Falling off the fiscal cliff was averted and the federal estate and gift tax exclusion was statutorily set at an indexed five million dollars, but the new income tax consequences for estates and trusts have gone largely unnoticed. The American Taxpayer Relief Act of 2012 (P.L. 112-240), signed by President Obama on January 2, 2013, established new income tax considerations for estates and trusts. Moreover, the Affordable Care Act of 2010 created a 3.8-percent surtax, which is also applicable to estates and trusts. These changes usher in a new era of increased income taxes and surtaxes. ective planning is essential to reduce or eliminate these taxes.
This article guides professionals with respect to important tax saving opportunities necessitated by recent tax legislation. The table below represents the new tax rates and highlights the condensed income tax brackets and imposition of the 3.8-percent Medicare surtax.
Estate and Trust Income Tax Rates (2013)
|Taxable Income||Income Tax Rate||Long-Term Capital Gains Rate|
|$2,450 – $5,700||25%||15%|
|$5,700 – $8,750||28%||15%|
|$8,750 – $11,950||33%||15%|
|Over $11,950||39.6% (+3.8% surtax)||20% (+3.8% surtax)|
It is important to note that once taxable income of an estate or trust exceeds $11,950, not only do the maximum rates apply, but also the 3.8-percent Medicare surtax applies to the lesser of (i) undistributed net investment income or (ii) the adjusted gross income in excess of $11,950. Net investment income includes capital gains, so this will affect nearly all estates and trusts.
The fundamental building block of estate and trust taxation is the concept of distributable net income (DNI). Estates and trusts function as a conduit and distributions are generally taxed at the beneficiary level, rather than at the estate or trust level. To avoid double taxation, the estate or trust is allowed a deduction for the income distributed. DNI plays a role in determining the character of the distribution and the amount of the corresponding deduction.
The distinction between income and principal is central to every estate and trust, in terms of both fiduciary accounting and income taxation. Income has different definitions depending on the context in which it is used. For example, taxable income is different from distributable net income or fiduciary accounting income. Clear definitions within the document are essential in order to avoid conflicts, particularly when there are different income and principal beneficiaries. A common example of such a conflict occurs when the spouse has a lifetime interest and the children have a remainder interest. The fiduciary has a duty to administer the trust impartially, according to its terms, considering both the income and remainder beneficiaries.
The trust’s receipts are allocated to either trust income or trust principal, depending on the source of the receipt. The fiduciary is tasked with making these allocation determinations by referring to the governing instrument and the applicable local law. Treasury Regulations recognize these fundamental sources. Reg. §1.643(b)1 generally defines income as “the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law.” For instance, dividends and interest are generally allocated to income, while proceeds from the sale or exchange of trust assets are generally allocated to principal. Likewise, trust distributions must also be allocated from either income or principal.
Importance of Tax Planning
The following example highlights the importance of tax planning. The terms of the Smith Family Trust require that Sally receive all income at least annually; principal may be distributed in the fiduciary’s discretion. In its first tax year, the Trust received taxable income of $71,950, represented by $11,950 of qualified dividends and $60,000 of long term capital gains. That year, the fiduciary distributed $11,950 of income to Sally, as required by the governing instrument. The fiduciary also distributed $60,000 of principal, pursuant to the fiduciary’s discretion. According to the general rule, the dividends are allocated to trust income and the capital gains are allocated to trust principal.
With regard to the DNI calculation, income is generally included in DNI, while capital gains are generally excluded. The $60,000 of capital gains is taxed to the trust, while the $11,950 of income is taxed to Sally. Accordingly, the trust incurs an income tax of approximately $14,000, including the Medicare surtax, even though principal was distributed to Sally. This tax may be substantially reduced if the capital gains are taxed at the beneficiary level. For example, if the $71,950 distribution represented all of Sally’s income for the tax year, she would incur a tax of approximately $3,855.
To reduce taxation at the trust level, capital gains may be included in DNI and taxed to the beneficiary. Regulations provide that specific requirements must be met in order to pass the tax to the beneficiary. According to Reg. §1.643(a)-3, one of two prerequisites and one of three methods must be utilized to include capital gains in DNI. The prerequisites provide that capital gains may be included in DNI only if inclusion is pursuant to (1) the governing instrument and local law or (2) “a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by local law or by the governing instrument if not prohibited by local law).”
