How Prop. Regs. on the Definition of Income Affect Total Return Trusts
Before using total
return trusts, practitioners should carefully analyze the tax
consequences, and should consider the impact of new Proposed
Regulations that revise the definition of trust income.
LAURA HOWELL-SMITH,
J.D., LL.M. TAX
LAURA HOWELL-SMITH
is a Senior Manager in the National Tax Office of Deloitte &
Touche, LLP, in Washington, D.C. The author would like to thank
Larry Rabun, Partner, and Laura Peebles, Director, of Deloitte
& Touche, LLP, for reviewing this article.
The modern portfolio
theory of investing, the 1997 Revised Uniform Principal and
Income Act (UPIA),
[1]
and the Prudent Investor Act
[2]
have together revolutionized trust practice and caused
practitioners to examine the use of the estate planning tool
of total return trusts.
[3]
This new manner of investing trust assets for total return
(i.e., income plus gain) replaces the traditional income and
principal trust that was typically invested to produce income.
While the concept of total return trusts may have a dramatic
impact on future trust drafting and investing, practitioners
should be alert to certain tax consequences of total return
trusts before adding this technique to their estate planning
toolkit.
There
are many variations
[4]
but, basically, a total return trust is a trust in which
the current beneficiary is annually entitled to a percentage
of the net fair market value (FMV) of the trust assets (this
value is calculated on the same date each calendar year). A
total return trust generally allows the trustee to distribute
significantly more than the trust accounting income and to invest
a greater amount of the trust fund in growth-generating assets.
[5]
Many states either have amended or are considering amending
their state law definition of “trust income” to be a unitrust
amount.
Overview of the Prop. Regs.
On 2/14/01, the
IRS issued Proposed Regulations
[6]
that revise the definition of income under Section 643(b)
to take into account changes in the definition of trust accounting
income under state laws. A Treasury Department official has
publicly said that this Regulation project considers how total
return trusts and the equitable adjustment provision of the
UPIA
[7]
will affect federal tax provisions. The Proposed Regulations
also clarify the situations in which capital gains are included
in distributable net income (DNI) under Section 643(a)(3).
Moreover, the Proposed Regulations make conforming amendments
affecting ordinary trusts, pooled income funds, charitable remainder
trusts (CRTs), marital deduction trusts, and trusts that are
exempt from generation-skipping transfer (GST) taxes.
Definition of income. Reg. 1.643(b)-1 provides that, for purposes
of subparts A through D, part I, Subchapter J, Chapter 1 of
the Code, the term “income,” when not preceded by the words
“taxable,” “distributable net,” “undistributed net,” or “gross,”
means 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. Trust provisions that depart fundamentally
from concepts of local law in the determination of what constitutes
income are not recognized for this purpose.
To take into
account certain state statutory changes to the concepts of income
and principal, Prop. Reg. 1.643(b)-1 provides that “income,”
when not preceded by the words “taxable,” “distributable net,”
“undistributed net,” or “gross,” means 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.
Trust provisions that depart fundamentally from traditional
principles of income and principal (that is, allocating ordinary
income to income and capital gains to principal) will generally
not be recognized.
Nevertheless,
amounts allocated between income and principal pursuant to applicable
local law will be respected if local law provides for a reasonable
apportionment between the income and remainder beneficiaries
of the total return of the trust for the year, including ordinary
income, capital gains, and appreciation. For example, a state
law that provides for the income beneficiary to receive each
year a unitrust amount of between 3% and 5% of the annual FMV
of the trust assets is a reasonable apportionment of the total
return of the trust.
Prop. Reg.
1.643(b)-1 makes clear that a state law that permits the trustee
to make equitable adjustments between income and principal to
fulfill the trustee’s duty of impartiality between the income
and remainder beneficiaries is generally a reasonable apportionment
of the total return of the trust. These equitable adjustments
are permitted when the trustee invests and manages the trust
assets under the state’s prudent investor standard, the trust
describes the amount that shall or must be distributed to a
beneficiary by referring to the trust’s income, and the trustee
after applying the state statutory rules regarding allocation
of income and principal is unable to administer the trust impartially.
