As March comes upon us, practitioners should be cognizant of the 65-day rule for trusts and estates under section 663(b) and a similar rule for charitable deductions under section 642. In a world where most individuals and trusts follow calendar-year reporting, generally actions taken after December 31 will be reported in the following year. Trustees and executors, and their related tax advisors, may have found when receiving year-end statements and Forms 1099 in early 2020 for tax year 2019 that the trust or estate had higher income than expected in 2019 and think it is too late to remedy the underestimation.
Luckily, there is some relief in these situations for select irrevocable trusts and estates to treat distributions made in 2020 as deductions on the 2019 tax return. Namely, it is possible that trusts and estates can receive an income tax deduction for distributions made in the first 65 days of the year on the prior year’s tax return. This means that practitioners should be wary of the upcoming March 5 deadline to determine if the trust or estate can benefit from a distribution made within the first 65 days of 2020. There is a similar rule that extends the ability to deduct some distributions made to charities in the calendar year 2020 on the 2019 fiduciary tax return.
On a somewhat related note, fiduciaries may wish to have capital gains be treated as “income” and taxed at the beneficiary level rather than the trust level to take advantage of the tax arbitrage between trust and individual tax rates. This article summarizes these rules in turn.
65-Day Rule: The Law
Section 663(b) allows a trustee or executor to make an election to treat all or any portion of amounts paid to beneficiaries within 65 days of the close of the trust’s or estate’s tax year as though they were made on the last day of the prior tax year. It is important to note that the trustee or executor must actively make an election on a timely filed tax return to enjoy the benefits: they are not automatically extended to a trust or estate. A fiduciary may make the election for only a portion of the distributions made within the 65-day window, but once the election is made it is irrevocable. Also, this rule is applicable for irrevocable trusts that file their own tax returns. Revocable living trusts and other grantor trusts are subject to different tax rules.
The election is not unlimited in amount. The election is limited to the greater of the trust’s accounting income as calculated under section 643(b) for the year in which the election is made, or the trust’s section 643 distributable net income (DNI) for the year reduced by amounts paid, credited, or required to be distributed in such year.
Trust Tier Accounting
Trust accounting uses a tier system to allocate taxable income among beneficiaries. Generally, Tier 1 distributions are made to those who are required to receive the income from the trust or estate, such as a surviving spouse beneficiary in a QTIP trust. Tier 1 distributions are governed by section 662(a)(1). The income must be required to be paid and not merely discretionary. The so-called “Middle Tier” is reserved for amounts paid to or permanently set aside for charities. Tier 2 is all other amounts paid to beneficiaries and is governed by section 662(a)(2). A trust can receive a DNI deduction for the amounts of income paid to beneficiaries which is then taxed via Schedule K-1 to the beneficiaries on their tax returns. In the event that DNI differs from the fiduciary income (such as if deductions are charged against income), the lesser of DNI or the amount actually distributed is to be used for purposes of calculating the deduction on the fiduciary income tax return.
The trust or estate’s DNI is first allocated to Tier 1 beneficiaries until the DNI is exhausted. It is possible to have remaining DNI available when calculating Tier 2 beneficiaries (especially if there are no Tier 1 beneficiaries). In the event DNI remains when distributions are made to Tier 2 beneficiaries, the remaining DNI can be allocated to the Tier 2 beneficiaries ratably before treating the distribution as a tax-free return of principal. The amount that is treated as DNI is taxed on the beneficiary’s income tax return since it is income earned by the trust or estate which then received an offsetting deduction on the fiduciary tax return.
The regulations under section 663 contain several examples for practitioners to follow. The 65-day rule can possibly provide substantial tax savings because trusts are subject to higher income tax brackets much more quickly than individuals. For instance, in 2020 trusts reach the highest tax bracket of 37% federally at taxable income of only $12,950; in contrast, married couples filing jointly are subject to the 37% tax bracket at income levels of $622,051.
