TEN THINGS ESTATE PLANNERS NEED TO KNOW ABOUT
INCOME TAX MATTERS
BY
MICKEY R. DAVIS
BRACEWELL & GIULIANI LLP
711 Louisiana, Suite 2300
Houston, Texas 77002–2770
(713) 221-1154
mickey.davis@bgllp.com
THE SAN ANTONIO ESTATE PLANNERS COUNCIL'S
DOCKET CALL IN PROBATE COURT
San Antonio, Texas
February 16, 2007
TEN THINGS ESTATE PLANNERS NEED TO KNOW ABOUT INCOME TAX MATTERS
TABLE OF CONTENTS
Page
I.
INTRODUCTION AND OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A.
Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B.
Scope. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C.
Importance of Subchapter J. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D.
Approach of this Outline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
1
1
1
1
II.
OVERVIEW OF TRUST AND ESTATE TAXATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A.
Simple Trusts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.
Mandatory Income Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.
No Charitable Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.
No Distributions in Excess of Current Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.
Effect of Simple Trust Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B.
Estates and Complex Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.
Treatment as a Complex Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.
Impact of Complex Trust Treatment Upon Distributions of Current Income . . . . . . . . . . . . .
3.
Other Effects of Complex Trust Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
a.
Income Retained by the Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
Application of the "Tier Rules" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
Undistributed Net Income, and the Accumulation Distributions and the Throwback
Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.
Special Distribution Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
a.
Specific Bequests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
Gain on Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
DNI Carry-out of In-Kind Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
d.
The 65 Day Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
e.
Distributions Discharging Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
f.
Grantor Trust Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.
Recent Rules Equating Trusts with Estates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.
Rules Equating Estates with Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
a.
The 65 Day Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
The Separate Share Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
Extension of the "Related Party" Rules to Estates . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.
Repeal of Accumulation Distribution Rules and Section 644 . . . . . . . . . . . . . . . . . . . . . . . . .
a.
Continued Application to Foreign Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
Pre-March '84 Multiple Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
Sales within Two Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
1
1
1
2
2
2
2
2
2
2
2
III.
THE TOP TEN THINGS THAT ESTATE PLANNERS NEED TO KNOW ABOUT INCOME TAX
MATTERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.
ESTATE DISTRIBUTIONS CARRY OUT DISTRIBUTABLE NET INCOME . . . . . . . . . . . . . . . . . . . . . . .
a.
Specific Sums of Money and Specific Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
i.
Requirement of Ascertainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
Formula Bequests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii.
Payments from Current Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iv.
Distributions of Real Estate Where Title has Vested . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
The Separate Share Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
Income From Property Specifically Bequeathed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
d.
Interest on Pecuniary Bequests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.
AN ESTATE MAY RECOGNIZE GAINS AND LOSSES WHEN IT MAKES DISTRIBUTIONS IN KIND . . .
a.
Distributions Satisfying the Estate's Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
Distributions of Assets to Fund Pecuniary Gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
Pension and IRA Accounts Used to Fund Pecuniary Bequests . . . . . . . . . . . . . . . . . . . . . . . .
i.
No Receipt By Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
No IRD Transfer by Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii.
Constructive Receipt Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iv.
Proper Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3
3
3
3
3
3
3
3
3
4
4
4
4
4
4
4
4
4
4
5
5
5
5
5
6
6
7
7
7
7
8
8
8
8
8
3.
4.
5.
6.
7.
d.
Section 643(e)(3) Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
ESTATE BENEFICIARIES MAY RECOGNIZE GAINS AND LOSSES IF THE ESTATE MAKES
UNAUTHORIZED NON PRO RATA DISTRIBUTIONS IN KIND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
INCOME IN RESPECT OF A DECEDENT IS TAXED TO THE RECIPIENT . . . . . . . . . . . . . . . . . . . . . . . . 9
a.
IRD Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
b.
Recognizing IRD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
c.
Deductions in Respect of a Decedent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
IMPACT OF DEATH UPON BASIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
a.
General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
b.
Exceptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
i.
No New Basis for IRD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
ii.
No New Basis for Deathbed Transfers to Decedent . . . . . . . . . . . . . . . . . . . . . . . . . . 10
THE EXECUTOR CAN ELECT TO DEDUCT MANY EXPENSES FOR EITHER INCOME OR ESTATE TAX
PURPOSES (BUT NOT BOTH) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
a.
Section 642(g) Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
b.
Method of Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
c.
Payments From Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
d.
Regulatory Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
e.
Estate Management Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
f.
Estate Transmission Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
g.
Reduction for Unrelated Estate Management Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
h.
Special Rule for Estate Management Expenses Deducted on Estate Tax Return . . . . . . . . . . 12
i.
Effective Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
WHEN AN ESTATE OR TRUST ALLOCATES "INCOME," THAT MEANS FIDUCIARY ACCOUNTING
INCOME, NOT TAXABLE INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
a.
Look to the Governing Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
b.
"Fair and Reasonable" Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
c.
Specific Trust Code Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
i.
Terms of the Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
ii.
Grants of Discretionary Authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
iii.
Application of the Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
iv.
When in Doubt, It's Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
v.
Fair and Reasonable Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
d.
Accrued Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
i.
General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
ii.
Trapping Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
iii.
Post-Death Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
e.
Receipts from Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
i.
Application to "Entities" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
ii.
General Rule–Distributions are Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
iii.
When Distributions are Not Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
iv.
Partial Liquidations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
v.
Information from the Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
f.
Business and Farming Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
i.
Treatment as a Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
ii.
Cash Flow vs. Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
iii.
Types of Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
iv.
Comparing Former Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
g.
Interest and Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
h.
Deferred Compensation, Annuities, and Similar Payments . . . . . . . . . . . . . . . . . . . . . . . . . . 15
i.
Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
ii.
New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
i.
Liquidating Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
i.
Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
ii.
New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
j.
Minerals, Water and Other Natural Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
i.
Specific Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
ii.
"Equitable" Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
iii.
Compare Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
iv.
"Deemed" Equitable Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
v.
Affect on Depletion Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
k.
Timber. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
8.
9.
10.
IV.
i.
Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii.
Applying Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
l.
Underproductive Property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
i.
Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
m.
Other Sales Proceeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
n.
Equitable Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o.
Allocation of Disbursements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
i.
Allocations to Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
Administration Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
p.
Allocations to Principal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
i.
Trustee and Other Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
Expenses that Affect Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii.
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iv.
Reserves for Extraordinary Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
v.
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
vi.
Taxes Attributable to Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
vii.
Taxes from Pass-Through Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
viii. Equitable Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
q.
Unitrusts and the Power to Adjust. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
i.
Unitrusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
The Power to Adjust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii.
Statement of the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iv.
Availability of the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
v.
Limitations of the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
vi.
Comments on the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
NON-PRO RATA DIVISIONS OF COMMUNITY PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
DEDUCTION OF INTEREST PAID ON PECUNIARY BEQUESTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
UNDERSTANDING THE GRANTOR TRUST RULES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
a.
Reversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
Power to Revoke . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c.
Retention of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
d.
Retention of Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
e.
Certain Administrative Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
f.