In addition, an allocation of capital gains to income will be
respected if the allocation is made either pursuant to the terms
of the governing instrument and local law, or pursuant to a
reasonable and consistent exercise of a discretionary power
granted to the fiduciary by local law or the governing instrument.
Capital gains. A total return trust allows the trustee to invest
in growth-producing assets as opposed to income-producing assets.
To pay the unitrust obligation, a trustee may have to either
sell a portion of the trust assets or distribute a portion of
the trust assets in satisfaction of the unitrust amount.
[8]
Such action will have capital gain consequences.
The Proposed
Regs. acknowledge that capital gains earned by a trust may be
distributed to a current beneficiary pursuant to the terms of
a trust or applicable local law that provides either for a unitrust
amount to be paid to the current beneficiary or for the trustee
to equitably adjust between income and principal to achieve
a total return on trust investing. As a result, the Proposed
Regulations provide that under certain circumstances capital
gains will be included in DNI.
Prop. Reg.
1.643(a)-3(b) states that capital gains are included in DNI
to the extent they are, pursuant to the terms of the governing
instrument and applicable local law, or pursuant to a reasonable
and consistent 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 inconsistent with local law):
1.
Allocated to income;
2.
Allocated to corpus but treated by the fiduciary on the trust’s
books, records, and tax returns as part of a distribution to
a beneficiary; or
3.
Allocated to corpus but used by the fiduciary in determining
the amount that is distributed or required to be distributed
to a beneficiary.
The
examples illustrating Prop. Reg. 1.643(a)-3 make clear that
if a fiduciary intends to follow a regular practice of (1) treating
discretionary distributions as being paid first from any net
capital gains realized, or (2) treating principal as distributed
to the beneficiary to the extent of any unitrust amount that
exceeds trust ordinary income, or (3) treating net capital gains
as distributed to the extent any unitrust amount exceeds the
trust’s ordinary income, the trustee must consistently treat
the item in such manner in the future.
To
explain Prop. Reg. 1.643(a)-3, the Preamble to the Proposed
Regulations indicates that capital gains are included in DNI
in the following four possible circumstances:
1.
Any capital gain that is included in the Section 643(b) definition
of income is included in DNI.
2.
Any capital gain that is used to determine the amount or timing
of a distribution to a beneficiary is included in DNI.
3.
Capital gains are included in DNI if the fiduciary, pursuant
to a discretionary power granted by local law or by the governing
instrument (if not inconsistent with local law), treats capital
gains as distributed to a beneficiary, provided the power is
exercised in a reasonable and consistent manner.
4.
If, under the terms of the governing instrument or applicable
local law, realized capital gains are treated as income to the
extent the unitrust amount or the equitable adjustment amount
exceeds ordinary income, capital gains so treated are included
in DNI.
Impact of the Proposed Regs.
Ordinary trusts. Amending Reg. 1.643(b)-1 (regarding the definition
of income) may change the character of simple trusts under Section
651 and the accompanying Regulations. Reg. 1.651(a)-1 defines
a simple trust as a trust the governing instrument of which
(1) requires that the trust distribute all its income currently
for the taxable year, and (2) does not provide that any amounts
may be paid, permanently set aside, or used in the taxable year
for the charitable and other purposes specified in Section 642(c).
With
respect to the definition of income, Reg. 1.651(a)-2(a) refers
taxpayers to Section 643(b) and Reg. 1.643(b)-1. It follows
that a change in the definition of income under Section 643(b)
to a unitrust amount that allows a trustee to distribute an
amount that may exceed trust accounting income would cause a
trust not to be a simple trust; and therefore to be ineligible
for the $300 exemption under Section 642(b).
Prop.