For example, if a trust has taxable income of $13,000 in 2019 and then subsequently makes a distribution of $13,000 to a beneficiary within the 65-day window in 2020, the trust could potentially reduce its taxable income to zero for 2019, saving approximately $3,150 in taxes (the 2019 trust tax rate is 37% for income above $12,750). If the trust had, instead, $50,000 of taxable income, the savings grow at a much faster rate because anything above $12,950 is taxed at 37%, saving approximately $16,850 in taxes if a $50,000 distribution is made. Of course, this is assuming the distribution qualifies for a DNI deduction. The $13,000 distribution or $50,000 distribution, respectively, would then be taxed on the beneficiary’s tax return at his or her marginal income tax rate (which is likely to be lower than the trust’s bracket).
There is also the 3.8% net investment income tax to consider as well, which may mean that making a distribution within the 65-day window could save more than 37% federally. This analysis does not even take into account state taxes. In high-tax states, trusts and estates can pay another large sum in state taxes. In California, for example, trusts and estates are subject to a top tax rate of 12.3%, which may increase to 13.3% if the income is over $1,000,000 and is subject to the Mental Health Services Tax.
Treating Capital Gains as Income
Due to this differential between fiduciary income tax rates and individual income tax rates, fiduciaries may wish to have as much of the trust’s earnings during the year as possible be treated as fiduciary income, which may be eligible for a DNI deduction and therefore taxed on the beneficiary’s tax return and not the fiduciary return. The vast majority of irrevocable trusts allow “income” to be paid out at least annually, with “principal” available to the beneficiary under an ascertainable standard. This is particularly so in the common marital trusts like QTIP trusts.
The default rule under section 643(a)(3) is that capital gains are considered trust principal, and therefore, not “income” in the fiduciary accounting sense of the term, unless such capital gains are: (1) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (2) paid, permanently set aside, or to be used for charitable purposes. These rules operate, as a general rule, to also exclude capital losses from DNI. Amounts treated as income are eligible for a DNI deduction and therefore possibly taxed at the beneficiary level instead of the fiduciary level.
Per the Governing Document
The regulations expand on the ways that capital gains can be treated as income instead of principal. The section 643(a) regulations state that one must subtract net capital gains to arrive at DNI unless pursuant to applicable law, the terms of the governing instrument and applicable local law, or pursuant to a reasonable and consistent impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by local law or the governing instrument, if not inconsistent with local law) those gains are (1) allocated to income; (2) allocated to corpus but treated by the fiduciary on the trust books, records and tax returns as part of a distribution to a beneficiary; or (3) allocated to corpus but utilized by the fiduciary in determining the amount which is distributed or required to be distributed to a beneficiary.1 This brings up the first way to take advantage of this tax arbitrage by simply defining capital gains as “income” in the governing trust document. That would allow any capital gains to be eligible to pass out to the beneficiary via Schedule K-1 and be taxed at the individual level since capital gains are then income “pursuant to the governing instrument.”
By Regular Practice
If the trustor or the drafter is not comfortable with labeling capital gains as income with such certainty in the trust document, such that the treatment of capital gains cannot be changed other than by an amendment to the trust, the regulations lay out other ways that capital gains can be included in DNI and therefore treated as paid to the beneficiary so they can be taxed at the individual level.