Section 678 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
i.
Power to Vest Trust Property in One's Self . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ii.
Releases of Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii.
Renunciations of Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
g.
Gift and Estate Taxation of Grantor Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
16
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17
17
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17
17
17
17
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20
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CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Income Tax Matters
TEN THINGS ESTATE PLANNERS NEED TO
KNOW ABOUT INCOME TAX MATTERS
I.
INTRODUCTION AND OVERVIEW
A.
Overview.
The goal of this outline is to provide some
practical guidelines on estate planning and administration from a federal income tax viewpoint. The
outline provides a review of general federal income tax
rules applicable to estates and trusts. It then focuses on
ten income tax issues with which every estate planner
should be familiar.
B.
Scope.
This outline provides a brief overview of general
fiduciary tax principles, but does not purport to be a
detailed analysis of Subchapter J of the Internal
Revenue Code of 1986 (the "Code"). For the most part,
this outline assumes that the reader has a passing
familiarity with important federal income tax issues
associated with the administration of trusts and estates.
The outline reviews recent changes to the fiduciary
income tax arena brought about by Congress and the
IRS. In addition, since they now play an increasingly
important role in sophisticated estate planning, a brief
overview of the grantor trust rules is provided.
Importance of Subchapter J.
Attorneys tend to de-emphasize federal income
tax issues in estate planning and administration, since
they usually do not do income tax compliance work for
estates and trusts. There is a strong and growing belief,
however, that income taxation of trusts, estates,
grantors and beneficiaries will become increasingly
important. The increase in the unified credit, the
prevalent use of the unlimited marital deduction, and
the generous generation-skipping tax exemption all
have resulted in a decline in the number of estates for
which transfer taxes are due. Increasing use of bypass,
marital deduction, and generation-skipping trusts
suggests that more and more wealth, and the income
resulting from that wealth, can be expected to be held
in trust. In addition, in a setting in which income tax
brackets for trusts are highly compressed, the IRS can
be expected to focus increased attention to the
application of the grantor trust rules which seek to shift
the tax liability for trust income away from the trust
itself. In short, we can expect the government to devote
more of its enforcement resources to the long-neglected
area of income taxation of decedents, estates, trusts, and
beneficiaries. Careless inattention to the federal income
tax principles associated with planning and
administration can not only increase overall taxes paid
by a family, but can also result in unintended shifts in
the beneficial interests of distributees.
1
Most estate planners can summarize their
understanding about estate and trust income tax issues
by citing two rules: (i) an inheritance is income tax free
to the recipient; and (ii) assets get a step-up in basis at
death. These rules are at best overly simplistic, and at
worst, downright misleading. This outline points out a
number of income tax notions that every estate planner
should know, whether in the process of administering
an estate or while designing sophisticated income or
wealth shifting techniques. The goal of the outline is
not to explain how to undertake these complex estate
planning or administration efforts. Rather, it seeks to
provide essential background knowledge about income
tax issues that are fundamental to the practice of estate
planning.
II. OVERVIEW OF TRUST AND ESTATE
TAXATION
A brief review of the fundamental principles of
income taxation of trusts and estates serves as a useful
background. Trusts fall into one of two categories,
simple or complex. In general, estates are taxed as
though they were complex trusts.
A.
Simple Trusts.
To qualify as a simple trust, a trust must satisfy
three requirements.
C.
D.
Approach of this Outline.
1. Mandatory Income Distributions. The first
requirement for simple trust treatment is that the trust
must, by its terms, require the trustee to distribute all
income at least annually. I.R.C. § 651(a)(1). "Income"
for this purpose means fiduciary accounting income
determined under local law -- not taxable income.
I.R.C. § 643(b). As discussed in detail below, this
provision is an area where the application of state law
can have a controlling impact upon the income taxation
of the entity and its beneficiaries. In Texas, "fiduciary
accounting income" is determined under the Texas
Trust Code and the relevant provisions of the governing
instrument. For periods beginning January 1, 2004, the
relevant provisions are those of the new Texas Uniform
Principal and Income Act described below. Note that
to qualify as a simple trust, the trustee need not
distribute all of its taxable or distributable net income.
Note also that "income" refers to the amount of income,
not the actual physical identification or labeling of the
distributed asset on the trustee's books of account.
Thus, even if the trustee distributes an asset categorized
on the trustee's books as corpus, that distribution will
nevertheless be treated as carrying out the trust's
income, to the extent that the trust has income as of the
last day of its fiscal year.
2. No Charitable Distributions.
The second
requirement to qualify as a simple trust is that the trust
must not provide that any amounts are to be paid,
2
2007 DOCKET CALL IN PROBATE COURT
permanently set aside, or used for charitable purposes.
I.R.C. § 651(a)(2).
3. No Distributions in Excess of Current Income.
Finally, to qualify as a simple trust, the trust must make
no actual distributions of corpus in the particular tax
year in question. I.R.C. § 651(a). The precise rule is
that simple trust treatment does not apply in any year
that the trust distributes amounts in excess of its
fiduciary accounting income. Of course, for this
purpose, the trustee can distribute any assets, whether
they are received with an income label or held as part of
corpus, but they will be regarded as income distributions so long as the aggregate value of all distributions
for the year do not exceed the amount of fiduciary
accounting income for the year. The trust loses simple
trust status only if "corpus" is distributed in the sense
that the value of all property distributed during the year
exceeds the amount of fiduciary accounting income for
the year.
4. Effect of Simple Trust Treatment. If the trust
meets the three-part test for a simple trust, the trust is
generally taxed as a conduit. The trust is allowed a
distribution deduction that washes ordinary income of
the trust out to the beneficiaries. The amount and
character of the income passes through pro rata to the
recipients, unless the instrument validly directs a
different allocation of various items of income.
Conduit taxation, measured by the notation of
"Distributable Net Income ("DNI") as defined in
Section 643(a) of the Code, is much as though the
beneficiaries owned the income-producing property
themselves and earned the income directly (except to
the extent that fiduciary accounting income differs from
distributable net income). Until the recent modification
of Treasury Regulation 1.643(a)-3, capital gains were
virtually never distributable from the trust, except in its
final year. The new Regulation substantially broadens
the circumstances under which capital gains may be
passed out to the trust's beneficiaries.
B.
Estates and Complex Trusts.
1. Treatment as a Complex Trust. Any trust that is
not a simple trust is complex, and all estates are taxed
as though they were complex trusts. Often, a trust is
complex merely because its terms do not require the
distribution of all income annually. Even nonaccumulation trusts may be complex because they
provide for charity, or make distributions in excess of
income. An otherwise simple trust which makes excess
distributions in some years but not in others (e.g.,
discretionary distributions of principal, or distributions
in the year of termination), can be complex in some
years and simple in others.
2. Impact of Complex Trust Treatment Upon
Distributions of Current Income. To the extent current
income is distributed, it doesn't matter whether the trust
is simple or complex. Both trusts get a distribution
deduction that washes out the distributable net income.
