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By David Schaengold, CPA, David Tarlow & Co., P.C.

The taxation of trusts is fundamentally complicated. In effect, a combination of individual and partnership rules that are applied both to the income which is retained in the trust and to that which flows through the trust. What is retained and what flows through is governed by the constantly puzzling distributable net income (DNI) principle.

In Crisp v. U.S. (Crt. Fed Claims, 76AFTR 2d 95-6261), the DNI principle is analyzed in a circumstance which, although common, is nonetheless troublesome: capital gains earned by a partnership and paid to a trust that owned a limited partnership interest. The crux of the decision centers on whether such gains constitute income or principal.

The rules for determining distributable net income as they pertain to capital gains are specified in Regulation section 1.643(a)-3 which provides as follows:

a) Gains from the sale or exchange of capital assets are ordinarily excluded from [DNI], and are not ordinarily considered as paid, credited, or required to be distributed to any beneficiary unless they are--

1) allocated to income under the terms of the governing instrument or local law by the fiduciary on its books or by notice to the beneficiary, [or]

2) allocated to corpus and actually distributed to beneficiaries during the taxable year...

In Crisp the court interprets this regulation in the following straightforward way:

The two alternative allocations to which the regulation refers--income and corpus (alternatively referred to as principal)--are the two possible allocations of funds within a trust. The term "income" as used in Regulation section 1.643(a) refers to "the amount of income of an estate or trust for the taxable year determined under the terms of its governing instrument and applicable local law." Regulation section 1.643(b)-1. Hence, under Treas. Reg. section 1.643(a)-3, capital gains are includable in DNI if they are either 1) allocated to income or 2) allocated to corpus and actually distributed to the beneficiary during the tax year.

In the instant case, the trustee of the trust contends that he properly applied regulation section 1.643(a) when he included in the trust's DNI the partnership's capital gains because the trust's auditor had allocated these gains to income.

In response, the IRS acknowledges that the trust's auditor allocated the partnership capital gains to income, but contends that this allocation was erroneous, i.e., that the trust agreement and local law required instead that the trustee allocate the capital gains to corpus.

Accordingly, the ultimate question for the Court to decide boils down to whether partnership net profits constitute "income" or "corpus." But first, in explaining its decision the court was required to clear a fog cast over this issue by the nature of the activities of the partnership.

The partnership engaged primarily in "deal arbitrage" which involves the purchase of securities sought in cash tender offers, exchange offers, or mergers and then the tendering of those securities for cash or new securities. It also engaged in option arbitrage and hedge trading. In doing so its primary focus was to buy and sell securities in an attempt to profit from sudden swings in market value that resulted from numerous mergers and acquisitions which were prevalent in the 1980's.

It is obvious that the results of such activities would fall into the capital gains and losses categories on the partnership's tax K-1s to its partners. But the court reviewed the results from the point of view of the dictionary definition of "net profits," partnership law, the trust agreement, and local law to determine whether such results constituted corpus or income.

It found that Black's Law Dictionary (3d ed. 1933) defines net profits as follows: "This term does not mean what is made over the losses, expenses, and interest on the amount invested. It includes the gain that accrues on the investment, after deducting simply the losses and expenses of the business." From this definition the court concluded that the trust became a passive investor in a "business run by the partnership," and that the partnership earned "net profits" (for accounting purposes) regardless of whether the IRC classifies these profits as ordinary income or capital gains.

In analyzing the trust agreement, it found that "corpus" is narrowly defined as consisting of property which the trustee acquires "through gift, devise, purchase or exchange...all of which is intended to create the corpus." Accordingly, it found that this "definition of the corpus of the trust does not encompass profits from the trust's share of a limited partnership" such as it held in this case. Moreover, it found that the "partnership profits credited to the trust resulted from the partnership's acquisition and sale of securities and options--however, those securities do not qualify as trust corpus because the trust did not "acquire" the securities, but rather the partnership (a distinct legal entity) acquired the securities."

In addition, the court pointed out, that this interpretation of the trust's interest in the partnership's assets is consistent with the applicable state law governing the partnership "which provides that a limited partnership does not itself own, possess or have legal title to the specific assets of the partnership." Accordingly, it concluded that the profits of the partnership were income, not principal:

Thus, although the trust "acquired" a limited partnership interest, the trust did not "acquire" the securities owned by the partnership and, hence, those securities are not classifiable as corpus. Because the securities themselves are not corpus, it would follow that the partnership profits credited to the trust based on the sale of those securities likewise would not be classifiable as corpus.

