inclusion of capital gains in distributable net income for trusts...

Inclusion of Capital Gains in Distributable Net Income for Trusts and Estates: Allocations for Optimal Tax TreatmentFiduciary Accounting Rules, Treas. Reg. Section 643(a)-3(b) Provisions, State Unitrust Rules, Crummey Powers

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WEDNESDAY, SEPTEMBER 18, 2019

Presenting a live 90-minute webinar with interactive Q&A

Alison F. Egan, Of Counsel, Caplin & Drysdale, Washington, D.C.

Dianne C. Mehany, Member, Caplin & Drysdale, Washington, D.C.

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Alison F. Egan & Dianne C. MehanySeptember 18, 2019

IRC Section 643 and Fiduciary Accounting Income rules

Crummey powers

Non-tax considerations

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IRC Section 643 and Fiduciary Accounting Income rules− Overview

− Including capital gains in DNI under Reg. Section 1.643 (a)-3

− State unitrust rules

− Allocations of capital gains to principal

Crummey powers


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Grantor trusts are treated as disregarded entities; the grantors (or “owners”) pay tax on all trust income− The majority of states have adopted federal income tax

classification of grantor trusts

A nongrantor trust is taxed separately

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Trusts climb the income tax brackets much more quickly

Moving income from a nongrantor trust to a beneficiary therefore may be an attractive tax planning opportunity

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Ordinary Income / ST Cap Gains

Tax Rate for SingleIndividual

Tax Rate for Trust

Up to $2,600 10% 10%

$2,601-$9,300 10% 24%

$9,301-$9,700 10% 35%

$9,701-$12,750 12% 35%

$12,751-$39,475 12% 37%

… 22%-35% 37%

$510,301+ 37% 37%

LT Cap Gains Tax Rate for Single Individual

Tax Rate for Trust

Up to $2,650 0% 0%

$2,650-$12,950 0% 15%

$12,951-$39,375 0% 20%

$39,376-$434,550 15% 20%

$434,551+ 20% 20%

*Excludes 3.8% NII tax which applies above AGI of $12,750 for trusts and above $200,000 for single individuals.

DNI (distributable net income) is a unique income tax concept that provides the accounting methodology by which income and gains are carried out to beneficiaries

It represents the maximum deduction a trust can take for distributions to beneficiaries and the maximum income a beneficiary can pick up on her tax return

DNI is essentially fiduciary accounting income distributable to beneficiaries, net of trust expenses and deductions

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Fiduciary Accounting Income (Section 643(b)) is the amount of income of a trust under the terms of the governing instrument and applicable local law

Several developments in the law have modified the traditional income/principal divide− Adjustments between principal and income

− Unitrusts

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DNI is−Taxable income

• Before the distribution deduction and the personal exemption; and

• Without accounting for the exclusion for qualified small business stock under Section 1202

−Plus tax exempt income

−Excluding capital gains and losses, absent special circumstances

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Legislative history explains the concept of DNI as giving statutory expression to the classification of trusts as mere conduits through which income flows to the beneficiaries, except where income is accumulated by the trust for future distribution.− Generally capital gains are taxed at the trust level, because

they are added to the trust principal and therefore not born by the beneficiary.

− This distinguishes a trust from a corporate structure that may be subject to double taxation, with the shareholder paying a second tax on income already taxed at the corporate level.

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Does an exception to the definition of DNI exist to include capital gains separate and apart from instances provided by Regulations?− Theory that distributions from flow-through entities are not classified

as capital gains; therefore, trustee must properly classify at trust level

In Crisp v. United States, 34 Fed. Cl. 112 (1995), capital gains earned by a limited partnership were includable in DNI− Limited application

• In Crisp, trustee had broad authority to distribute “net earnings” but was precluded from distributing corpus

• Court almost backed into classification of capital gains as net earnings to justify action of trustees

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The Preamble to the final 1.643(b) Regulations laid out what they were attempting to achieve− “Capital gains allocated to corpus are included in DNI if they are either paid,

credited, or required to be distributed, to a beneficiary during the year.− “In certain situations it is easily ascertained whether capital gains are paid to a

beneficiary.• “For example, if the trust instrument provides that the proceeds from the sale of a

certain asset are to be paid to a beneficiary upon sale, then any capital gain recognized upon the sale of that asset is paid to the beneficiary and is includible in DNI. However, the circumstances in which recognized capital gain determines the amount to be distributed to a beneficiary during the year are relatively rare.

