Charles A. Redd discusses strategies geared towards minimizing the aggregate income taxes of a trust and its beneficiaries.
In the aftermath of the American Taxpayer Relief Act of 2012 (ATRA)1 and the Tax Cuts and Jobs Act (TCJA),2 the focus for many estate planners and their clients is more on income tax planning than transfer tax planning. ATRA and TCJA have yielded, among other things, historically high basic exclusion amounts (currently $11.4 million), indexed for inflation, portability, a relatively low estate, gift and generation-skipping transfer tax rate (40 percent), a relatively high top marginal income tax rate on ordinary income (37 percent) and an increased (from 15 percent) top tax rate on capital gains and qualified dividends (20 percent).
The 37 percent rate applies, in the case of single individuals, starting at taxable income above $510,300 and, in the case of a married couple filing jointly, starting at taxable income above $612,350 but, in the case of estates and trusts,3 starting at taxable income above $12,750.4 The 20 percent rate applies, in the case of single individuals, starting at taxable income above $434,550 and, in the case of a married couple filing jointly, starting at taxable income above $488,850 but, in the case of estates and trusts, starting at taxable income above $12,750.5 On top of all that is the 3.8 percent Medicare surtax on “net investment income,” which applies, in the case of single individuals, starting at adjusted gross income (AGI) above $200,000 and, in the case of a married couple, starting at AGI above $250,000 but, in the case of estates and trusts, starting at taxable income above $12,750.6 State income tax, if any, must be considered as well.
Distribution Powers
The governing instrument of a trust can confer an almost infinite variety of distribution powers on a trustee as to income and/or principal. Sometimes, trust provisions mandate distributions of income and confer discretion on the trustee regarding distributions of principal. In some cases, the trustee has discretion as to disposition of both income and principal. Discretionary distribution powers are sometimes limited by an ascertainable standard relating to health, education, maintenance and support of one or more beneficiaries. In other situations, discretionary distribution powers are very broad—almost open-ended—as in cases in which discretion is stated as “sole and absolute.”
Given the current framework of income taxation of individuals and trusts, if given the authority to do so, a trustee may desire to make discretionary distributions so as to carry out as much of the trust’s distributable net income (DNI) to trust beneficiaries as possible.7 Trustees shouldn’t, however, overlook the potential impact of the “kiddie tax” (that is, a tax applied on a portion of a child’s unearned income), which may apply in the case of trust distributions to certain young beneficiaries.8 When the kiddie tax would be imposed, shifting a trust’s taxable income to children would be no more beneficial, from an income tax perspective, than retaining that income in the trust and subjecting such income to the same compressed income tax brackets applicable to trusts that would apply to the children’s unearned income.9
Important Principles
In considering strategies geared towards minimizing the aggregate income taxes of a trust and its beneficiaries, a trustee should, as a threshold matter, focus on a couple of important principles. First, the trustee should recognize that, by increasing a beneficiary’s taxable income by causing a larger portion of a distribution to be taxable, while overall income taxes of the trust and its beneficiaries may be reduced, that beneficiary’s financial situation may be exacerbated by his additional income tax liability. In such a case, the trustee should be prepared to make a larger distribution to that beneficiary sufficient to alleviate his burden. Second, the trustee should be mindful of his fiduciary duties to all trust beneficiaries—current, future and remainder beneficiaries, vested and contingent. By maximizing current trust distributions to reduce income taxes, the trustee may be making distributions that are excessive in relation to the distributee’s needs, the size of the trust and the standards set out in the trust’s governing instrument for the making of distributions. Moreover, by maximizing current trust distributions to reduce income taxes, the trustee may be jeopardizing the interests of other or future or remainder beneficiaries by depleting the trust’s asset base and depriving those other or future or remainder beneficiaries of their legitimate beneficial interests in the trust.