Pursuant to one of the above prerequisites, capital gains may be included in DNI by utilizing one of three methods. These three instances require that capital gains be either (1) allocated to income; (2) allocated to corpus, but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to the beneficiary; or (3) allocated to corpus, but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to the beneficiary. As described in more detail below, the applicability of Method One, requiring an allocation to income, is limited unless broad discretion is granted in the governing instrument. Method Two requires a consistent practice and may not be available if the trust is not in its first year of existence or if the fiduciary wants to avoid a binding obligation. Method Three appears to provide more flexibility. However, the examples do not clearly illustrate the extent of fiduciary discretion to include the capital gains in DNI when inclusion is not required by the governing instrument or part of a consistent practice.
Governing Instrument and Local Law
The emphasis on local law and on the governing instrument necessitates a critical analysis of the applicable state statutes and the governing instrument’s distribution provisions and fiduciary powers. Though the specifics of each state’s statutes differ, most states have adopted some version of the Uniform Principal and Income Act (UPIA). The UPIA provides a uniform law for trust and estate accounting and was revised to coordinate with the Uniform Prudent Investor Act (Prudent Investor Act). Both the UPIA and the Prudent Investor Act impose a fiduciary duty of impartiality and require that the trust be administered fairly and equitably.
Proper investment of trust assets is one aspect of trust administration. Under the Prudent Investor Act, the fiduciary administers a trust by investing with a view towards the total return, rather than a specific income level. The fiduciary is required to consider relevant circumstances and the respective beneficiaries’ needs. The commentary to the UPIA acknowledges that, under such an investment model, the trust’s total return, which includes both income and capital appreciation, may not provide equitably for both income and principal beneficiaries. Accordingly, the UPIA supplies mechanisms by which the fiduciary may reallocate resources to maintain fair and equitable administration. The central mechanism, the power to adjust, is described later in this article.
The fiduciary is obligated to account to beneficiaries with respect to receipts and disbursements. To assist the fiduciary in administering the trust, the UPIA provides four general principles for allocating receipts and disbursements to or between income and principal. First, the fiduciary must administer the trust according to the governing instrument’s terms, even if those terms contradict the UPIA. Second, if the trust grants the fiduciary a discretionary power, the fiduciary may administer the trust by that power, even if the “exercise of the power produces a result different from a result required or permitted” by the UPIA. Third, if the governing instrument is silent or does not grant the fiduciary a discretionary power, the fiduciary must administer the trust according to the UPIA. Finally, if both the UPIA and the governing instrument are silent, the receipt or disbursement must be allocated to principal.
Capital gains under the UPIA are generally allocated to principal, in accordance with traditional convention. In the example of the Smith Family Trust, may the fiduciary include the capital gains in DNI and tax them to Sally? And if so, should the fiduciary do so? This certainly might be the goal if she is in a lower income tax bracket than the trust, but such distribution might be adverse to the remainder beneficiary’s interest. The first step in answering these questions is to look to Reg. §1.643(a)-3, which necessitates an analysis of the governing instrument and local law. The fiduciary must review the settlor’s intent and direction as stated in the governing instrument. The second step is to analyze the fiduciary’s duty of impartiality to determine whether the funds should be distributed or re-invested. Best practice includes documenting the fiduciary’s analysis of the statutory requirements, discretionary powers, and relevant factors.
Method One of Reg. §1.643(a)-3 includes capital gains in DNI to the extent they are allocated to income. Such allocation must be pursuant to either (i) “the terms of the governing instrument and applicable local law” or (ii) a “reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law).” Example 4 of Reg. §1.643(a)-3(e) allows an allocation to income pursuant to the governing instrument, provided that the provision is not be prohibited by local law. This seems to be a reasonable extension of the first prerequisite and may provide additional flexibility and planning opportunities; local law will rarely allocate capital gains to income, other than by recognizing the discretion granted in the governing instrument.
The governing instrument may expressly grant the fiduciary discretion to allocate capital gains to income. Such discretion, exercised reasonably and impartially, does not appear to be prohibited by the UPIA. Clear and concise drafting is important and should expressly allow the inclusion of capital gains in income. A mere general statement that the fiduciary has discretion to allocate receipts and disbursements between income and principal may not be sufficient.
If the governing instrument is silent, the fiduciary must rely only on the general terms of the UPIA (or the applicable local law) to allocate capital gains to income. In the Smith Family Trust, the fiduciary had discretion to distribute principal, but no mention was made of the discretion to allocate capital gains to income or to include capital gains in a distribution. In this regard, the Smith Family Trust is similar to many others and provides only limited guidance for the fiduciary. In such instances, it may be possible to allocate capital gains to income by utilizing the UPIA’s power to adjust under Section 104 or 506. The power to adjust may be considered a discretionary power “granted to the fiduciary by applicable local law.” In exercising this discretion, the fiduciary should consider the income tax considerations and the various economic interests of the income and remainder beneficiaries.
