IRS Final Regulations Define Trust Income

By Robert S. Barnett

APRIL 2005 - Final regulations concerning the definition of trust income have been promulgated by the IRS, addressing many state law changes affecting trust accounting income. New York State, as part of its Prudent Investor Act, allows a trustee the power to adjust the amount that may be distributed to a beneficiary by trust provisions referring to trust income, and to adjust distributions between principal and income “if the trustee determines ... that such an adjustment would be fair and reasonable to all the beneficiaries” [EPTL 11-2.3(b)(5)(A)]. The trustee must exercise this discretion considering the settlor’s intent, provisions in the governing instrument, the nature of assets held in the trust, and the general circumstances of the income beneficiary and the remainder beneficiaries. The objective is to provide an equitable balance between the income needs of the current income beneficiaries and future growth for the remainder beneficiaries.

Current prudent-investor requirements are generally applicable to all trustees. The trust instrument may contain specific directives and are generally respected and given top priority. Trust provisions that depart significantly from the traditional concepts of income and principal, however, will most likely be disregarded [Treasury Regulations section 1.643(b)-(1)].

Dividends, interest, and rents are generally allocated to income, and proceeds from the sale or exchange of trust assets are generally allocated to principal. The regulations will respect an allocation of amounts between income and principal pursuant to applicable local law. There must be a reasonable apportionment between income and remainder beneficiaries of all items representing the total yearly return of the trust, including ordinary income, tax-exempt income, capital gains, and appreciation. The federal regulations approve of state statutes that provide a unitrust payment of income to the income beneficiary of between 3% and 5% of the fair market value of trust assets as reasonable [Treasury Regulations section 1.643(b)-(1)]. The New York statutes provide trustees with new flexibility to determine income under a unitrust payout or to utilize their discretion, which is generally respected, to allocate and make adjustments between the income and principal beneficiaries. The trustee has an overriding duty of impartiality, and any such adjustments must be fair and reasonable in the circumstances.

Fiduciary income is often not given proper attention by trustees and their advisors. In an economic sense, fiduciary income helps determine the relative interests of the income and remainder beneficiaries and provides a means of allocating receipts, disbursements, and expenses among the parties involved. The parties will generally have the same objectives and agenda, but there are cases where not all family members’ interests are aligned. For example, in situations involving a second marriage where a qualified terminal interest property trust (QTIP) is established, conflicts are likely to arise.

A trust provision providing for trustee discretion should be drafted to minimize conflict and provide certainty and stability in trust administration. From the trustee’s view, it may be necessary to apply to the appropriate court for confirmation that the trustee’s discretion to allocate fiduciary income is fair and appropriate. Even though the courts are inclined to abide by the trustee’s decision, this will still help protect the fiduciary from potential liability. A court will not change a fiduciary’s decision to exercise or not exercise an adjustment power unless it determines that the decision was an abuse of the fiduciary’s discretion [EPTL section 11-2.3-A(a)].

In drafting the trust, advisors should work carefully with the settlor in determining the appropriate standards for trustee discretion and allocation. For example, a trust provision that allocates principal of a QTIP in a manner directed by the income beneficiary of the QTIP, might subject the trustees to attack and surcharge by trust beneficiaries at a later date. Items to consider include the outside income and assets of the income beneficiary, the ages and needs of the residuary beneficiaries, the nature of the anticipated trust assets, and the resulting accounting and tax issues. For example, a limited partnership interest held in trust will carry issues concerning the amount and character of partnership distributions, the realization of phantom income, and allocation issues for depreciation. Clear guidelines might also help eliminate the constant need to seek court approval, which could be time-consuming and costly.

Trust income can include an allocation of capital gains, if allowed under the governing instrument and local law. Such allocation may also be made in accordance with a discretionary power granted to the trustee by local law or the governing instrument, provided it is not prohibited by applicable law. These new changes provide substantial flexibility for trustees, but are also fraught with danger, uncertainty, and potential criticism. For example, if a trust has only a small amount of income available due to the investment strategy of the trust, what guidelines should a trustee utilize to be certain that an allocation or equitable adjustment is appropriate and beyond surcharge? The trustee must make the difficult decision to distribute capital gains or invade principal for the beneficiary’s benefit.

The final regulations provide guidance and examples of how to apply capital gains in the computation of distributable net income (DNI). DNI provides a computation for the amount of the distribution deduction available to trusts for distribution to the income beneficiaries. A simple trust distributes all its DNI and fiduciary income. The general rule provides that capital gains are not included in DNI and are not considered paid or distributed to any beneficiary. They are therefore taxed to the trust and not to the beneficiaries; however, capital gains may be included in DNI.

Example 11 of the Treasury Regulations shows the effect of a state unitrust statute on the allocation of capital gains between principal and DNI [section 1.643(a)-3]. The applicable state unitrust statute provides that a trustee may make an election to pay to an income beneficiary 4% of the fair market value of the trust’s assets in full satisfaction of that beneficiary’s right to income. If the trustee elects a 4% unitrust, the 4% shall be taken first from ordinary income, then from capital gains, and then from return of principal. Assume, for example, that a trust’s assets have a fair market value of $500,000. The trust receives $5,000 of ordinary income and $80,000 of capital gain. Under the unitrust method, the trustee distributes to the beneficiary $20,000 (4% of $500,000). Therefore, $15,000 of the capital gain is allocated to income pursuant to the ordering rule of the state statute, and is included in DNI.

The objective of providing a fair balance between income and remainder beneficiaries is not always easily attained, and the discretion exercised by the trustee may result in liability.

Robert S. Barnett, Esq., CPA, practices tax law and is a founding partner of Capell, Barnett & Matalon, LLP, in Jericho, N.Y. He can be reached at (516) 931-8100.