The Service was kind enough to include regulatory examples illustrating these concepts. It is clear that the trustee must “consistently” treat the gains as part of the distribution to the beneficiary(ies) on the trust books, records, and tax returns.2 It is allowable for the trustee to have the discretion to distribute principal, but the trustee must treat capital gains as part of the distribution each year for the gains to be included in DNI (or in the very least consistently on an asset-by-asset class since “consistently” is not clearly defined). A simple distribution of principal is not enough; the trustee must show that he or she intends to follow a regular, consistent practice of labeling any discretionary distributions of principal as coming first from any gains realized that year from the sale of capital assets before dipping into other trust principal.3 If a trustee fails to treat a discretionary principal distribution as consisting of capital gains realized that year, the trustee may not be able to treat discretionary principal payments as coming from capital gains in all future taxable years.4
First Year of Trust Existence
If a “regular” practice is required, can such treatment still be shown in the first year of the trust’s existence to allow inclusion in DNI that year? The examples in the regulations seem to suggest that is possible. Trustees should be wary though that the actions they take in the first year will obligate them to the same treatment in future years.5
How to Implement
To make it possible to treat capital gains as income, the drafting attorney may wish to insert language in the trust document that allows the trustee, in his or her discretion, to treat capital gains as income. Then, in the first year a trust becomes irrevocable, the attorney should have a discussion with the trustee and the trust’s CPA evaluating all the circumstances to determine whether paying out capital gains as income would be the right course of action for that particular trust based on the facts. Paying out capital gains to the beneficiary may have adverse effects as well, such as if the beneficiary does not have enough liquid cash to pay the taxes, or if the payout will cause the beneficiary to have so much income that Social Security payments become taxable, or if the beneficiary is too young or inexperienced to manage a large distribution on his or her own.
Charitable Deductions: Special Rules
Like the 65-day rule, there is a similar rule available for some irrevocable trusts and estates which make distributions to charities allowing a deduction for actions taken in a subsequent tax year. Under the regulations, the trustee can elect to deduct charitable payments made before the close of the next following taxable year on the returns for the preceding taxable year (i.e. deduct in 2019 amounts paid before the tax year ending in 2020).6 This election must be made not later than the due date of the trust’s income tax return for the year following the year for which election is made (i.e., in the above example, not later than April 15, 2021). Once the election is made, it is irrevocable. It is important that the fiduciary first determine that the payment does in fact qualify for the charitable deduction.
Qualifying for the Charitable Deduction
Charitable deductions for trusts and estates are governed by section 642(c). Estates may claim a charitable deduction for amounts paid to or permanently set aside for charity. Trusts which make a section 645 election will be treated as part of the deceased’s estate and therefore also may take a charitable deduction for amounts paid to or permanently set aside for charity. Trusts which do not or are not eligible to make a section 645 election (and are created after 1969) may claim a charitable income tax deduction only for amounts that are actually paid to the charity. Additionally, the deduction is only available if the donation is made pursuant to the terms of the governing instrument and also paid from gross income.
To determine if the distribution is made from funds “permanently set aside” for charity, one must look to section 642(c)(2) which references section 170(c) or specifies that the money must be “used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, or for the establishment, acquisition, maintenance, or operation of a public cemetery not operated for profit.” If anyone else besides the charity, such as a creditor, can obtain the funds that are set aside, it may be that they are not truly “permanently set aside” for charity.
To determine if the distribution is made “pursuant to the terms of the governing document,” practitioners generally rely on the Old Colony Trust case.7 So long as the executor or trustee has the discretion to make payments to charity, generally the payment will be considered as being made pursuant to the terms of the governing instrument. However, affirmative action should be taken to actually make a payment or set aside the funds. Payments made to charity that are not directed or authorized by the Will or trust will not be deductible. For instance, in the Heywood case,8 an estate was not allowed to take a charitable deduction when paying down charitable pledges promised by the decedent during life because the Will did not authorize payment of just debts and expenses. If the Will had authorized payment of the decedent’s debts and expenses, it is likely that the payments would have qualified for a charitable deduction.
To determine if the distribution is made from “gross income,” subchapter J essentially requires the tracing of the funds used for the donation. Although capital gains are generally considered trust “principal” rather than “income,” capital gains can be used to calculate “gross income” for purposes of determining the charitable deduction in the year earned.
It is important to note as well that trusts that claim a charitable deduction may need to file an informational return pursuant to section 6034 and regulations section 1.642(c)-3(f) and split-interest trusts may need to file Form 5227.
These few small decisions could add up to huge tax savings for trusts and estate. Tax return preparers and attorneys alike should be cognizant of these potential tax savings to properly advise clients where possible. ■