TAXATION

Estates & Trusts

Old Provision Can Lower Taxes for Trust Beneficiaries

By David Schaengold

Trust beneficiaries will benefit greatly from the lower 15% tax rate on dividends—more so if trust expenses are deducted under an old provision that is now seldom used. The provision gives the trustee flexibility over allocating trust administration expenses to the different classes of income: generally rents, dividends, and interest. It allows the shifting of trust income from the 35% bracket, interest or rent classification, to the 15% bracket, dividend classification. This discretion could lower beneficiaries’ taxes substantially.

Treasury Regulations section 1.652(b)-3(b) provides that deductions, such as trustees’ commissions and state income taxes, that are not directly attributable to a specific class of income may be allocated to any item of income, such as rents, dividends, or interest. A portion of this amount, however, must be allocated proportionately to nontaxable income. Administration expenses not allocated to nontaxable income need not be proportionate.

The regulation applies to both simple and complex trusts. For example, a simple trust with gross income of $150,000 ($100,000 of taxable interest income and $50,000 of dividend income) incurs $45,000 in administration expenses (trustee commissions and state income taxes), for a net of $105,000 reported as taxable to the beneficiary.

Up to 2002, most trusts would have allocated the administration expenses proportionally, thus reporting to the beneficiary $70,000 of interest income and $35,000 of dividend income, for a total of $105,000. Current trustees should reconsider whether to allocate proportionally or discretionally; it makes a big difference. If the administration expenses are allocated entirely to interest income, the result to the beneficiary on Form K-1 is still a total of $105,000. But $55,000 would be classified as interest income and $50,000 as dividend income. This discretion yields a potential tax savings of $3,000, based on a reduction of tax rates from 35% to 15% on the $15,000 of income shifted from the high-bracket interest income rate to the low-bracket dividend rate. (If there was any nontaxable interest income, a proportionate share of the expenses would be allocated to the nontaxable interest income, with the rest eligible for the discretionary allocation permitted by the regulations.)

Tax preparers, individual trustees, and bank trust departments are urged to review this policy.