Reg. 1.651(a)-2 states that if a trust distributes property
in kind as part of its requirement to distribute currently all
the income as defined under Section 643(b) and the applicable
Regulations, the trust will be treated as having sold the property
for its FMV on the date of distribution. This Proposed Regulation
further states that if no amount in excess of the amount of
income as defined under Section 643(b) and the applicable Regulations
is distributed by the trust during the year, the trust will
qualify for treatment under Section 651, even though property
in kind was distributed as part of a distribution of all the
income. The preceding sentence appears to indicate that a trust
will be a simple trust if it does not distribute an amount in
excess of trust accounting income.
Prop. Reg.
1.661(a)-2(f) provides that gain or loss is realized by a trust
or estate (or the other beneficiaries) by reason of a distribution
of property in kind if the distribution is in satisfaction of
a right to receive a distribution (1) of a specific dollar amount,
(2) of specific property other than that distributed, or (3)
of income as defined under Section 643(b) and the accompanying
Regulations, if income is required to be distributed currently.
In addition, gain or loss is realized if the trustee or executor
makes an election to recognize gain or loss under Section 643(e).
Pooled income funds. A pooled income fund is a split-interest trust.
A donor of a pooled income fund transfers money or other property
to a separate fund that a charitable organization invests with
other contributed funds. The donor or some other person designated
by the donor receives an income interest for life or for a term
of years from the donor’s separate fund, and the charitable
organization receives the remainder interest. Reg. 1.642(c)-5(a)(5)(i)
specifies that the income that a pooled income fund pays to
a noncharitable beneficiary is income as defined under Section
643(b) and the Regulations thereto.
The
Preamble to the Proposed Regulations notes that a pooled income
fund is subject to taxation under Section 641, relating to the
income taxation of estates and trusts. A pooled income fund
is entitled to a distribution deduction under Section 661 for
income distributed to the noncharitable beneficiaries. In addition,
the fund receives a charitable deduction under Section 642(c)
for any net long-term capital gain that is permanently set aside
for charitable purposes under the terms of the governing instrument.
A pooled income fund is taxed on any net short-term capital
gain that is not required to be distributed to the income beneficiaries
pursuant to the governing instrument and local law.
Under
traditional principles of income and principal, ordinary income
would be paid to the income beneficiaries. Any long-term capital
gain would be allocated to principal and held for the ultimate
benefit of the charitable remainder beneficiaries, and therefore
would qualify for the charitable deduction under Section 642(c)(3).
The
Preamble to the Proposed Regulations provides that if state
law or the governing instrument defines the income of a pooled
income fund as a unitrust amount, or allows the trustee to make
adjustments between principal and income, the charitable deduction
under Section 642(c)(3) permitted to pooled income funds for
net long-term capital gain will be jeopardized if long-term
capital gain is not permanently set aside for charitable purposes.
To
address the problem arising from a pooled income fund that pays
an income beneficiary a unitrust amount in satisfaction of the
right to income that may include net long-term capital gain,
the Proposed Regulations amend Reg. 1.642(c)-2(c) to provide
that no amount of net long-term capital gain will be considered
permanently set aside for charitable purposes if it is possible,
under the terms of the fund’s governing instrument or local
law, that the income beneficiaries’ right to income may--at
any time--be satisfied by the payment of either an amount equal
to a fixed percentage of the annual FMV of the trust property
or any amount based on unrealized appreciation in the value
of the trust property.
Charitable remainder trusts. There are several types of charitable
remainder unitrusts (CRUTs), two of which are income type of
trusts: the net income unitrust (NICRUT) and the net income
with make-up charitable remainder unitrust (NIMCRUT). A NICRUT
limits the unitrust amount to the lesser of a fixed percentage
amount or the trust’s net income for the year. The NIMCRUT
similarly limits the unitrust amount to the lesser of the fixed
percentage amount or the trust’s net income for the year, but
any shortfall in the amount of income compared with the fixed
percentage amount in any year can be paid in a future year when
the trust income exceeds the fixed percentage amount.
Practitioners
may believe that applying the total return trust concept to
NICRUTs and NIMCRUTs would allow the noncharitable beneficiary
to receive a substantial amount without investing the trust
assets in such a way as to deplete the corpus.
