When a mandatory income trust holds an interest in a partnership or other pass-through entity, allocating the trust's tax on the entity's taxable income between income and principal is easier said than done. Before its amendment, section 505 was ambiguous. There were at least two interpretations among practitioners and academics. Trustees were often unaware of the problem. The most widely accepted interpretation was that of E. James Gamble, co-reporter of the UPIA. These two interpretations produced vastly different results as this article illustrates below. To prevent litigation over the matter, the Uniform Law Commission amended section 505 to clarify that it carries out James Gamble's intent.
Concerns Underlying UPIA § 505 Changes
Before discussing the technical reasons for this change, one must understand the basic income tax rules governing business entities and trusts and how they interact.
Income Tax Rules Governing Business Entities
Three different tax paradigms apply to business entities. These include Internal Revenue Code Subchapters C, S, and K, governing the taxation of C corporations, S corporations, and partnerships, respectively.
A C corporation pays income tax on its own income. When it distributes its current or accumulated earnings, the distribution is taxed to its shareholders as a dividend. The corporation receives no deduction for the payment. For example, suppose individual A is the sole shareholder of the corporation. A invests $1,000. The corporation earns $100,000 and pays $40,000 in income tax. This leaves $60,000 of after-tax earnings, which it distributes to A as a taxable dividend. The corporation receives no deduction for the dividend payment and A reports the $60,000 dividend as taxable income. A also pays a 40% tax on the dividend, leaving only $36,000 in A's pocket to spend.
S corporations, on the other hand, pay no entity level income tax on their taxable income, except in limited circumstances when they were formerly C corporations within the last 10 years or have accumulated C corporation earnings and profits. Code §§ 1374, 1375. When an S corporation distributes its earnings, the distribution is generally not taxed to the shareholders as long as they have sufficient basis in their stock. For example, suppose the same facts as above, except that the corporation was an S Corporation from inception. The S corporation pays no income tax on its $100,000 of earnings. Instead, it reports the $100,000 to A on a Schedule K-1, which A reports on his or her personal income tax return, paying $40,000 of personal income tax. Code § 1366(c). The S corporation also pays a $40,000 dividend to A for which it receives no income tax deduction. Nor is this $40,000 taxable to A because it does not exceed A's basis in his stock. Code § 1368(b)(1). A shareholder has more "value" with an S corporation than a C corporation because S corporations and their shareholders have only a single layer of tax, whereas C corporations impose a "double tax"—one at the corporate level and another at the individual level.
Partnerships (including limited liability companies taxed as partnerships) are the third paradigm. They have income tax attributes similar to that of S corporations in that their taxable income passes through to their owners without a double tax. Therefore, this article refers to S corporations and partnerships as "pass-through" entities and uses "Schedule K-1 income" to describe the income from the pass-through entity that an owner reports.
Income Tax Rules Governing Trusts That Own Business Entities
Now suppose that, in the examples above, a mandatory income trust was the sole shareholder (all calculations ignore the trust's small income tax exemption):
- The trust with the C corporation has trust accounting income equal to the $60,000 distribution it received from the C corporation. When the trust pays the $60,000 to the income beneficiary, the trust receives an income tax deduction for the payment, reducing its taxable income to zero. Hence, it has no trust level tax to allocate between income and principal. The trustee's job is simple in this case.
- But the task becomes more complicated when the trust owns a pass-through entity. Assume it is a partnership. How much of the $60,000 distribution from the partnership should the trust pay the beneficiary? If the trust pays the full $60,000 to the beneficiary, the trust receives a tax deduction for $60,000 but still has taxable income of $40,000 ($100,000–$60,000) and no wherewithal to pay the tax if the trust has no other assets. Alternatively, the trust could retain some of the $60,000 to satisfy its own tax obligation. But the question is "how much?" The trust's tax is a moving target. Every time it pays the beneficiary, its tax changes because it is entitled to deduct the payment.
Before this amendment, disputes often arose over how much tax, if any, the trustee should allocate to "trust income" before making a distribution to the beneficiary. Beneficiaries receiving no cash from a mandatory income trust were understandably upset. On the other hand, trustees could not afford to pay the beneficiary the entire distribution it received from the entity because they had their own tax obligation to satisfy on their share of the entity's taxable income.