I.R.C. §§ 651(a); 661(a)(1). Beneficiaries include the
income on their income tax returns subject to the same
timing and characterization rules. If distributions are
made to multiple beneficiaries, they generally include
that income on their respective income tax returns pro
rata in proportion to the total amount that each
beneficiary receives. I.R.C. §§ 652(b) and (c); 662(b)
and (c).
3. Other Effects of Complex Trust Treatment. The
key difference between simple and complex trusts is the
treatment of accumulated income, and the treatment of
distributions made among mandatory vs. discretionary
distributees.
a. Income Retained by the Trust. When an estate or
complex trust retains taxable income, the entity itself
becomes a taxpayer. The trust or estate must pay tax on
taxable income in excess of its distribution deduction.
This retained net income may thereafter be held as part
of the principal under local law, but the governing
instrument may provide for different treatment.
Distributions that exceed current income are treated as
a distribution of corpus, which are tax free to the
beneficiary under Code Section 102.
b. Application of the "Tier Rules". The so-called
"tier rules" are designed to address the problem that
arises by the general pro rata carry-out rules for DNI
when a trust makes distributions of income to both
mandatory and discretionary income beneficiaries. DNI
is allocated first to "Tier I distributions," which are
either required current distributions of income, or
income used for any required distribution. I.R.C.
§ 662(a)(1). Tier II distributions are all other distribution, whether required or discretionary, and whether
made from current income, accumulated income, or
corpus. I.R.C. § 662(a)(2).
Example 1: A trust instrument requires the trustee to
distribute $50,000 of income to A each year, and
permits the trustee to distribute to B as much principal
and income as B may require. In a year in which the
trust has $60,000 of taxable income, the trustee makes
distributions totaling $50,000 to A, and $25,000 to B.
If the general pro rata rules were applied to these
distributions, A would report $40,000 of taxable
income ($60,000 x ($50,000/$75,000)) and B would
report $20,000 ($60,000 x ($25,000/$75,000)). In other
words, income would be reported in the ratio of the
total distributions made to each beneficiary. The tier
rules, however, require instead that all DNI be allocated
first to A to the extent of the required distribution
Income Tax Matters
($50,000), with only the balance ($10,000) allocated to
B–a result much more in keeping with the terms of the
trust agreement's description of the distributions.
Except in the limited circumstances noted in the
following paragraph, the balance of the distribution to
B ($15,000) is treated as a tax-free distribution of
corpus.
c. Undistributed Net Income, and the Accumulation
Distributions and the Throwback Rules. For years prior
to 1998, regardless of whether a trust's retained income
was treated as principal or income under the governing
instrument, it was required to be tracked by the trustee
as "undistributed net income" (UNI) for income tax
purposes. I.R.C. § 665(a). Distributable net income
not distributed to beneficiaries in a given year, net of
the amount of the taxes paid by the trust, was known as
UNI, available for distribution in future years. The
later distribution of this UNI was referred to as an
"accumulation distribution." The throwback rules
imposed an additional tax upon accumulation
distributions that was designed to be a rough
approximation of the tax that the ultimate beneficiary
would have paid in the year that the income was
recognized by the trust, as if there had been no
accumulation. This tax was measured by a series of
computations which sought to approximate the
additional tax that would have paid if an average
distribution had been made to the beneficiary in a
typical year. The Taxpayer Relief Act of 1997 repealed
the accumulation distribution and throwback rules for
distributions after 1997, except for distributions from
trusts formed before March 1, 1984, and then only for
distributions to a beneficiary who is entitled to receive
distributions from multiple trusts formed for tax
avoidance purposes. I.R.C. § 665(c).
4. Special Distribution Rules. The general rules
outlined above are subject to a number of exceptions
and refinements. For example:
a. Specific Bequests. Distributions of specific
bequests, devises or legacies do not carry out DNI.
I.R.C. § 663(a)(1).
b. Gain on Distributions. Distributions of property
in kind (as opposed to cash) to satisfy an obligation of
the entity, including an obligation to make distributions
of income to a beneficiary, are effectively treated as a
sale or exchange of the distributed property by the trust
or estate that may generate gain or loss (and
correspondingly adjust basis), and carry out DNI to the
extent of the fair market value of the property. Rev.
Rul 68-392, 1968-2 CB 284.
c. DNI Carry-out of In-Kind Distributions. In-kind
distributions that are not themselves gain realization
events are governed by Section 643(e). DNI is carried
3
out to the extent of the lesser of basis or fair market
value of the asset. However, the executor or trustee
may elect to treat the distribution as a realization event,
with the corresponding basis adjustment and effect on
the DNI carry out. I.R.C. § 643(e)(3).
d. The 65 Day Rule. If the trustee of a complex trust
(or an executor) makes a distribution during the first 65
days of its tax year, it may elect to treat those
distributions as having been made on the last day of the
prior year. If this election is made, DNI for the prior
year will be carried out and reported by the distributees
as though they actually received the distribution on the
last day of the trust or estate's prior year. I.R.C.
§ 663(b).
e. Distributions Discharging Obligations. Theoretically, distributions that discharge a person's legal
obligation to the recipient of the distribution will cause
the obligated person to be treated as the beneficiary.
Treas. Reg. § 1.643(c)-1(a). Neither this regulation nor
Treasury Regulation Section 1.662(a)-4, which also
deals with distributions discharging legal obligations,
has been litigated.
f.
Grantor Trust Rules. If a trust is characterized as
a "grantor trust," then the grantor trust rules are given
preference over the foregoing rules taxing income to the
trust or its beneficiaries. I.R.C. § 671. The grantor
trust rules are discussed below, beginning at page 20
5. Recent Rules Equating Trusts with Estates. For
the most part, estates and trusts are treated the same for
income tax purposes after the grantor's death.
Historically, there have been several relatively minor
differences, though, most of which gave estates a slight
edge from an income tax standpoint over post-death
revocable trusts used as estate surrogates. The
Taxpayer Relief Act of 1997 largely eliminated these
differences. Under the new rules, after a grantor's
death, the trustee of a revocable trust created by the
grantor, and the executor of the grantor's estate (if any),
may irrevocably elect to treat a "qualified revocable
trust" as part of the grantor's estate for income tax
purposes. I.R.C. § 645. This election should cure a
whole array of potential income tax disparities,
including, but not limited to, fiscal year-end selection,
holding periods for S stock, waiver of active
participation for passive losses, use of the $600
allowance in lieu of personal exemption, income tax
deductions for charitable set asides, Section 194
amortization of reforestation expenditures, avoidance of
estimated tax payment requirements for two years, etc.
The election must be made on the estate's first timely
income tax return (including extensions), and applies
until "the date which is 6 months after the date of the
final determination of the liability for tax imposed by
4
chapter 11," or if no estate tax return is due, two years
after the date of death.
6. Rules Equating Estates with Trusts. In those few
areas where revocable trusts held the edge over estates,
changes were made to bring estates in line with trusts.