• “More frequently, the trustee is authorized by the trust instrument to make discretionary distributions of principal or, by the recently-enacted state statutes, to pay the income beneficiary a unitrust amount.

• “In these circumstances, the amount of realized capital gain during the year does not affect the amount distributed to a beneficiary, and because money is fungible, it is difficult to ascertain whether capital gains are actually paid to the beneficiary.

• “The . . . regulations attempt to clarify the circumstances in which capital gains are treated as distributed to a beneficiary and therefore are includable in DNI.”

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Gains from the sale or exchange of capital assets are treated as paid to a beneficiary and included in DNI to the extent (i) there is the authority to allocate those gains in one of three ways, pursuant to− The terms of the governing instrument and applicable local

law, or− A reasonable and impartial exercise of discretion by the

fiduciary in accordance with a power that is• Granted to the fiduciary by applicable local law or

• Granted to the fiduciary by the governing instrument and not prohibited by applicable local law

And (ii) such an authorized allocation actually arises

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Three prescribed allocation methods− Allocated to income [fiduciary accounting income]• However, if income under the 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 DNI determined without regard to the 1.643(a)-3(b) Regulations;

− Allocated to corpus and• Treated consistently by the fiduciary on the trust’s books, records and

tax returns as part of a distribution to a beneficiary; or• 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

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States that adopted unitrust statutes varied in their approach with respect to whether they provided for how the unitrust payment should be allocated− 20 Pennsylvania C.S. Section 8105(f)(2) was very directive : “Unless

otherwise provided by the governing instrument, the unitrust distribution shall be considered to have been paid from the following sources in order of priority:• (i) net income determined as if the trust were not a unitrust;• (ii) ordinary income for Federal income tax purposes that is not

allocable to net income under subparagraph (i);• (iii) net realized short-term capital gains for Federal income tax

purposes;• (iv) net realized long-term capital gains for Federal income tax

purposes; and• (v) the principal of the trust estate.”

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− 12 Delaware Code 61-106(h) provided flexibility in its direction : “Following the conversion of an income trust to a total return unitrust, the trustee:

• (1) Shall consider the unitrust amount as paid from net accounting income determined as if the trust were not a unitrust;

• (2) Shall then consider the unitrust amount as paid from ordinary income not allocable to net accounting income;

• (3) After calculating the trust’s capital gain net income described in I.R.C. §1222(9), may consider the unitrust amount as paid from net short-term capital gain described in I.R.C. § 1222(5) and then from net long-term capital gain described in I.R.C. § 1222(7); and

• (4) Shall then consider the unitrust amount as coming from the principal of the trust.”

− New York EPTL Section 11-2.4, by contrast, is silent on the allocation of the optional unitrust amount

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− The Uniform Fiduciary Income and Principal Act (UFIPA), formerly known as the Uniform Principal and Income Act, is also silent on the allocation of the optional unitrust amount

− It contemplates that the fiduciary will adopt a unitrust policy, which could include ordering rules outlined by the fiduciary

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Recall: Gains from the sale or exchange of capital assets are treated as paid to a beneficiary and included in DNI to the extent (i) there is the authority to allocate those gains in one of three ways, pursuant to− The terms of the governing instrument and applicable local law, or

− A reasonable and impartial exercise of discretion by the fiduciary in accordance with a power that is