The best practice is to grant the fiduciary ex- press discretion to allocate capital gains to income. The UPIA’s power to adjust is limited and may be exercised only under appropriate facts and circumstances. As such, reliance on the UPIA’s power to adjust is not ideal. The fiduciary may also be limited by the duty of impartiality and the needs of the remainder beneficiary. Though the regulations and the UPIA are related, they are not synchronized and do not cross-reference one another. Thus, it is not definitively stated whether the power to adjust is broad enough to allow an adjustment for DNI purposes under Reg. §1.643(a)-3.
Reg. §1.643(a)-3(b) allows capital gains to be included in DNI if they are “allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary.” The fiduciary must do so pursuant to the governing instrument and applicable local law or “pursuant to a reasonable and impartial exercise of discretion” granted by local law or by the governing instrument if not prohibited by local law. The fiduciary must clearly evidence that capital gains are included in the distribution. Such evidence might include appropriate documentation on the trust’s books and records and inclusion of the capital gains in DNI on the trust’s income tax return.
The term “consistent” and how such consistency is established are not clearly defined in either the regulations or the accompanying examples. The examples refer to a “regular practice” or to “treating” or “deeming” capital gains as distributed in current and future years. A “regular practice” may be established with regard to all capital gains or to a specific asset or class of investment. An open question remains as to whether a consistent practice can be established with regard to pre-existing trusts.
The Smith Family Trust fiduciary might establish a consistent practice and “deem” the $60,000 as distributed from the capital gains. The fiduciary should evidence this treatment on the trust’s books and records and include same in DNI. The capital gains are then taxed to Sally, resulting in significant income tax savings for the Trust.
Method Three includes capital gains in DNI when “allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.” The actual distribution must be pursuant to the governing instrument and local law or pursuant to a reasonable and impartial exercise of discretion granted by local law or by the governing instrument in a provision not prohibited by local law.
When the governing instrument mandates a distribution, such as fifty percent at age forty or after a specified period, and an asset must be sold to satisfy this requirement, the examples allow capital gains to be included in DNI. If no distribution is required, but capital gains are utilized to determine the amount of a distribution, the examples appear to require consistent treatment. The extent of fiduciary discretion when not applied in a consistent manner is not clearly delineated by the regulations or the examples. The regulations seem to provide broad flexibility, provided that the governing instrument has the required administrative provisions.
Alternative Consideration for Tax Savings
An in kind distribution of appreciated property may be a valuable method of reducing a trust’s income taxes. Code Sec. 643(e) provides that the beneficiary reports capital gain on the sale of appreciated property received from a trust or estate. For example, pursuant to the discretionary power to distribute principal, the fiduciary may distribute appreciated stock to Sally. Sally receives a carry-over basis in the stock received and recognizes the capital gain when she sells the stock. In this manner, the fiduciary is able to avoid taxation at the trust level.
In order to achieve this result, it is recommended that the fiduciary not elect to recognize the capital gain at the trust level. In addition, the governing instrument should expressly grant both the power to distribute principal and the power to distribute in kind or in cash, or partly in kind and partly in cash. If the governing instrument does not provide this power, the fiduciary must rely on local law. An in kind distribution may not be available in all situations depending upon the nature of the trust corpus.
Recent legislation highlights the importance of considering the income tax effects in trust and estate planning and administration. As illustrated, there may be significant income tax savings if the fiduciary is able to include the capital gains in DNI. The benefits will depend on the relative tax brackets of the beneficiaries and the trust. The fiduciary is caught between Scylla and Charybdis, and needs the wisdom of Solomon to balance the conflicting interests. A clear statement of the settlor’s intent and discretionary powers should be included in the underlying document and are essential to proper trust administration. As demonstrated by the UPIA and the regulations, fiduciaries must document that all actions are appropriately undertaken. Tax and financial advisors must work together to achieve the desired result and to balance the beneficiaries’ competing objectives. The trust, beneficiaries, and the fiduciary are best served when the appropriate discretion is expressly granted in the governing instrument. In other instances, local law may be available to provide supplemental discretionary powers. The UPIA and the regulations are not well synchronized, but do provide some guidance for fiduciaries. As a result of the recent tax changes, fiduciaries are faced with new challenges and will be required to consider the income tax consequences of their decisions. Proper guidance in the governing instrument is essential in order to meet the requirements of the UPIA and the regulations.