Thus:
a. The 65 Day Rule. The 65-day rule is extended to
estates, so that an executor who makes distributions
during the first 65 days of an estate's fiscal year can
treat them as having been made during the prior year.
This rule allows post-year-end planning to minimize
DNI left in an estate. I.R.C. § 663(b).
b. The Separate Share Rule. The "separate share
rule" is applied to estates. This rule acts as an
exception to the general rule that DNI gets carried out
pro rata based upon distributions made in any given
year. Instead, by applying the separate share rule, DNI
is allocated to estate beneficiaries based upon
distributions of their respective "share" of the estate's
DNI. I.R.C. § 663(c). The IRS has now issued final
regulations applying the separate share rules to estates.
See T.D. 8849, 2000-2 I.R.B. 245; Treas. Reg.
§ 1.663(c)-4.
c. Extension of the "Related Party" Rules to Estates.
In one area that estates held an edge, the advantage was
taken away to a certain degree. Specifically, the
"related party" rules, which prohibit recognition of
losses in transactions between related parties, were
extended to transactions between an estate and its
beneficiaries. They continue to apply to trusts and their
beneficiaries. The new rules do not apply, however, to
disallow losses if depreciated assets are used to fund
pecuniary gifts. I.R.C. § 267(b)(13). Qualified
revocable trusts can now get this same post-death loss
recognition treatment when funding pecuniary gifts by
electing to be treated as estates under new Section 645.
7. Repeal of Accumulation Distribution Rules and
Section 644. As noted above, the accumulation
distribution throwback rules are repealed for most trusts
for distributions made in years beginning after
August 5, 1997. These rules sought to impose
additional income taxes on beneficiaries who received
a distribution from a trust that had accumulated income
in prior years at marginal rates lower than the
beneficiary's. The goal of the tax was to keep trustees
from accumulating income in years when the trust's tax
brackets were lower than the beneficiary's, and then
distributing that accumulated income in later years.
The tax computation was complex, and ever since the
advent of trust income tax rate compression (which
started in 1986), rarely resulted in any additional tax
being paid. I.R.C. § 665(c).
2007 DOCKET CALL IN PROBATE COURT
a. Continued Application to Foreign Trusts. The
repeal does not apply to foreign trusts, or (except to the
extent permitted by regulations) to domestic trusts that
were at one time foreign trusts. I.R.C. § 665(c)(1).
b. Pre-March '84 Multiple Trusts. The repeal also
does not apply to trusts created before March 1, 1984
unless it can be established that the "multiple trust" rule
described in Section 643(f) does not apply. I.R.C.
§ 665(c)(2). Section 643(f) applies to aggregate
multiple trusts if: (i) the trusts have substantially the
same grantor and primary beneficiary; and (ii) a
principle purpose of the trusts is the avoidance of
income tax. Note that the statute seems to require the
taxpayer to establish the non-applicability of the
multiple trust rule. Therefore, beneficiaries of preMarch 1, 1984 trusts may still be required to undertake
this computation if they are beneficiaries of more than
one trust created by the same grantor.
c. Sales within Two Years. Also repealed is the
somewhat related rule taxing trusts that sell property
within two years of contribution at the tax rate of the
grantor. This change applies to sales or exchanges after
the date of enactment. Former I.R.C. § 644.
III. THE TOP TEN THINGS THAT ESTATE
PLANNERS NEED TO KNOW ABOUT INCOME
TAX MATTERS
With apologies to David Letterman, here is my
own personal list of the top ten income tax issues that
every estate planner should know. I don't pretend to
present them in order of importance (or, for that matter,
in any particular order). There are certainly other
income tax issues that merit consideration. (Send your
favorites to me at mdavis@mrd-law.com. I'll try to
work them into the next version of this outline.)
Mastery of these ten, however, should give you a good
background in fundamental income tax issues that arise
in the estate planning and administration context.
Most estate planners think of an inheritance as being
free from income tax. I.R.C. § 102(a). Nevertheless, I
start my "top ten list" with four important income tax
issues that arise when estate assets are distributed.
These areas are the carry out of estate income; the
recognition of gain by the estate at the time of funding
certain gifts; the impact upon beneficiaries of making
unauthorized non-pro rata distributions of assets in
kind; and the impact of distributing IRD assets. The
income tax effect of estate distributions is an important
area both in terms of language included in the
governing instrument and the steps taken and elections
made by the executor in the administration of the estate.
1. E STATE D ISTRIBUTIONS C ARRY O UT
DISTRIBUTABLE NET INCOME. The general rule is that
Income Tax Matters
any distribution from an estate will carry with it a
portion of the estate's distributable net income ("DNI").
Estate distributions are generally treated as coming first
from the estate's current income, with tax free
distributions of "corpus" arising only if distributions
exceed DNI. If distributions are made to multiple
beneficiaries, DNI is allocated to them pro rata.
Example 2: Assume A and B are beneficiaries of an
estate worth $1,000,000. During the year, the executor
distributes $200,000 to A and $50,000 to B. During the
same year, the estate earns income of $100,000. Unless
the separate share rule discussed at page 6 below
applies, the distributions are treated as coming first
from estate income, and are treated as passing to the
beneficiaries pro rata. Therefore, A will report income
of $80,000 ($100,000 x ($200,000/$250,000)); B will
report income of $20,000 ($100,000 x
($50,000/$250,000)). The estate will be entitled to a
distribution deduction of $100,000. If the estate had
instead distributed only $50,000 to A and $25,000 to B,
each would have included the full amount received in
income, the estate would have received a $75,000
distribution deduction, and would have reported the
remaining $25,000 as income on the estate's income tax
return.
Section 663 (b) of the Code has permitted complex
trusts to treat distributions made during the first 65 days
of the trust's tax year as though they were made on the
last day of the preceding tax year. This election enables
trustees to take a second look at DNI after the trust's
books have been closed for the year, to shift income out
to beneficiaries. The Taxpayer Relief Act of 1997
extends the application of the 65 day rule to estates for
tax years beginning after August 5, 1997. As a result,
for example, the executor of an estate can make
distributions during the first 65 days of Year 2, and
elect to treat them as though they were made on the last
day of Year 1. If the executor makes this election, the
distributions carry out the estate's Year 1 DNI, and the
beneficiaries include the distributions in income as
though they were received on the last day of the estate's
Year 1 fiscal year.
The general rule regarding DNI carry-out is subject to
some important exceptions.
a. Specific Sums of Money and Specific Property.
Section 663(a)(1) of the Code contains a special
provision relating to gifts or bequests of "a specific sum
of money" or "specific property." If the executor pays
these gifts or bequests all at once, or in not more than
three installments, the distributions will effectively be
treated as coming from the "corpus" of the estate. As a
result, the estate will not receive a distribution
deduction for these distributions. By the same token,
5
the estate's beneficiaries will not be taxed on the estate's
DNI as a result of the distribution.
i.