• Granted to the fiduciary by applicable local law or



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If the statute is like Pennsylvania’s with a clear ordering provision, then if the trust directs that state law applies in determining fiduciary accounting income, that is enough to have DNI included in capital gains

See Example 11− Statute provides trustee may elect to pay 4% of FMV of trust assets in

satisfaction of beneficiary’s right to income− Also orders unitrust amount: (1) ordinary income, tax-exempt income,

(2) short-term capital gain, (3) long-term capital gain, (4) principal− Trust agreement provides income is defined under state statute− Trustee makes election and assets are valued at $500,000− Trust realizes $5,000 dividend income, $80,000 long-term gain and

distributes $20,000− Beneficiary receives $15,000 long-term gain

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If the statute is like New York’s with no ordering provision, then consistency is critical

See Example 12− No ordering rules in statute or governing instrument; left to discretion of trustee− Statute provides trustee may elect to pay 4% of FMV of trust assets in

satisfaction of beneficiary’s right to income− Trustee intends to follow regular practice of treating principal, other than capital

gains, as distributed to extent unitrust exceeds ordinary and tax-exempt income− Trustee makes unitrust election and assets are valued at $500,000− Trust realizes $5,000 dividend income, $80,000 long-term gain and distributes

$20,000− Trustee includes all $80,000 of long-term gain on trust’s Federal income tax

return− This is deemed reasonable, but in future years, trustee must continue not to

allocate realized capital gains to income

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See Example 13− No ordering rules in statute or governing instrument; left to

discretion of trustee− Statute provides trustee may elect to pay 4% of FMV of trust assets in

satisfaction of beneficiary’s right to income− Trustee intends to follow regular practice of treating net capital gains

as distributed to extent unitrust exceeds ordinary and tax-exempt income

− Trustee makes unitrust election and assets are valued at $500,000− Trust realizes $5,000 dividend income, $80,000 long-term gain and

distributes $20,000− Trustee includes $15,000 of long-term gain as DNI on trust’s Federal

income tax return− This is deemed reasonable, but in future years, trustee must continue

to realize capital gains in that way

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What if the trust instrument did not provide the trustee with discretion to allocate capital gains to income and the trust was being administered as a unitrust?− Consider whether it provides for an ordering regime

− Review what authorities are provided to the trustee

− Might consider decanting

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The original UFIPA (when it was UPIA) did not include a provision with ordering rules in the event of an adjustment

Therefore, in most cases the trust instrument will need to authorize the trustee to allocate capital gains to income / DNI

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Trust provides that capital gains are allocated to income, and state law does not prohibit this

See Example 4− All income is to paid to A for life per trust instrument

− Trustee may invade principal for A’s benefit

− Trust has $5,000 of dividend income and $10,000 of capital gain from securities

− Trustee distributes $5,000 of income and $12,000 of principal to A

− $10,000 of capital gains is included in DNI

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Example 1− All income is to paid to A for life per trust instrument− Trustee may invade principal for A’s benefit− Trust has $5,000 of dividend income and $10,000 of capital

gain from securities− Trustee allocates $10,000 to principal− Trustee distributes $5,000 of income and $12,000 of

principal to A, but does not exercise discretion to deem the distributions of principal as from capital gains realized

− $10,000 in capital gains are taxed to the trust− In future years, may not treat principal distributions as made

from realized capital gains

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Example 2− All income is to paid to A for life per trust instrument− Trustee may invade principal for A’s benefit− Trust has $5,000 of dividend income and $10,000 of capital gain

from securities− Trustee allocates $10,000 to principal− Trustee distributes $5,000 of income and $12,000 of principal to

A, and does exercise discretion to deem the distributions of principal as from capital gains realized by including it in DNI on trust’s Federal income tax return

− $10,000 in capital gains are taxed to the trust− Trustee must treat discretionary distributions in future as coming

first from realized capital gains

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Example 3− All income is to paid to A for life per trust instrument

