately yield the TAI for the trust and the beneficiaries.
The DNI of a trust is determined under IRC § 643(a). At the most basic level, the computation of DNI begins with the “taxable income” of the trust. The taxable income of the trust is computed in the same manner as an individual’s, except as otherwise provided in Subchapter J. Taxable income is then subject to five major adjustments under IRC § 643(a) to determine DNI. First, any deduction under IRC §§ 651 or 661 that would be allowed for distributions to beneficiaries is not subtracted from taxable income. Second, the personal deduction under IRC § 642(b) is not permitted. Third, capital gains and losses are generally excluded. This will require the subtraction of capital gains from taxable income or the addition of deductible capital losses back to taxable income. Fourth, in a “simple trust” (a trust that distributes all income currently and does not distribute principal), DNI does not include extraordinary dividends or taxable stock dividends that the trustee allocates to principal. Fifth, DNI includes tax-exempt interest, notwithstanding the fact that this is not includable in taxable income, less any deductions under IRC § 265 that would be permissible for such income.
Capital Gains. The determination of whether capital gains enter the computation of DNI is arguably the most complex consideration for DNI. Notwithstanding the general rule that capital gains and losses are excluded from DNI, the nuances and exceptions to this rule make the determination of DNI far more complex when capital gains are involved. The statutory language of IRC § 643(a)(3) contemplates this additional complexity by providing that capital gains and losses are excluded from DNI to the extent that they are allocated to principal and not otherwise paid, credited, or required to be distributed to any beneficiary during the taxable year. The Regulations expand on the statutory language by providing that capital gains are included in DNI under three major exceptions, provided that such inclusion is consistent with the terms of the governing instrument and applicable state law or under a reasonable and impartial exercise of discretion by the trustee.
First, capital gains are included in DNI when they are allocated to FAI. As the Regulations provide, this allocation can be required under the express terms of the governing instrument or under applicable local law. In addition, the governing instrument can provide the trustee with discretion to allocate capital gains to FAI, in which case, the allocation will be respected, provided that the exercise of the trustee’s discretion is reasonable and impartial.
Second, capital gains are included in DNI even when they are allocated to principal, provided that they are treated consistently by the trustee on the trust’s books, records, and tax returns as part of a distribution to a beneficiary. The Regulations recognize that a variety of circumstances can condition a trustee’s exercise of this discretion. For example, the allocation of capital gains to DNI will be respected when the trustee consistently chooses to allocate capital gains from a particular asset or particular class of assets.
Third, capital gains are included in DNI even when they are allocated to principal if they are actually distributed to the beneficiary or used by the trustee to determine the amount that is distributed or required to be distributed to a beneficiary. Again, this can arise in a variety of circumstances. For example, when a trustee has the discretion to make discretionary distributions but decides that distributions will be made only to the extent that the trust has realized capital gains during the year, the capital gains will be included in DNI. This result obtains regardless of whether capital gains are allocated to income or principal for FAI purposes. Similarly, when a beneficiary is entitled to the proceeds from the sale of a specific asset, the capital gain realized from the sale of that asset is included in DNI. The rule that capital gains enter DNI when actually distributed also is applicable in the case of a termination of a trust, when the result is that the gain realized is actually distributed to the beneficiary. In the case of a partial termination, capital gains also will be included in DNI to the extent actually distributed; this determination can require the exercise of some discretion by the trustee.
Capital Losses. Capital gains and capital losses are generally netted at the trust level, so capital losses do not affect the amount of DNI independently. When the amount to be distributed to a beneficiary, however, is determined by reference to the trust’s capital gains, the capital losses will not net with the capital gains at the trust level. Instead, the capital losses will be left out of the computation of DNI, while the capital gain will enter the computation and be distributed to the beneficiary.
Charitable Contributions. DNI also includes any capital gains that are paid, permanently set aside, or used for a charitable purpose. This provision is intended to prevent any tax rate arbitrage that might otherwise be possible by isolating ordinary income for distribution to charitable beneficiaries.
Extraordinary Dividend Rule. The extraordinary dividend rule provides that in the case of a simple trust, DNI does not include extraordinary dividends or taxable stock dividends that are allocated to principal. In a simple trust, the trust is only authorized to distribute FAI, so this rule makes sense because an extraordinary dividend or taxable stock dividend is typically allocated to principal.
Foreign Trusts. Three special rules apply to the computation of DNI for a foreign trust. First, non-U.S. source income is generally included in DNI. This rule is necessary to square FAI concepts with the fact that taxable income as the starting point for computation of DNI does not include non-U.S. source income when the trust is foreign. Second, U.S.-source taxable income is determined without any exclusion from gross income under an income tax treaty. Third, notwithstanding the general rule excluding capital gains from DNI, capital gains are always included in the DNI of a foreign trust. These special rules are often critical to determine a foreign trust’s “undistributed net income” for purposes of the so-called “throwback rules” of IRC §§ 665–668.