Requirement of Ascertainability. In order to
qualify as a gift or bequest of "a specific sum of
money" under the Treasury Regulations, the amount of
the bequest of money or the identity of the specific
property must be ascertainable under the terms of the
governing instrument as of the date of the decedent's
death. In the case of the decedent's estate, the
governing instrument is the decedent's Will.
ii. Formula Bequests. Under the Treasury Regulations, a marital deduction or credit shelter formula
bequest typically does not qualify as a gift of "a specific
sum of money." The identity of the property and the
exact sum of money specified are both dependent upon
the exercise of the executor's discretion. For example,
if the executor elects to deduct administration expenses
on the estate's income tax return, the amount of the
formula marital gift will be higher than if those
expenses are deducted on the estate tax return. Since
the issues relating to the final computation of the
marital deduction or credit shelter bequest cannot be
resolved on the date of the decedent's death, the IRS
takes the position that the bequest will not be
considered "a specific sum of money." Treas. Reg.
§ 1.663(a)-1(b)(1); Rev. Rul. 60-87, 1960-1 C.B. 286.
Thus, funding of formula bequests whose amounts
cannot be ascertained at the date of death does carry out
distributable net income from the estate.
iii. Payments from Current Income. In addition,
amounts that an executor can pay, under the express
terms of the will, only from current or accumulated
income of the estate will carry out the estate's
distributable net income. Treas. Reg. § 1.663(a)1(b)(2)(i).
iv. Distributions of Real Estate Where Title has
Vested. The transfer of real estate does not carry out
DNI when conveyed to the devisee thereof if, under
local law, title vests immediately in the distributee,
even if subject to administration. Treas. Reg.
§ 1.661(a)-2(e); Rev. Rul. 68-49, 1968-1 C.B. 304.
Title vests immediately under Section 37 of the Texas
Probate Code. See Welder v. Hitchcock, 617 S.W.2d
294, 297 (Tex. Civ. App.--Corpus Christi 1981, writ
ref'd n.r.e.). Therefore, a transfer by an executor of real
property to the person or entity entitled thereto should
not carry with it any of the estate's distributable net
income. Presumably, this rule applies both to specific
devisees of real estate and to devisees of the residue of
the estate. Otherwise, the no-carry-out rule would be
subsumed within the more general rule that specific
bequests do not carry out DNI. Rev. Rul. 68-49,
1968-1 C.B. 304. Note, however, that the IRS Office of
the Chief Counsel recently released an IRS Service
6
Center Advice Memorandum (SCA 1998-012) which
purports to limit this rule to specifically devised real
estate (not real estate passing as part of the residuary
estate) if the executor has substantial power and control
over the real property (including a power of sale).
b. The Separate Share Rule. Generally, in the
context of estate distributions made to multiple
beneficiaries, DNI is carried out pro rata among the
distributees of the estate. For example, in a year in
which the estate has $10,000 of DNI, if the executor
distributes $15,000 to A and $5,000 to B, A will
include $7,500 of DNI in his income, and B will
include $2,500 in his income, since the distributions
were made 75% to A and 25% to B. The Taxpayer
Relief Act of 1997 has made a substantial modification
to the pro rata rule by applying the "separate share rule"
to estates. Under this rule, DNI is allocated among
estate beneficiaries based upon distributions of their
respective "share" of the estate's DNI. I.R.C. § 663(c).
The Committee Report describing this change provides
that there are separate shares of an estate "when the
governing instrument of the estate (e.g., the will and
applicable local law) creates separate economic
interests in one beneficiary or class of beneficiaries
such that the economic interests of those beneficiaries
(e.g., rights to income or gains from specific items of
property) are not affected by economic interests
accruing to another separate beneficiary or class of
beneficiaries."
The IRS has now issued final
regulations applying the separate share rules to estates.
See T.D. 8849, 2000-2 I.R.B. 245; Treas. Reg.
§ 1.663(c)-4. As a result of this change, the executor
will have to determine whether the Will (or the intestate
succession law) creates separate economic interests in
one beneficiary or class of beneficiaries.
Example 3: A Will bequeaths all of the decedent's
IBM stock to X and the balance of the estate to Y.
During the year, the IBM stock pays $20,000 of
dividends. No other income is earned. The executor
distributes $20,000 to X and $20,000 to Y. Prior to the
adoption of the separate share rule, the total
distributions to X and Y would have simply been
aggregated and the total DNI of the estate in the year of
distribution would have been carried out pro rata.
Under the separate share rules, the distribution of
$20,000 to X carries out all of the DNI to X. No DNI
is carried out to Y. Thus, application of the separate
share rule more accurately reflects the economic
interests of the beneficiaries resulting from estate
distributions.
Distributions to beneficiaries who don't have "separate
shares" continue to be subject to the former "pro rata"
rules. As noted above, application of the separate share
rule is mandatory. The executor doesn't elect separate
share treatment, nor may it be elected out of.
2007 DOCKET CALL IN PROBATE COURT
Apparently, application of the separate share rules to
estates was simply one of a host of small statutory
changes that sought to bring the taxation rules for trusts
and estates in line with one another. In practice,
however, application of the separate share rules to
estates may prove to be very complex. Unlike separate
share trusts, which are typically divided on simple
fractional lines (e.g., "one-third for each of my
children") the "shares" of estates may be hard to
identify, let alone account for. Under the final
Regulations, a revocable trust that elects to be treated as
part of the decedent's estate is a separate share. The
residuary estate (and each portion of a residuary estate)
is a separate share. A share may be considered as
separate even though more than one beneficiary has an
interest in it. For example, two beneficiaries may have
equal, disproportionate, or indeterminate interests in
one share which is economically separate and
independent from another share in which one or more
beneficiaries have an interest. Moreover, the same
person may be a beneficiary of more than one separate
share. A bequests of a specific sum of money paid in
more than three installments (or otherwise not
qualifying as a specific bequest under Section 663(a)(1)
of the Code) is a separate share. If the residuary estate
is a separate share, than presumably pre-residuary
pecuniary bequests (such as marital deduction formula
bequests) are also separate shares. For a good
discussion of some of the complexities associated with
the application of the separate share rules to estates, see
Cantrell, Separate Share Regulations Propose
Surprising Changes, TRUSTS & ESTATES, March 1999
at 56.
c. Income From Property Specifically Bequeathed.
The 2003 Texas Legislature enacted two major pieces
of legislation that affect the administration of trusts in
Texas. These statutes, the Uniform Prudent Investor
Act and the Uniform Principal and Income Act (dubbed
by the estate planning community as the "UPIA
Twins") apply to all trusts existing on or created after
January 1, 2004. For existing trusts, the new rules
apply to all acts or decisions relating to the trust
occurring after December 31, 2003. Section 378B of
the Probate Code now provides that income from the
assets of a decedent's estate that accrues after the date
of death of the testator and before distribution, is to be
allocated as provided in the Texas Uniform Principal
and Income Act. See also Zahn v. National Bank of
Commerce, 328 S.W.2d 783 (Tex. Civ. App.--Dallas,
1954, writ ref'd n.r.e.). Historically, if the property was
distributed by the estate, together with the income to
which the devisee was entitled, the distribution of
income might or might not have been treated as taxable
income by the beneficiary. Until the adoption of the
separate share rules, DNI was distributed on a pro rata
basis among all beneficiaries receiving distributions.