The court further pointed out that "if the trust had directly acquired the securities that produced the profits at issue, rather than purchasing an interest in a partnership which in turn acquired the securities, then the securities would constitute corpus, and apparently so too would any profits that resulted from the sale of those securities." It noted that the IRS argued that as a matter of law it would be unreasonable to give trustees "the power to convert undistributable corpus into distributable income simply by interposing a partnership between the trustee and the underlying securities." However, the court was not persuaded by such an argument. Instead it pointed out that, to the contrary and particularly in this instance, the governing instrument and common law intended to grant the trustee such power. Both permitted the trustee to chose among various business structures to direct receipts from an investment either to income beneficiaries or remaindermen.

The court concluded that for the foregoing reasons the capital gains earned in the partnership and credited to the trust fit squarely within the definition of distributable income and do not fit squarely within the trust agreement's definition of undistributable corpus. "Accordingly the capital gains of the partnership distributed to the income beneficiary are properly allocable to income and thus includable in DNI under IRC section 643(a)3 and Regulation section 1 643(a)-3(a)(1)." *


By David Schaengold, CPA, David Tarlow & Co., P.C.

Testators often choose family members or close friends to be the executors of their estates. But too often the chosen ones are unaware of the personal liability that is assumed when serving in a fiduciary capacity. Most significantly, this includes being personally liable for the Federal estate tax and state inheritance taxes. Such liability can be limited by a timely request to the IRS.

Although the estate is the first and foremost obligor of the estate tax, it is the executor who has the duty to pay it. This duty applies to the entire estate tax, even though the entire estate may include property which does not come under administration or possession of the executor. For instance, life insurance may account for a major portion of the taxable estate and the estate tax, but the proceeds of the life insurance may be paid directly to beneficiaries. Even so, the executor may still be held personally liable for the tax.

The extent of the executor's personal liability for estate tax is founded under Title 31 of the U.S. Code former section 3467 which states in part as follows:

If the executor...pays a debt due by the decedent's estate or distributes any portion of the estate before the entire estate tax is paid, the executor...is personally liable for the estate tax remaining unpaid to the extent of the amount paid out on the debt or distributed. [31 USC section 192 prior to 1982.]

Suppose an executor files an estate tax return, pays the tax due thereon from the decedent's assets and distributes the remaining assets to the heirs. Under Title 31 of the U.S. Code, the executor would be personally liable for any deficiency later found to be due.

Several factors place a haze over exactly how much and for how long the executor is liable. An estate tax audit can require an additional amount of tax to be paid or the discovery of an asset years after the audit can extend the duration of personal liability.

Such onerous situations can be eliminated by taking advantage of the procedure set forth in IRC section 2204. It merely requires that the executor ask the IRS to set the estate tax. The IRS has nine months to do so. As soon as the executor pays the tax he's free of any further liability. This is set forth in IRC section 2204(a) which provides as follows:

If the executor makes written application to the Secretary for determination of the amount of the tax and discharge from personal liability therefore, the Secretary (as soon as possible, and in any event, within 9 months after the making of such application...) shall notify the executor of the amount of the tax. The executor, on payment of the amount of which he is notified...shall be discharged from personal liability for any deficiency in tax thereafter found to be due and shall be entitled to a receipt or writing showing such discharge.

Even if the IRS fails to notify the executor within the nine-month period, once the tax is paid the executor is released from any further liability.

Accordingly, it's always wise for executors to apply for discharge from liability. If an additional tax is assessed at a later time, the estate or beneficiaries will be liable for the payment, but not the
executor. *

David Schaengold, CPA, is a partner with David Tarlow & Co., P.C. He serves as the AICPA observer for the drafting committee to revise the state uniform principal and income act.

Marco Svagna, CPA
Lopez Edwards Frank
& Company LLP

Lawrence Foster, CPA
KPMG Peat Marwick LLP

Contributing Editors:
Richard H. Sonet, CPA
Marks Shron & Company LLP

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

Eric Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

James McEvoy, CPA
Chase Manhattan Bank

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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