Tax Accounting Income
Once DNI is determined, the distribution deduction and income inclusion rules of IRC §§ 651 and 652 and IRC
§§ 661 and 662 will determine the proper allocation of income and deductions between the trust and its beneficiaries. Under IRC §§ 651 and 661, all trusts receive a deduction for the amount of FAI required to be distributed currently and, in the case of a “complex trust” under IRC § 661, other amounts properly paid, credited, or required to be distributed for the taxable year. The IRC provides a limitation on the amount of this deduction. Namely, the deduction cannot exceed the trust’s DNI, reduced by the net items of nontaxable income entering the computation of DNI. This quantitative limitation on the trust’s distribution deduction aims to allocate the tax incidences between the trust and its beneficiaries. This is perhaps most evident in the case of the tax imposed on capital gains. As discussed above, under the general rule DNI does not include capital gains, so to the extent that the distribution to the beneficiaries exceeds DNI, the excess is treated as a tax-free distribution of principal with the tax incidence of the capital gain borne by the trust. But, when FAI rules permit deviation from the standard practice of allocating capital gains to principal such that the capital gains are instead allocated to income, the tax incidence of the capital gains are passed to the income beneficiary consistent with the nuanced computation of FAI. Squaring FAI, DNI, and TAI, however, is not always so basic.
Nonstandard Distributions. Four common types of nonstandard distributions can create conceptual difficulties in determining the passing of DNI out to beneficiaries. First, is the case of specific bequests governed by IRC § 663(a)(1),
which applies to any amount that, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of a specific sum of money or of specific property. The bequest also must be paid or credited in three or fewer installments. When the governing instrument provides for such a gift or bequest, the satisfaction of the gift or bequest is not a distribution that carries out DNI from the trust. This rule does not apply, however, if the gift or bequest can only be paid or credited from FAI.
Second is when the holder of a nongeneral power of appointment exercises the power to effect a distribution from the trust. The treatment of the distribution made at the direction of the power holder is unclear. At least one private letter ruling indicates that the distribution carries out DNI. See PLR 9218076. This result, however, may be technically inaccurate, because state law may indicate that the distribution is not being made by the trustee but rather by the power holder as the agent of the settlor, and the appointees may not technically be trust beneficiaries. In this case, the application of standard DNI distribution rules would seem inappropriate.
Third is a trust severance or partition. In a series of private letter rulings, the IRS has indicated that because the new trusts resulting from a trust severance or partition are not beneficiaries of the original trust, the standard DNI distribution rules do not apply.
Fourth is the case of a complete trust decanting into further trust. There is no settled answer here, but two theories exist. Under one theory, the recipient trust is viewed merely as a continuation of the original trust and succeeds to the original trust’s tax attributes. The other theory is that the decanting terminates the original trust with a distribution of all its assets to the recipient trust. Regardless of the theory, the result would be that the recipient trust would receive all of the DNI from the original trust, which may then be distributed to the beneficiaries of the recipient trust.
Unitrusts. For FAI purposes, unitrusts create some complexities independent from the tax consequences. This is in part attributable to the fact that no unitrust statute was adopted in the UPIA. In states with unitrust statutes that specify the fiduciary accounting treatment of a unitrust payment, the unitrust payment is treated as FAI for trust accounting purposes. The general treatment is that the unitrust payment consists first of the FAI determined as if the trust were not a unitrust. Then, to the extent that FAI is less than the unitrust payment, the difference may be composed of principal or capital gain, depending on state law. Some states permit the trustee to allocate capital gain to the unitrust payment in the trustee’s discretion.
Thus, the tax treatment of the unitrust payment is conditioned in large part on the state law that determines the composition of the unitrust payment. Treas. Reg. § 1.643(b)-1 creates a safe harbor: if state law provides that the unitrust payment is between 3% and 5%, then the treatment of the unitrust payment as FAI will be respected for tax purposes. The taxable items allocated to the unitrust payment, therefore, will factor into the determination of the distribution deduction. This consideration is important for the allocation of capital gains to FAI. Treas. Reg. § 1.643(a)-3(b)(1) provides that if income under state law is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income also must be exercised consistently and the amount so allocated cannot be greater than the excess of the unitrust amount over the amount of DNI determined without regard to the allocation of capital gains to FAI. To the extent that the unitrust amount exceeds the amount of FAI determined as if the trust were not a unitrust, the allocation of capital gains to FAI made under the terms of the governing instrument or state law will result in the inclusion of capital gains in DNI.
Pass-Through Entities. A trust owning an interest in a pass-through entity (such as a tax partnership) creates various issues resulting from the interplay of TAI and FAI. This is because the taxable income from the entity flows through to the trust, but the trust might not receive any distribution from the entity to allocate to FAI. This mismatch between TAI and FAI can create a host of problems. For example, in the case of a trust that receives taxable income from its distributive share of a partnership but receives no corresponding distribution, the trust has no FAI and all of the tax is payable by the trust, not the beneficiaries. Even if a distribution is made, if the distribution is not large enough to cover the tax liability, a mismatch can still occur. In subsequent years, if the partnership eventually makes a cash distribution when there is little or no DNI, the income beneficiary will receive the distribution tax-free. The savvy trustee can eliminate this inequity by exercising the power to allocate a portion of the cash distribution to principal in the amount of the taxes paid on the income in the earlier year.
Additional issues may arise in the case of a trust that earns taxable income from a partnership and other tax-exempt income. The result may be that the trust’s distribution of any tax-exempt income to the income beneficiary will carry out part of the taxable income the trust receives from the partnership. This results in the income beneficiary being taxed on a portion of the distribution, rather than the entire distribution being tax-exempt. In such a case, the trustee may decide to exercise the power to adjust to make an additional distribution to the income beneficiary to “gross up” the income tax liability.
The concepts of FAI, DNI, and TAI present many complexities beyond the basics. Practitioners and fiduciaries alike should keep these points in mind in their next round of Forms 1041—with the potential for a decrease in the number of federal estate tax returns audited, the not-so-basics may become of increasing importance.