From inception, UPIA § 505 was intended to instruct the trustee on how to allocate taxes between income and principal in precisely those situations in which the trust owned a pass-through entity. Unfortunately, UPIA § 505 was ambiguous. Therefore, members of the ABA, the AICPA, and ACTEC asked the Uniform Law Commission to clarify its intended operation.
Explanation of UPIA § 505 Changes
The UPIA amendment clarifies the overriding principle that the trustee of a mandatory income trust should use distributions from an entity to the extent necessary to pay its own income taxes and distribute any remaining trust income to the beneficiary. The official comments, as amended, contain an algebraic formula that the trustee can use to allocate taxes between income and principal when the pass-through entity distributes less than its taxable income reflected on Schedule K-1. The formula produces the optimum beneficiary distribution so that the trustee has just enough to pay its own taxes on entity taxable income after deducting the payment to the beneficiary. See Appendix to this article in Comment to amended UPIA § 505.
The policy behind this change is that the UPIA should not place trustees in a position where they cannot pay their income tax. Generally, it is not practical or prudent for a trustee to borrow to pay income tax on pass-through taxable income when the trustee has no control or knowledge of when, if ever, the entity will make a distribution that the trustee could use to repay the loan. In the example above, suppose the business entity annually accumulated the $40,000 excess taxable income but later distributed these accumulated amounts to the trust. UPIA § 506(a)(3) authorizes the trustee to reimburse income or principal for the tax paid in prior years on these accumulated amounts. Section 506, however, is purely discretionary, and trustees might be reluctant to exercise it, or any other discretionary power, for that matter. In addition, if the trustee embarks on a program to reimburse income or principal each year for taxes paid in prior years on distributions of accumulated entity taxable income, the mathematics and the resulting equities become so complicated that it produces a greater problem than the trustee attempted to resolve in the first place. Clarifying UPIA § 505 greatly reduces the number of instances when the trustee will need to rely on the equitable adjustment power in UPIA § 506.
It is also important to discuss how section 505 applies to trusts that own S corporation stock. Special income tax rules apply to trusts that own S corporation stock, which UPIA § 505 affects differently from trusts owning a partnership interest.
- An electing small business trust (ESBT) does not receive an income tax deduction when it makes a distribution to its beneficiary(ies). Instead, it pays its own entity level tax on its share of the S corporation's taxable income. An ESBT simply withholds its entity level tax from any distributions it receives from the S corporation and pays the excess, if any, to the beneficiary(ies). Code § 1361(e) and Treas. Reg. § 1.641(c)-1(i). If the S corporation does not pay the ESBT enough to cover its taxes, the taxes are paid from principal. Thus, the tax allocation for an ESBT is fairly simple.
- A qualified subchapter S trust (QSST) under Code § 1361(d), or a wholly owned grantor trust with one beneficiary, does not pay taxes on any of the Schedule K-1 taxable income from an S corporation. Instead, for income tax purposes the individual beneficiary or grantor is treated as the shareholder and pays all the income taxes attributable to the S corporation's Schedule K-1 income. Code § 1361(d)(1)(B). Therefore, because the trustee has no entity level tax, it should pay the beneficiary of a QSST or grantor trust the entire distribution the trustee receives from the S corporation. Like an ESBT, the tax allocation for a QSST or grantor trust is simple.
- In only a few instances besides ESBTs, QSSTs, and grantor trusts are nongrantor trusts eligible to own S corporation stock. These include testamentary trusts and revocable trusts after the death of the grantor, but only for a period of two years from transfer of the S corporation stock to the testamentary trust or from the death of the grantor in the case of a revocable trust. In addition, estates are eligible to own S corporations. In these limited situations, the trust or estate is taxed in the same manner as if it owned a partnership interest. That is, the income of the S corporation passes through to the trust or estate and the trust or estate is entitled to an income tax deduction for payments it makes to its beneficiaries. Code § 1361(c)(2). See Steven B. Gorin et al., Checklists for Determining Whether a Trust Is a Valid S Shareholder , The Tax Advisor, March 2006, at 152–57; Steven B. Gorin, Transferring Ownership of Stock in an S Corporation , 61 J. Mo. Bar 92 (Mar./Apr. 2005).