The items of income were not specifically identified
Income Tax Matters
7
and traced. As a result, the beneficiary may well have
been taxed not on the income item actually received,
but on his or her pro rata share of all income distributed
to beneficiaries. However, since the income earned on
property specifically bequeathed appears to be a
"separate economic interest . . .", the separate share
rules should change this result. This change means that
if an estate makes a current distribution of income from
specifically bequeathed property to the devisee of the
property, the distribution will carry the DNI associated
with it out to that beneficiary, regardless of the amount
of the estate's other DNI or distributions. If the estate
accumulates the income past the end of its fiscal year,
the estate itself will pay tax on the income. When the
income is ultimately distributed in some later year, the
beneficiary will be entitled to only the net (after tax)
income under Section 378B of the Texas Probate Code.
In addition, the later distribution should not carry out
DNI under the separate share rules, since it is not a
distribution of current income, and since the
accumulation distribution throwback rules (which still
apply to certain pre-1985 trusts) do not apply to estates.
As this example illustrates, the separate share rules,
while complex to administer, have the advantage of
making the income tax treatment of estate distributions
more closely follow economic reality.
by an in-kind distribution to a beneficiary is the lesser
of the adjusted basis of the property prior to
distribution, or the fair market value of the property at
the time of the distribution. I.R.C. § 643(e). The estate
does not generally recognize gain or loss as a result of
making a distribution to a beneficiary. This general
rule is subject to some important exceptions.
d. Interest on Pecuniary Bequests. The Texas
Uniform Principal and Income Act requires that a
devisee of a pecuniary bequest (that is, a gift of a fixed
dollar amount), whether or not in trust, is entitled to
interest on the bequest, beginning one year after the
date of death. Tex. Prop. Code § 116.051(3). The
amount of interest that will be paid on pecuniary
bequests is the legal rate of interest on open accounts
provided for under Section 302.002 of the Texas
Finance Code (currently, six percent). The provision
for paying interest on pecuniary bequests does not limit
itself to payments from estate income. The executor
must charge this "interest" expense to income in
determining the estate's "net" income to be allocated to
other beneficiaries. Tex. Prop. Code § 116.051(4).
Note that former Section 378B(f), which started the
running of interest one year after Letters Testamentary
were issued, was repealed by the legislature in favor of
the new provisions of the Trust Code. Unfortunately,
it was then later re-enacted (apparently unintentionally)
in legislation correcting references to the Texas
Finance Code. Presumably only the Trust Code
provision applies. For a discussion of the income tax
issues associated with the deductibility of this interest
payment by the estate, see page 19, below
Example 4. A formula gift requires an executor to
distribute $400,000 worth of property. If the executor
funds this bequest with assets worth $400,000 at the
time of distribution, but worth only $380,000 at the date
of death, the estate will recognize a $20,000 gain.
2. AN ESTATE MAY RECOGNIZE GAINS AND
LOSSES WHEN IT MAKES DISTRIBUTIONS IN KIND.
Unless a specific exception applies, all estate
distributions, whether in cash or in kind, carry out the
estate's DNI. Generally, the amount of DNI carried out
a. Distributions Satisfying the Estate's Obligations.
Distributions which satisfy an obligation of the estate
are recognition events for the estate. The fair market
value of the property is treated as being received by the
estate as a result of the distribution, and the estate will
recognize any gain or loss if the estate's basis in the
property is different from its fair market value at the
time of distribution. Rev. Rul. 74-178, 1974-1 C.B.
196. Thus, for example, if the estate owes a debt of
$10,000, and transfers an asset worth $10,000 with a
basis of $8,000 in satisfaction of the debt, the estate
will recognize a $2,000 gain.
b. Distributions of Assets to Fund Pecuniary Gifts.
A concept related to the "discharge of obligation"
notion is a distribution of assets to fund a bequest of "a
specific dollar amount," including a formula pecuniary
bequest.
The rules governing this area should not be confused
with the "specific sum of money" rules which govern
DNI carry outs. Unless the formula language is drawn
very narrowly, most formula gifts do not constitute gifts
of a "specific sum of money," exempt from DNI
carryout, because they usually cannot be fixed exactly
at the date of death (for example, most formula marital
bequests must await the executor's determination of
whether administration expenses will be deducted on
the estate tax return or the estate's income tax return
before they can be computed). Such gifts are, however,
treated as bequests of "a specific dollar amount" for
gain recognition purposes, regardless of whether they
can be precisely computed at the date of death. As a ,
result, gains or losses we be recognized by the estate if
the formula gift describes a pecuniary amount to be
satisfied with date-of-distribution values, as opposed to
a fractional share of the residue of the estate. Compare
Treas. Reg. § 1.663(a)-1(b) (to qualify as bequest of
specific sum of money or specific bequest of property,
and thereby avoid DNI carry-out, the amount of money
or the identity of property must be ascertainable under
the will as of the date of death) with Treas. Reg.
§ 1.661(a)-2(f)(1) (no gain or loss recognized unless
distribution is in satisfaction of a right to receive a
8
specific dollar amount or specific property other than
that distributed). See also Treas. Reg. § 1.1014-4(a)(3);
Rev. Rul. 60-87, 1960-1 C.B. 286. For fiscal years
beginning on or before August 1, 1997, estates could
recognize losses in transactions with beneficiaries.
Although the Taxpayer Relief Act of 1997 repealed this
rule for most purposes, an estate may still recognize a
loss if it distributes an asset that has declined in value
in satisfaction of a pecuniary bequest.
I.R.C.
§ 267(b)(13). Note, however, that loss recognition is
denied to trusts used as estate surrogates as a result of
the related party rules of Section 267(b)(6) of the Code,
except for qualified revocable trusts electing to be
treated as estates under Section 646 of the Code.
c. Pension and IRA Accounts Used to Fund
Pecuniary Bequests. Several commentators have
argued that if a pension asset is used to satisfy a
pecuniary legacy, the use of that asset will be treated as
a taxable sale or exchange, and this treatment will
accelerate the income tax due. This analysis is based
upon Treasury Regulation 1.661(a)-2(f)(1), which
requires an estate to recognize gain when funding a
pecuniary bequest with an asset whose fair market
value exceeds its basis, as though the asset is sold for
its fair market value at the date of funding. See Rev.
Rul. 60-87, 1960-1 C.B. 286. If an estate uses an asset
constituting income in respect of a decedent to satisfy
a pecuniary bequest, application of this principle would
cause the gain to be accelerated. In this author's
opinion, however, it can be persuasively argued that
this acceleration will not occur if the beneficiary is not
the estate, but the trustee named in the participant's
Will. Three lines of analysis confirm this result:
i.