[9]
However, Reg. 1.664-3(a)(1)(i)(b)(4) prohibits the allocation
of precontribution capital gain to income of NICRUTs and NIMCRUTs.
Thus, the benefit that a total return trust NICRUT or NIMCRUT
could provide by permitting the trust to distribute gain to
the current beneficiary would be limited because the trustee
could distribute only post-contribution gain to the current
beneficiary.
Moreover,
none of the benefits associated with using a total return NICRUT
are possible if Prop. Reg. 1.664-3(a)(1)(i)(b)(3) is finalized
as proposed because the Proposed Regulation prohibits CRTs from
defining income as a unitrust amount. The Proposed Regulations
provide that trust income for purposes of the CRUT rules means
income as defined under Section 643(b) and the applicable Regulations.
However, trust income may not be determined by reference to
a fixed percentage of the annual FMV of the trust property.
If
applicable state law provides that income is a unitrust amount,
the trust’s governing instrument must contain its own definition
of trust income. In addition, capital gains attributable to
appreciation in the value of a trust asset after the date it
was contributed to the trust or purchased by the trust may be
allocated to income pursuant to local law and the governing
instrument but not pursuant to a discretionary power granted
to the trustee.
Effect on other trusts
Marital deduction trusts. Sections 2056(b)(5) and 2523(e) respectively
set forth the estate and gift tax marital deduction rules for
a life estate with a general power of appointment trust. Sections
2056(b)(7) and 2523(f) respectively provide estate and gift
tax marital deduction rules for QTIP trusts. In order for these
trusts to qualify for the marital deduction, the trust must
require that the surviving spouse be paid all the trust income
at least annually.
Regs.
20.2056(b)-5(f) and 25.2523(e)-1(f) contain rules for determining
whether the spouse is entitled to all the income from either
a life estate with a general power of appointment trust or a
QTIP trust. These rules provide that, if an interest is transferred
in trust, the surviving spouse is entitled for life to all the
income from the entire interest or a specific portion of the
entire interest if the effect of the trust is to give the surviving
spouse substantially that degree of beneficial enjoyment of
the trust property during the surviving spouse’s life which
the principles of trust law accord a person who is unqualifiedly
designated as the life beneficiary of a trust.
To take into
account state law changes to the definition of income with respect
to marital deduction trusts, the Proposed Regulations provide
that a spouse’s interest satisfies the income standard of Regs.
20.2056(b)-5(f) and 25.2523(e)-1(f) if the spouse is entitled
to income as defined under a state statute that provides for
a reasonable apportionment between the income and remainder
beneficiaries of the total return of the trust and that meets
the requirements of Reg. 1.643(b)-1.
With respect
to the QTIP provisions, the Proposed Regulations
[10]
make clear that a power under state law that permits the
trustee to adjust between income and principal to fulfill the
trustee’s duty of impartiality between the income and remainder
beneficiaries that meets the requirements of Reg. 1.643(b)-1
will not be considered a power to appoint trust property to
a person other than the surviving spouse.
The
marital deduction provisions of the Proposed Regulations are
applicable with respect to trusts for taxable years that begin
on or after the date that final Regulations are published in
the Federal Register.
Qualified
domestic trusts. Generally, the estate tax marital deduction
is disallowed for property passing to a non-U.S. citizen spouse
unless the property is in a qualified domestic trust (QDOT).
Moreover, Section 2056A(b) imposes an estate tax on any distributions
from the QDOT in excess of trust income during the life of the
surviving non-U.S. citizen spouse. Reg. 20.2056A-5(c)(2) defines
income as Section 643(b) income, but income specifically does
not include capital gains. Hence, under Reg. 20.2056A-5(c)(2),
if income is defined as a unitrust amount, an estate tax will
be imposed on all amounts distributed in satisfaction of the
unitrust payment in excess of trust accounting income.
