ESTATES AND TRUSTS

AN ALTERNATE METHOD FOR ALLOCATING THE NEW YORK STATE FIDUCIARY ADJUSTMENT

By Nathan H. Szerlip, CPA, Edward Isaacs & Co., LLP

Trusts and estates are hybrid entities for income tax purposes in that taxable income may be taxed not only to the entity but also to the beneficiaries to the extent that they share in that income. Similarly the New York State fiduciary adjustment may also be allocated among the entity and its beneficiaries.

The New York fiduciary adjustment consists of modifications to Federal taxable income to conform to New York law. The addition for state or foreign income taxes is one of the more common modifications. There are two methods for allocating the fiduciary adjustment modification among the fiduciary and its beneficiaries: the general method and a special equitable method.

The general method allocates the fiduciary adjustment in the same manner as the entity and its beneficiaries share in Federal distributable net income (DNI). Where there is no DNI or where DNI is negative, the fiduciary adjustment is allocated in the same manner as local law or the governing instrument allocates accounting income.

Example: A simple trust has $10,000 of N.Y. municipal bond interest, a capital loss of $3,000, and a deduction for N.Y. income taxes paid because of prior capital gains of $3,000. The trust's accounting income required to be distributed is $10,000. The income taxes are an additional modification of $3,000. Although the tax payments are allocable to principal, the general method of allocation will pass this fiduciary adjustment out to the income beneficiary and leave the trust with a net loss of $3,300, the capital loss of $3,000, and a personal exemption of $300.

The beneficiary is taxed on the modification of $3,000 even though the income creating the modification belonged to the trust and the beneficiary received no benefit from that income. In this case, although the general method of allocation is simple and mechanical, it is not equitable.

Where this general method of allocation produces an inequitable result that is "substantial both in amount and in relation to the amount of the fiduciary adjustment [N.Y. Income Tax Law section 619(d)]," an alternate method of allocation my be elected by the fiduciary. This method allows the fiduciary to allocate modifications to the trust or estate in the manner in which the items producing the modifications were allocated, with the remaining modifications allocated in accordance with the general method.

The regulations [section 1193 (c)] define inequity as the difference between the beneficiary's amount of the fiduciary adjustment calculated by the general method and that calculated by the alternate method. The inequity is substantial in amount if it exceeds $1,000 for any one beneficiary and substantial in relation to the fiduciary adjustment in total if it equals at least 15% of the total fiduciary adjustment for any one beneficiary. Both conditions must be met.

In the above example, the alternate method of allocating the fiduciary adjustment may be elected. The capital gain creating this adjustment is attributable to the trust's principal. The difference between the beneficiary's share of the adjustment under the general method ($3,000) and the share of that adjustment under the alternate method ($0) produces an inequity in the amount of $3,000. Since this difference exceeds $1,000 and 15% of the total fiduciary adjustment, the alternate method may be elected. Thus the trust will add the fiduciary adjustment to its income, giving it a taxable loss of $300 instead of the $3,300 loss under the general method. The beneficiary will not include the fiduciary adjustment in New York income.

The election to use the alternate method is discretionary to the fiduciary, must be used for all modifications to which it applies, and is binding only for the year in which the election is made. In addition a schedule must be attached to the return showing--

1. the election to use the alternate method under section 916(d) of the Tax Law;

2. the amount of each modification;

3. the fiduciary adjustment under the general method;

4. the fiduciary adjustment under the alternate method;

5. the computation showing that the inequity is substantial both in amount and in relation to the total fiduciary adjustment;

6. the name and address of each beneficiary if not in the return;

7. a statement that the beneficiary has received a copy of the schedule; and

8. a statement showing the authority for the fiduciary to make the allocation.

LIFE INSURANCE: ESTATE TAXATION

By Lee Slavutin, Stern Slavutin-2, Inc.

The IRS has issued two interesting private letter rulings on the estate taxation of life insurance owned by a trust. The first is PLR 97 48 020.

Situation: George created a living trust that, on his death, will be divided into two trusts. Trust A is a martial trust equal to the smallest amount which, if allowed as a martial deduction, would result in the least possible estate tax liability by reason of his death. Trust B is equal to the remaining trust assets. George died in 1996.