Capital Gains
As a general rule, capital gains realized within a trust aren’t included in a trust’s DNI, except in the year in which the trust terminates, and so aren’t ordinarily considered as paid, credited or required to be distributed to any beneficiary.10 Thus, ordinarily, the trustee pays the tax on its net capital gains. In addition, capital gains realized within a trust are generally allocated to principal.11
There are important exceptions to the general rule. These exceptions provide that capital gains will be included in DNI (and, therefore, be available for distribution to beneficiaries even in a year other than the trust’s termination year) if they’re:
• allocated to income;12
• allocated to principal but treated consistently by the trustee on the trust’s books, records and tax returns as part of a distribution to a beneficiary;
• allocated to principal but actually distributed to the beneficiary; or
• allocated to principal but utilized by the trustee in determining the amount that’s distributed or required to be distributed to the beneficiary.13
None of the exceptions delineated above, however, are available unless the trustee, in implementing a given exception, is acting:
• pursuant to the terms of the governing instrument and applicable local law; or
• pursuant to a reasonable and impartial exercise of discretion in accordance with a power granted to the trustee by applicable local law or by the governing instrument if not prohibited by applicable local law.14
Most well-drafted governing instruments of trusts contain language conferring on the trustee the power to allocate gains, receipts and credits and to apportion losses, disbursements and charges between income and principal whether or not any particular allocation or apportionment is consistent with applicable state law. No one questions the effectiveness of such language, and a trustee is certainly entitled to rely on it,15 but a trustee must always exercise his powers, regardless of the source of such powers, in an impartial manner in the absence of clear countervailing governing instrument language.16
Capital gains will be a part of DNI notwithstanding that they’re allocated to principal if the trustee treats such gains consistently on the trust’s books, records and tax returns as part of a distribution.17 This consistent treatment may be declared by the trustee or evidenced by the trustee’s actions in the trust’s first taxable year or the first time gains are realized and distributions are made.18 In future years, the trustee must treat all discretionary distributions as being made first from any realized capital gains.19 Furthermore, if, when the first time capital gains are realized and distributions are made, the trustee doesn’t treat such distributions as being paid from such gains, he’s foreclosed from doing so thereafter.20
Also, capital gains will be included in DNI if allocated to principal but actually distributed.21 The preamble to the Treasury regulations provides that capital gains allocated to principal will be treated as part of a distribution if the trustee properly allocates capital gains to the distribution (pursuant to a discretionary power under local law or under the governing instrument if not inconsistent with local law), and the allocation is exercised in a reasonable and consistent manner and evidenced on the trust’s books, records and tax returns.22
Examples in the Treasury regulations apply this principle as follows: A trust provides that all income is to be distributed currently to A and that one-half of the principal is to be distributed to A when A reaches age 35 with the balance of the principal to be distributed to A when A reaches age 45. When A reaches age 35, the trustee sells one-half of the principal and distributes the net sale proceeds to A. All of the gains from such sale are included in DNI. If the trustee sold all of the trust assets when A reached age 35 but distributed to A only one-half of the proceeds, then only up to one-half of the capital gains resulting from such sales would be included in DNI.23
In addition, capital gains allocated to principal but used by the trustee in determining the amount that’s distributed or required to be distributed will be included in DNI.24 There’s a subtle but important distinction between this method of including capital gains in DNI and the method whereby the trustee treats capital gains consistently on the trust’s books, records and tax returns as part of a distribution. Here, the trustee first looks at the realized capital gains and uses that data in arriving at the amount to be distributed, while the consistent treatment approach involves a trustee’s always treating capital gains as part of a distribution.25
The Treasury regulations offer an example of how capital gains could be included in DNI when allocated to principal but utilized by the trustee in determining the amount that’s distributed or required to be distributed.26 Unfortunately, the example is unhelpful, and, in fact, bizarre, because it postulates a trustee’s deciding that discretionary distributions will be made only to the extent the trust has realized capital gains. It’s hard to imagine that any responsible trustee would tie the amount of a discretionary distribution to the amount of realized capital gains. Discretionary distribution decisions are based on many factors, including the target beneficiary’s needs and circumstances, the distribution standards set out in the trust instrument, the beneficiary’s other available resources, the size of the trust and the amount of cash available for distributions (which may or may not have any relationship to the amount of realized capital gains).
Among all the methods for distributing capital gains to beneficiaries as part of DNI, allocating such gains to income and then distributing the income is in most cases the easiest and most flexible approach. The sole requirements for success imposed by Treasury Regulations Section 1.643(a)-3(b) are that the trustee possesses the power to allocate the gains to income (and almost all trustees have such power) and that the trustee exercises that power impartially. By contrast with other avenues for shifting capital gains to beneficiaries, there’s no requirement of consistent treatment of such gains as part of a distribution or that the trustee use such gains to determine the amount that’s distributed or required to be distributed.
A trust could be designed to require the trustee to allocate capital gains to income, but, in most cases, that would be a mistake. Such a requirement would often result in grossly distorting the traditional economic relationship between income beneficiaries and remainder beneficiaries and would dramatically reduce otherwise readily available flexibility.
Endnotes
1. The American Taxpayer Relief Act of 2012, P.L. 112-240 (Jan. 2, 2013).
2. An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018 (sometimes referred to as the “Tax Cuts and Jobs Act” or “TCJA”), P.L. 115-97 (Dec. 22, 2017).
3. Throughout this article, the term “trust” refers to nongrantor trusts that have no provisions allowing charitable distributions.
4. Internal Revenue Code Section 1.
5. IRC Section 1(h).
6. IRC Section 1411.
7. IRC Sections 661 and 662.
8. See IRC Section 1(g).
9. See IRC Section 1(j)(4).
10. IRC Section 643(a)(3) and Treasury Regulations Section 1.643(a)-3(a).
11. See Uniform Principal and Income Act (UPIA) Section 404.
12. If, however, income under an applicable state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently, and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to Treas. Regs. Section 1.643(a)-3(b).
13. Treas. Regs. Section 1.643(a)-3(b).
14. Ibid.
15. See UPIA Section 103(a); Uniform Trust Code Section 1006.
16. See UPIA Section 103(b).
17. Treas. Regs. Section 1.643(a)-3(b)(2).
18. See Treas. Regs. Section 1.643(a)-3(e), Example 2.
19. Ibid.
20. See Treas. Regs. Section 1.643(a)-3(e), Example 1.
21. Treas. Regs. Section 1.643(a)-3(b)(3).
22. Alan S. Acker, 852-4th T.M., “Income Taxation of Trusts and Estates”; see also T.D. 9102, 69 Fed. Reg. 12 (Jan. 2, 2004).
23. See Treas. Regs. Section 1.643(a)-3(e), Examples 9 and 10.
24. Treas. Regs. Section 1.643(a)-3(b)(3).
25. See supra note 22.
26. See Treas. Regs. Section 1.643(a)-3(e), Example 5.