The
Proposed Regulations address problems that may arise if a QDOT
defines income as a unitrust amount or allows a trustee to adjust
between income and principal. Prop. Reg. 20.2056A-5(c)(2) provides
that distributions made to the surviving spouse as the income
beneficiary of the QDOT in conformance with state law that defines
income as a unitrust amount, or permits the trustee to adjust
between principal and income to fulfill the trustee’s duty of
impartiality between income and principal beneficiaries, will
be considered distributions of trust income, if the state statute
provides for a reasonable apportionment between the income and
remainder beneficiaries of the total return of the trust and
meets the requirements of Reg. 1.643(b)-1.
GST tax trusts. Generally, the GST tax provisions impose a tax on
the transfer of property to a donee who is at least two generations
below the generation of the donor. Congress enacted the GST
tax provisions as part of TRA ’86, and imposed the tax on all
generation-skipping transfers made after 10/22/86.
[11]
Section 1433(b)(2) of TRA ’86 exempts from GST tax transfers
from certain trusts. The GST tax does not apply to any transfer
from a trust that was irrevocable on 9/25/85, but only to the
extent the transfer is not made out of corpus added to the trust
after 9/25/85. The GST tax also does not apply to any generation-skipping
transfer under a will or revocable trust executed before 10/22/86,
if the decedent died before 1/1/87.
The
benefits associated with total return trusts are attractive
and may be used in newly created GST trusts. However, practitioners
may want to use a total return concept with a grandfathered
GST-tax-exempt trust by converting an income interest GST-tax-exempt
trust to a total return GST trust. An issue exists as to whether
the conversion would cause an exempt trust to be subject to
GST tax and otherwise lose its grandfathered status.
Practitioners
who commented on the Proposed Regulations governing grandfathered
GST-tax-exempt trusts
[12]
raised this issue. The IRS indirectly responded to this
comment by adding an example to the final Regulations on grandfathered
GST-tax-exempt trusts.
[13]
Example 9 of Reg. 26.2601-1(b)(4)(i)(E) illustrates the
consequences of a judicial modification of a grandfathered GST-tax-exempt
trust to allow the trustee to allocate capital gain to income.
The example concludes that the modification does not subject
the trust to the GST tax provisions.
The
Proposed Regulations on the definition of trust income set forth
a definitive rule as to whether a GST-tax-exempt trust will
lose its grandfathered status if the trust is modified to define
income as a unitrust amount, or to permit the trustee to adjust
between income and principal. Prop. Reg. 26.2601-1(b)(4)(i)(D)(2)
provides that administration of a trust in conformance with
applicable state law that defines income as a unitrust amount,
or permits the trustee to adjust between principal and income
to fulfill the trustee’s duty of impartiality between income
and principal beneficiaries, will not be considered to shift
a beneficial interest in the trust, if the state statute provides
for a reasonable apportionment between the income and remainder
beneficiaries of the total return of the trust and meets the
requirements of Reg. 1.643(b)-1.
Accordingly,
the Proposed Regulations allow a GST-tax-exempt trust to maintain
its grandfathered status upon a modification of the definition
of income only if state law defines income as a unitrust amount,
or permits the trustee to adjust between principal and income
to fulfill the trustee’s duty of impartiality between income
and principal beneficiaries.
Other tax provisions not addressed by the Prop. Regs.
The Proposed Regulations
do not address a number of other tax provisions that are affected
by the definition of income under Section 643(b) and the accompanying
Regulations. Practitioners should nonetheless be aware of the
impact of these other tax provisions when using a total return
trust. These other provisions pertain to limitations on the
charitable deduction, private foundations, information reporting
rules, Subchapter S trusts, and foreign trusts.
Charitable deduction limitations. The limitation rules relating to
the charitable contribution deduction of trusts will be affected
by an amendment to Reg. 1.643(b)-1. Reg. 1.681(a)-1 limits
the otherwise unlimited charitable contribution deduction allowable
to a trust under Section 642(c) under the following circumstances:
1.
To the extent that the deduction is allocable to unrelated business
income;
2.
For taxable years beginning before 1970, if the trust has engaged
in a prohibited transaction; or
3.