No Receipt By Estate. The recognition rules
under Treasury Regulation Section 1.661(a)-2(f)(1)
apply only in the context of a distribution by the estate
in satisfaction of a right to receive a specific dollar
amount. When a "testamentary trustee" is named as the
beneficiary of a pension plan or IRA, there is clearly no
distribution by the estate, and no acceleration event
should occur to the estate. The estate, after all, is
subjected to taxation only on income received by the
estate during the period of administration or settlement
of the estate. I.R.C. § 641(a)(3). Pension benefits
payable directly to the trustee of the trust established
under the Will of the plan participant are never
"received by the estate." This fact remains true even if
the Will contains instructions directing the testamentary
trustee to use these funds in whole or in part to fund a
pecuniary bequest. The fact that the executor takes
these non-testamentary transfers into account in
measuring the amount of other amounts needed to fund
the pecuniary bequest should not change this result.
Since the non-probate pension assets are not subject to
administration, the estate cannot properly be said to be
2007 DOCKET CALL IN PROBATE COURT
the taxpayer with respect to any transaction involving
these benefits.
ii. No IRD Transfer by Estate. Separate and apart
from the gain recognition rules of Treasury Regulation
Section 1.661(a)-2(f)(1) is the IRD recognition rule of
Section 691 of the Code. However, the recognition
rules of Section 691(a)(2) of the Code, by their terms,
apply only if the right to receive income in respect of a
decedent is transferred "by the estate of the decedent or
a person who receives such right by reason of the death
of the decedent . . ." (emphasis added). If the
testamentary trustee is the beneficiary, there is simply
no transfer by the estate. Moreover, there is no transfer
by any "person" who receives such right by reason of
the decedent's death. The Code expressly excludes
from the definition of "transfer" requiring IRD
acceleration any "transmission at death . . . to a person
pursuant to the right of such person to receive such
amount by reason of the death of the decedent . . .".
I.R.C. § 691(a)(2) (emphasis added). In that event, the
recipient (here, the trust) includes these amounts in
gross income not when the right to the payment is
received, but only when the payments themselves (i.e.,
the distributions from the retirement plan) are actually
received. I.R.C. § 691(a)(1)(B).
iii. Constructive Receipt Rules. The general rules
which describe the timing of recognition for income
attributable to an IRD asset are reinforced by the
statutes expressly governing pension distributions.
Amounts held in qualified plans and IRA's are taxable
to the recipient only when actually distributed. I.R.C.
§§ 72, 402(a). The mere fact that benefits under the
plan or IRA are made available, or that the participant
or beneficiary has access to them, is not determinative,
since the constructive receipt rules do not apply to
these assets. I.R.C. §§ 402(a)(1), 408.
Therefore, if the
iv. Proper Tax Treatment.
testamentary trustee receives, whether by a spouse's
disclaimer or by direct designation by the participant,
the right to receive plan distributions, no income tax
should be payable until such time as distributions are
actually made from the plan or IRA to the trust, even if
the assignment of the right to receive plan assets
otherwise reduces (or eliminates) the amount that the
estate needs to distribute in satisfaction of a pecuniary
bequest. Instead, the testamentary trust should be able
to defer taxation on pension and IRA proceeds until
such time as those accounts are distributed (which may
be until they are required to be distributed in
accordance with the minimum required distribution
rules). See PLR 9630034 (pecuniary disclaimer by
spouse of ½ interest in decedent's IRA does not cause
recognition to spouse or estate).
Income Tax Matters
d. Section 643(e)(3) Election. The executor may
elect under Section 643(e)(3) of the Code to recognize
gain and loss on the distribution of appreciated and
depreciated property. If this election is made, the
amount of the distribution for income tax purposes will
be the fair market value of the property at the time of
the distribution. The Section 643(e) election must be
made on an "all or nothing" basis, so that the executor
may not select certain assets and elect to recognize gain
or loss on only those assets. Of course, if the executor
wants to obtain the effect of having selected certain
assets, he or she may actually "sell" the selected assets
to the beneficiary for the fair market value of those
assets, recognizing gain in the estate. The executor can
thereafter distribute the sales proceeds received to the
beneficiary who purchased the assets. Note that if an
executor makes a Section 643(e)(3) election in a year
that an IRD asset is distributed by the estate, gain
would be accelerated, even if the distribution is
otherwise subject to a Section 691(a)(2) exception,
since the asset representing the IRD will be treated as
having been sold by the estate in that year. For fiscal
years beginning after August 1, 1997, the Section
643(e)(3) election (or an actual sale to a beneficiary)
can cause the estate to recognize gains, but not losses,
since under the principles of Section 267 of the Code,
the estate and its beneficiary are now treated as related
taxpayers. I.R.C. § 267(b)(13).
3. ESTATE BENEFICIARIES MAY RECOGNIZE
GAINS AND LOSSES IF THE ESTATE MAKES
UNAUTHORIZED NON PRO RATA DISTRIBUTIONS IN
KIND. If an estate makes unauthorized non-pro rata
distributions of property to its beneficiaries, the IRS has
ruled that the distributions are equivalent to a pro rata
distribution of undivided interests in the property,
followed by an exchange of interests by the
beneficiaries. This deemed exchange will presumably
be taxable to both beneficiaries to the extent that values
differ from basis. Rev. Rul. 69-486, 1969-2 C.B. 159.
Example 5: A decedent's estate passes equally to A and
B, and contains two assets, stock and a farm. At the
date of death, the stock was worth $100,000 and the
farm worth $110,000. At the date of distribution, each
are worth $120,000. If the executor gives the stock to
A and the farm to B and if the will fails to authorize
non-pro rata distributions, the IRS takes the view that
A and B each received one-half of each asset from the
estate. A then "sold" his interest in the farm (with a
basis of $55,000) for stock worth $60,000, resulting in
a $5,000 gain to A. Likewise, B "sold" his interest in
the stock (with a basis of $50,000) for a one-half
interest in the farm worth $60,000, resulting in a
$10,000 gain to B. To avoid this result, the governing
9
instrument should expressly authorize non-pro rata
distributions.
See page 19 for a discussion of an analogous issue in
the context of non-pro rata divisions of community
property between the estate and the surviving spouse.
INCOME IN RESPECT OF A DECEDENT IS TAXED
TO THE RECIPIENT. A major exception to the rule that
4.
an inheritance is income tax free applies to beneficiaries
who receive payments that constitute income in respect
of a decedent. I.R.C. § 691.
a. IRD Defined. Income in respect of a decedent
("IRD") is not defined by statute, and the definition in
the Treasury Regulations is not particularly helpful.
Generally, however, IRD is comprised of items which
would have been taxable income to the decedent if he
or she had lived, but because of the decedent's death
and tax reporting method, is not includable in the
decedent's final Form 1040. Examples of IRD include
accrued interest; dividends declared but not payable;
unrecognized gain on installment obligations; bonuses
and other compensation or commissions paid or payable
following the decedent's death; and amounts in IRAs
and qualified benefit plans upon which the decedent has
not been taxed. A helpful test for determining whether
an estate must treat an asset as IRD is set forth in Estate
of Peterson v. Commissioner, 667 F.2d 675 (8th Cir.