The amendments to UPIA § 505 do not purport to solve all of the trustee's problems in allocating taxes on entity income between the trust and its beneficiaries. For instance, the trustee will usually not know the amount of its income tax on entity income until well after year end, including the 65-day grace period in Code § 663(b). Thus, the trustee needs to estimate the trust's after-tax income during the year and true up the distributions for the current year during the following year. But there are ways to overcome those problems. For example, the trustee can ignore the effect of a post year-end distribution when computing the tax for the following year. But those problems are minor compared with the problems before its amendment, which produced vastly different tax allocations depending on which interpretation of section 505 the trustee adopted.
Advising Clients About UPIA § 505 Changes
The changes to UPIA § 505 provide clarity on how the trustee should allocate taxes on the entity's taxable income between income and principal. It also provides a means for the trustee to pay its taxes notwithstanding the other significant challenges of owning pass-through entities. But when a mandatory income trust owns only an interest in a pass-through entity that makes little or no distributions, other difficult challenges arise as well. One must consider why this difficult situation arises, what the trustee must do to alter the trust's investments if the trust agreement does not address the issue, and how to minimize disputes about what the trustee should do.
Why This Difficult Situation Arises
The first question is: why would the settlor provide for a mandatory income trust, while expecting that it would be funded with assets producing no income available to distribute to the beneficiary? Scenarios include:
- Marital Deduction Mandatory Income Requirement. The trust is for a surviving spouse who does not need distributions but must provide for mandatory income to qualify for the marital deduction. The trust has the usual clause allowing the spouse to require the trustee to make the property productive. In some cases, using a separate trust to hold only a pass-through entity might be necessary to minimize the estate tax risk of below market value buy-sell agreements. The IRS has taken the position that a fixed-price buy-sell agreement, in which the sale price of a decedent's equity is less than the IRS-determined fair market value, effectively passes property to a person other than the surviving spouse. Therefore the marital trust is ineligible for a marital deduction. See, e.g., Estate of Rinaldi v. United States , 38 Fed. Cl. 341 (1997), aff'd per curiam, 82 A.F.T.R.2d 98-7217 (Fed. Cir. 1998); Estate of McCabe v. United States, 475 F.2d 1142 (Ct. Cl. 1973); TAM 9147065. In this case, the marital deduction could be protected by placing the non-income-producing property into a separate marital trust from the one that holds the income-producing assets. In that case, the settlor should make sure that the spouse understands the trust's purposes and does not expect any distributions from the trust. If, however, the surviving spouse's interest is adverse to that of the remaindermen, then the settlor might consider a prenuptial agreement or other ways to document a particular expectation of cash flow to the surviving spouse.
- Future Income Expected. The settlor does not expect income to be generated by the business entity initially but expects it eventually to generate income. In addition, the settlor does not expect the beneficiary to need the income until later. In this case, the settlor might consider describing the settlor's expectation regarding income so that the trustee has more guidance on what the settlor expects and can respond to concerns that the income beneficiary might raise.
- Post-Mortem Business Sale Expected. The settlor wanted to mandate income distributions, knowing full well that the business would need to be sold. The settlor might not have been able to find a buyer while alive, might have wanted to have a place to work for as long as the settlor lived, or might have wanted to wait until death to save income (including capital gain) tax on the sale.
What the Trustee Must Do to Alter the Trust's Investments If the Trust Agreement Does Not Address the Issue
The Uniform Prudent Investor Act imposes strict requirements on a trustee regarding the trust's investments:
- The trustee must consider "the purposes, terms, distribution requirements, and other circumstances of the trust." Uniform Prudent Investor Act § 2(a).
- The trustee must further consider not only total return from income and appreciation of capital but also needs for liquidity and regularity of income. Uniform Prudent Investor Act § 2(c)(5) and (7).
- "A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying." Uniform Prudent Investor Act § 3.
- "Within a reasonable time after accepting a trusteeship or receiving trust assets, a trustee shall review the trust assets and make and implement decisions concerning the retention and disposition of assets, in order to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust, and with the requirements of this [Act]." Uniform Prudent Investor Act § 4.
- "If a trust has two or more beneficiaries, the trustee shall act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries." Uniform Prudent Investor Act § 6.
Under the Uniform Prudent Investor Act, adopted in nearly all of the states, the trustee may have a duty to sell some or all the business interests to generate income, unless the trust instrument directs otherwise. Selling assets might be necessary to fairly balance the income beneficiary's interests against the remainder beneficiaries' interests. The trustee might also need to sell the business interests to satisfy the duty to diversify. Therefore, for all practical purposes, the trustee must dispose of substantially all of the business interests in many cases.