For taxable years beginning before 1970, if income is accumulated
for a charitable purpose, and the accumulation is (a) unreasonable,
(b) substantially diverted for a noncharitable purpose, or (c)
invested against the interests of the charitable beneficiaries.
If
(1) or (3) above is applicable, the deduction is limited to
income actually paid out for charitable purposes, and is not
allowed for income only set aside or to be used for those purposes.
Income for this purpose is defined as income under Section 643(b)
and Reg. 1.643(b)-1.
Private foundations. An amendment of Reg. 1.643(b)-1 may affect the
private foundation rules with respect to the computation of
undistributed income. The private foundation rules impose an
excise tax on the undistributed income of a private foundation.
Reg. 53.4942(a)-2(a) defines undistributed income by taking
into account the “distributable amount,” which must be increased
by the “income portion” of amounts placed in trusts after a
certain date. The computation of this “income portion” must
take into account Section 643(b) income.
[14]
Information reporting. Practitioners must also be aware of any impact
that an amendment of Reg. 1.643(b)-1 would have on the information
reporting rules under Reg. 1.6034-1(b)(1). Reg. 1.6034-1(b)(1)
excepts certain charitable split-interest trusts claiming a
Section 642 charitable deduction from filing a Form 1041-A.
The types of trusts that are excepted include trusts whose terms
require the trustee to distribute currently all the Section
643(b) income.
Subchapter S. One type of trust that is eligible to hold S corporation
stock is the qualified subchapter S trust (QSST). A QSST is
defined, in part, as a trust the terms of which require that
all the income (within the meaning of Section 643(b)) of the
trust is distributed (or required to be distributed) currently
to one individual who is a U.S. citizen or resident.
[15]
To qualify as a QSST, either the terms of the trust must
require that all income be distributed annually, or the trustee
must annually distribute all the trust accounting income.
A
total return trust distributes a percentage of the total value
of the trust assets; this payout may not include all the trust
accounting income. A total return trust may not be usable as
a QSST because it may be difficult to determine whether all
the income would be annually distributed. Further, practitioners
may not want to use the total return trust concept for a QSST
because of the nontax reason that the hard-to-value S stock
must be valued annually.
Foreign trusts. Although a discussion of foreign trusts is beyond
the scope of this article, practitioners who want to use the
total return concept with foreign trusts should consider the
various tax ramifications, including the fact that the throw
back rules apply to foreign trusts.
Collateral consequences of using total return trusts. If a trust
agreement or local law provides that the definition of trust
accounting income is a unitrust amount, advisors should be aware
of the collateral effect that such a definition will have for
valuation purposes. For instance, a total return trust will
influence the valuation of partially complete gifts under Section
2512, the valuation of interests in trust under Section 7520,
the valuation of 5% reversionary interests of grantor trusts
under Section 673, and the valuation of beneficial interests
in trust with respect to the attribution rules under Sections
267, 318, and 4946.
Conclusion
While a total return
trust is a dynamic, revolutionizing estate planning tool, total
return trusts have certain tax consequences that practitioners
should analyze carefully. Before using total return trusts,
practitioners should consider the Proposed Regulations that
revise the definition of income to take into account governing
instruments or state laws that define trust accounting income
as a unitrust amount or permit the trustee to make adjustments
between income and principal. Practitioners should also consider
the tax consequences of a total return trust under other existing
federal tax provisions not addressed by the Proposed Regulations.
Blurbs
The Preamble to
the Prop. Regs. on the definition of trust income explains that
capital gains are included in DNI in certain circumstances.
The Prop. Regs.
take into account state law changes in the definition of income
with respect to trusts qualifying for the marital deduction.
Under the Prop.
Regs., a GST-tax-exempt trust may maintain its grandfathered
status after modification to a total return GST trust.
PRACTICE NOTES
If a trust agreement
or local law provides that the definition of trust accounting
income is a unitrust amount, practitioners should be aware of
the collateral effect that such a definition will have for valuation
purposes.