− Trustee may invade principal for A’s benefit

− Trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid from capital gain realized during the year from the sale of certain specific assets or a particular class of investments

− This is a reasonable exercise of Trustee’s discretion

Query what a particular class of investments means –may want to consider seeking PLR

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The examples in the Regulations seem to suggest two possible ways to utilize this allocation method− Actually distribute capital gains

− Use capital gains to determine amount to be distributed

In reality, these can be effectively the same since money is fungible− If the trust holds stock and cash, sells the stock, and the

trustee distributes from what is now a larger pool of cash, it is a distinction without a difference

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Actual Distributions− Can arise from complete or “partial” terminations

See Examples 7 and 9− Trust provides that all income is to be paid to A− Example 7• When A reaches 35, trust terminates and principal distributed to A• Because all assets will be distributed, all capital gains realized in year of

termination are includible in DNI

− Example 9• Trustee is to distribute ½ principal to A at age 35, balance at age 45• Trust owns stock worth $1,000,000 with basis of $300,000• When A reaches 35, Trustee sells one-half the stock and distributes $500,000 to A

[described as sales proceeds]• All sales proceeds and all capital gain attributable to the sales proceeds are

distributed to A and included in DNI

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Actual Distributions− Can also arise from keying discretionary distributions to the amount of

realized capital gains or sales proceeds− Under Reg. Section 1.643(a)-3(d), in this situation, capital gains are not to be

netted against capital losses

See Examples 5 and 6− Example 5• Trust requires all income to A for life, and trustee has discretionary powers to

invade principal and deem distributions to be from capital gains• Trust has $5,000 of dividend income and $10,000 of capital gain from sale of

securities• Trustee decides to limit discretionary distribution of principal to realized capital

gains of $10,000 • Because amount of realized capital gain determines distribution, capital gain is

included in DNI

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− Example 6

• Trust holds Blackacre and other property

• Under terms of trust, Trustee directed to hold B for 10 years and then sell it, distributing proceeds to A

• Because amount of sales proceeds dictates the distribution, capital gain on the sale is included in DNI

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Crummey powers


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If the grantor is not treated as the owner of the trust,− To the extent that a beneficiary has a withdrawal right over trust

assets, either through a Crummey power or through a 5 and 5 power, the beneficiary is treated as the owner under Section 678(a)(1) of a portion of the trust, including income and capital gains thereon

− There is a debate about whether the beneficiary remains the owner under Section 678(a)(2) upon a lapse of a withdrawal right• Section 678(a)(2) “A person other than the grantor shall be treated as the

owner of any portion of a trust with respect to which such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles [of the grantor trust rules], subject a grantor to treatment as the owner”

• Query whether failure to withdraw is equivalent to releasing or otherwise modifying a power

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Crummey powers


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Relative needs of beneficiaries

Settlor’s intent

Creditor protection

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______________________________________________

DisclaimerThis communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome.

Attorney Advertising It is possible that under the laws, rules, or regulations of certain jurisdictions, this may be construed as an advertisement or solicitation.

© 2019 Caplin & Drysdale, CharteredAll Rights Reserved.

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Alison F. EganOf CounselCaplin & Drysdale, [email protected]

Dianne C. MehanyMemberCaplin & Drysdale, [email protected]

______________________________________________

DisclaimerThis communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome.

Attorney Advertising It is possible that under the laws, rules, or regulations of certain jurisdictions, this may be construed as an advertisement or solicitation.

© 2019 Caplin & Drysdale, CharteredAll Rights Reserved.

47

Alison F. EganOf CounselCaplin & Drysdale, [email protected]

Dianne C. MehanyMemberCaplin & Drysdale, [email protected]

Is this right for this trust?− Think through state taxation of trust vs beneficiaries− Think about possibility to limit state taxation− Be wary of “locking in” an approach required by consistency

Consider other options− Harvest losses− Use of opportunity zone investments to delay gain

realization− Change in governing law (if want to take account of unitrust

statutes)

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