The trust agreement can expressly modify this duty to sell. It might include some or all of the following provisions:
- Expressly authorize the trustee to hold the property (for a particular period of time or indefinitely), notwithstanding its failure to produce income and notwithstanding any requirement to diversify that might otherwise apply under the state's version of the Uniform Prudent Investor Act. A mere authorization, however, might be insufficient to prevent an attack on the trustee for failing to diversify when the stock is performing poorly. In re Will of Dumont, 791 N.Y.S.2d 868 (Surr. Ct. 2004), reversed, In re Chase Manhattan Bank, 809 N.Y.S.2d 360 (App. Div. 2006). Although the lower court's decision was reversed, it was an expensive and unpleasant journey for the trustee. Also, a waiver of the duty to diversify should not be used for a marital deduction trust if it would deprive the surviving spouse of the right to all the income. Treas. Reg. §§ 20.2056(b)-5(f)(5) and 20.2056(b)-7(d)(2). Most practitioners routinely include language authorizing the spouse to require that the trustee either make the trust's property productive or convert it to income-producing property within a reasonable time. In fact, Treas. Reg. § 20.2056(b)-5(f)(4) suggests that such a provision be included if the trust's assets "consist substantially of unproductive property."
- Subject to the marital trust concerns described above, if the settlor intends for the trustee to hold the property for a particular period of time or indefinitely, the trust agreement should expressly contain that requirement. The mere authorization to hold might be viewed as requiring the trustee to consider the merits of selling even if it places less pressure to sell. Dumont , 791 N.Y.S.2d at 868. Whereas the requirement to hold should remove any requirement to sell that asset.
- Give family members interested in the business the power to direct the trustee to hold the business interest. Some states completely relieve the trustee of liability for following directions that the trust agreement authorizes; others might implicitly impose a duty to resist instructions if the instructions appear inconsistent with the trustee's duties to various beneficiaries.
- If the trust is not a marital trust, include as beneficiaries those family members working in the business by stating that a purpose of retaining the business interest is to provide jobs for those family members. Even if the trust agreement does not provide for distributions to them, some steps should be taken to recognize their interests; otherwise, the trustee has no duty to protect their interests. Uniform Prudent Investor Act § 5.
How to Minimize Disputes About What the Trustee Should Do
The most effective way to minimize disputes is to have legally binding, unambiguous language in the trust. Being too detailed, however, might unduly tie the trustee's hands when the settlor really wanted to maintain flexibility and rely on the trustee's judgment. Because it is impossible to predict the future, giving the trustee flexibility is generally more desirable.
The settlor should consider discussing with family members the settlor's intent in placing an essentially unproductive asset into a mandatory income trust. An income beneficiary who has lowered expectations might be less demanding, especially if the settlor communicates his intent directly to the beneficiaries during his lifetime.
The settlor might also consider writing a precatory letter to the trustee (and beneficiaries, if appropriate) expressing this intent. Although the trustee cannot rely on this letter to change the trustee's legal obligations, a trustee usually finds comfort to the extent the letter supports the trustee's discretionary actions under the trust agreement.
For example, to create flexibility for a trustee who must make the ultimate decision, the settlor might include in the trust agreement express authority (but not a mandate) for the trustee to retain assets originally contributed or sold to the trust by the settlor. This would include without limitation the particular business interest in question, without any requirement to diversify under the Uniform Prudent Investor Act. In addition, the settlor should write a precatory letter to the trustee.
Extreme caution is recommended in using such provisions with a marital deduction trust or other trust that is required to distribute all its income for tax purposes. An express direction to the trustee to hold non-income-producing assets might jeopardize the marital estate tax deduction for what was intended to be a marital deduction trust.
The amendment to UPIA § 505 will be very helpful to avoid disputes over how the trustee should allocate taxes on taxable income from pass-through entities between income and principal. Indeed, it may also help trustees focus on the bigger issue, that is, whether a mandatory income trust should hold assets that produce little or no after-tax income in the first place. Trusts that hold most or all of their assets in non-income-producing pass-through entities should be drafted with a great deal of care. They should probably have a discretionary rather than a mandatory income distribution requirement. In addition, they should be drafted and funded with careful consideration to the trustee's duties under the Uniform Prudent Investor Act and, if applicable, the requirements for obtaining a marital deduction under the Internal Revenue Code and regulations.