Kathy, George's wife, is the current beneficiary and one of three co-trustees of Trust B. During her life, the trustees of Trust B are to distribute all of the net income of the trust to her. The trustees are also authorized to distribute principal to Kathy if the income is insufficient to provide for her health, support, and maintenance. Kathy does not have a power of appointment over the assets in Trust B. George and Kathy's children and grandchildren are contingent beneficiaries of Trust B. Kathy resigned as co-trustee of Trust B on January 15, 1997. The trust provides that no successor trustee is to be appointed and the remaining trustees will serve as co-trustees.

Trustees of Trust B propose to purchase an insurance policy on Kathy's life. Will the life insurance proceeds be includible in Kathy's gross estate?

Ruling: The IRS ruled that Kathy will not possess any incidents of ownership over a life insurance policy on her life purchased by the remaining trustees of Trust B, because she resigned as a trustee of the trust [Regulations section 20.2042I(c)(4), revenue ruling 84-179, and Estate of Fruehauf v. Commissioner, 427 F.2d 80 (6th Cir. 1970)].

The proceeds of a life insurance policy on Kathy's life "purchased by the trustee of Trust B and held as an asset of Trust B will not be included in decedent's spouse's gross estate provided that 1) she has not transferred any assets to Trust B, 2) the premiums on the policy are paid from the principal of Trust B, 3) she does not maintain the policy with personal assets, and 4) she is not reinstated as a trustee of Trust B." If Kathy transferred assets to the trust (for example, gifts to fund premium payments), then the IRS would probably rule that the proceeds will be includible under IRC section 2036 (because Kathy retains an income interest in the trust).

The IRS did not rule on the possible application of section 2035 to the three-year period following Kathy's resignation as trustee.

The second private letter ruling of interest is PLR 97 48 029.

Situation: On May 7, 1990, Vinnie established an irrevocable trust for the benefit of his wife, Mary, and his children. The trust was funded with a second-to-die life insurance policy on the lives of Vinnie and Mary. The trustees are Vinnie's two children. Under the terms of the trust, any contribution to the trust may be withdrawn by Mary, provided the amount of the withdrawal cannot exceed $5,000 for any year. Vinnie's children also have withdrawal rights. Each withdrawal right lapses on the earlier of a) the last day of the year in which the contribution was made, or b) 60 days after the contribution. During Vinnie's lifetime, the trustee is authorized to use trust income to pay the life insurance premiums. After paying any insurance premium, the trustees may distribute to or for the benefit of Mary and the children so much of the trust income and principal as the trustees deem appropriate.

After Vinnie's death, the trustees are to pay to or for the benefit of Mary and the children so much of the trust's income and principal as the trustees deem appropriate for the comfort and general welfare of those beneficiaries. Upon Mary's death, the trustees have discretion to pay her burial expenses and death and succession taxes. Any remaining corpus is to be divided into separate shares for each child.

Vinnie transferred property to the trust, and the trust applied for a second-to-die insurance policy on the lives of Vinnie and Mary. The trust has owned the policy at all times and the trustees possess all incidents of ownership in the policy. Vinnie died on January 26, 1996, survived by Mary. Mary has made no transfers to the trust. The trustees have continued to pay the premiums on the policy from trust funds. The trust instrument does not prohibit Mary from being added as an additional co-trustee.

Ruling: The IRS ruled that Mary has made no direct contributions nor indirect contributions by reason of the lapse of the $5,000 withdrawal right. "Under the terms of the trust, B (Mary) does not possess any rights within the meaning of IRC sections 2036 or 2038. Assuming B (Mary) is not named as an additional trustee, B will not have any incidents of ownership in the policy by reason of section 20.2042-1(c)(4). Assuming B does not make any contributions to the trust (either directly or indirectly), we conclude that the trust and insurance policy will not be included under sections 2036, 2038, and 2042(2) in B's gross estate upon her death. However, we express no opinion regarding the application of section 2042(I)..." It is important to note that if the trustee is legally bound to use insurance proceeds to pay estate taxes, then those proceeds will be included in the insured's estate for Federal estate tax purposes. *

Excerpted from "Well Informed Is Well Insured," the bi-weekly newsletter of Stern Slavutin-2 Inc.

Editors:
Laurence I. Foster, CPA
KPMG Peat Marwick LLP

Eric M. Kramer, JD, CPA
Farrell, Fritz, Caermmerer, Cleary, Barnosky & Armentano, PC

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

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

James B. McEvoy, CPA
Chase Manhattan Bank

Nathan H. Szerlip, CPA
Edward Issacs & Company LLP

Lenore J. Jones, CPA
Jacobs Evall & Blumenfield LLP