1981). The estate's basis in an IRD asset is equal to its
basis in the hands of the decedent. No step-up is
provided. I.R.C. § 1014(c).
b. Recognizing IRD. If the executor distributes an
IRD asset in a manner which will cause the estate to
recognize gain on the distribution, or if a Section
643(e)(3) election is made and the asset is distributed in
the year of the election, the result will be to tax the
income inherent in the item to the decedent's estate.
Absent one of these recognition events, if the estate of
the decedent transmits the right to an IRD asset to
another person who would be entitled to report that
income when received, the transferee, and not the
estate, will recognize the income. Thus, if a right to
IRD is transferred by an estate to a specific or residuary
legatee, only the legatee must include the amounts in
income when received. Treas. Reg. § 1.691(a)-4(b)(2).
If IRD is to be recognized by the estate, the tax costs
may be substantial. In a setting where a substantial
IRD asset is distributed from the estate in a manner
causing recognition, a material decrease in the amount
passing to other heirs might result.
Example 6: In 2007, X dies with a $2.5 million estate.
The Will makes a formula marital gift of $500,000 to
the spouse, leaving the rest of the estate to a bypass
trust. If an IRD asset worth $500,000 but with a basis
10
of $0 is used to fund this marital gift, the estate will
recognize a $500,000 gain. The spouse will receive the
$500,000 worth of property, but the estate will owe
income tax of some $173,900, presumably paid from
the residue of the estate passing to the bypass trust.
Payment of this tax would leave only $1,826,100 to
fund the bypass trust.
Under these circumstances, the testator may wish to
consider making a specific bequest of the IRD asset to
insure that the income will be taxed to the ultimate
beneficiary as received, and will not be accelerated to
the estate.
c. Deductions in Respect of a Decedent. A concept
analogous to income in respect of a decedent is applied
to certain deductible expenses accrued at the date of the
decedent's death. Those "deductions in respect of a
decedent" ("DRD") are allowable under Code Section
2053(a)(3) for estate tax purposes as claims against the
estate, and are also allowed as deductions in respect of
a decedent for income tax purposes to the person or
entity paying those expenses. I.R.C. § 691(b). The
general rule disallowing both income and estate tax
deductions for administration expenses, discussed
below at page 10 does not apply to DRD. The theory
behind allowing this "double" deduction is that had the
decedent actually paid this accrued expense prior to
death, he could have claimed an income tax deduction,
and the cash on hand in his estate would be reduced,
thereby effecting an estate tax savings as well. Of
course, interest, administration expenses, and other
items not accrued at the date of the decedent's death are
subject to the normal election rules of Section 642(g) of
the Code discussed below.
5. IMPACT OF DEATH UPON BASIS.
Most
practitioners describing the impact of death upon basis
use a kind of short-hand by saying that assets get a
"step-up" in basis at death. In inflationary times, this
oversimplification is often accurate. However, it is
important to remember that the basis of an asset may
step up or down. For most assets, the original cost
basis in the hands of the decedent is simply irrelevant.
It is equally important to remember that the basis
adjustment rule is subject to some important exceptions.
a. General Rule. In general, the estate of a decedent
receives a new cost basis in its assets equal to the fair
market value of the property at the appropriate valuation date. I.R.C. § 1014. In most cases, the basis is the
date-of-death value of the property. However, if the
alternate valuation date for estate property has been
validly elected, that value fixes the cost basis of the
estate's assets. I.R.C. § 1014(a)(3). The basis
adjustment rule also applies to a decedent's assets held
by a revocable trust used as an estate surrogate, since
they are deemed to pass from the decedent pursuant to
2007 DOCKET CALL IN PROBATE COURT
Sections 2036 and 2038 of the Code. Although often
called a "step up" in basis, various assets may be
stepped up or down as of the date of death. The
adjustment to the basis of a decedent's assets occurs
regardless of whether the estate is large enough to be
subject to federal estate tax. Original basis is simply
ignored and federal estate tax values are substituted.
Note that the new cost basis applies not only to the
decedent's separate property but also to both halves of
the community property owned by a married decedent.
I.R.C. § 1014(b)(6).
b. Exceptions. There are two important exceptions
to the basis adjustment rule.
i.
No New Basis for IRD. Items which constitute
income in respect of a decedent receive a carryover
basis. I.R.C. § 1014(c). This rule is necessary to
prevent recipients of income in respect of a decedent
from avoiding federal income tax with respect to items
in which the income receivable by a decedent was
being measured against his basis in the asset.
ii. No New Basis for Deathbed Transfers to
Decedent. Section 1014(e) of the Code provides a
special exception for appreciated property given to a
decedent within one year of death, which passes from
the decedent back to the donor as a result of the
decedent's death. This rule is presumably designed to
prevent avaricious taxpayers from transferring property
to dying individuals, only to have the property
bequeathed back to them with a new cost basis.
6. THE EXECUTOR CAN ELECT TO DEDUCT MANY
EXPENSES FOR EITHER INCOME OR ESTATE TAX
PURPOSES (BUT NOT BOTH). An executor is often
confronted with a choice of deducting estate
administration expenses on the estate tax return, or the
estate's income tax return. In most instances, double
deductions are disallowed. I.R.C. § 642(g). Between
1986 and 1992, the decision about where to deduct an
expense was simplified by the fact that the lowest
effective federal estate tax bracket (37%) was always
higher than the highest marginal income tax bracket
applied to estates (typically 31%). If estate tax was
due, a greater tax benefit was always obtained by
deducting expenses on the estate tax return. Between
1993 and 2003, the analysis was more difficult. Now
that the highest income tax bracket for estates is 35%,
while the lowest effective estate tax bracket is 45%, the
old analysis once again applies.
a. Section 642(g) Expenses. The executor must
make an election to take administration expenses as a
deduction for income tax purposes by virtue of Section
212 of the Code, or to deduct those same expenses as
an estate tax deduction under Section 2053 of the Code.
Income Tax Matters
No double deduction is permitted. Expenses to which
this election applies include executors' fees, attorneys'
fees, accountants' fees, appraisal fees, court costs, and
other administration expenses, provided that they are
ordinary and necessary in collection, preservation, and
management of the estate. There is no requirement that
the estate be engaged in a trade or business or that the
expenses be applicable to the production of income.
Treas. Reg. § 1.212-1(i). Note, however, that expenses
attributable to the production of tax-exempt income are
denied as an income-tax deduction to estates, just as
they are to individuals, under Section 265(1) of the
Code.
Interest on estate taxes deferred under
Section 6166 of the Code, which now accrues at only
45% of the regular rate for interest on under payments,
is no longer allowed as an estate tax or on income tax
deduction. I.R.C. §§ 2053(c)(1)(D); 163(k).
b. Method of Election. Technically, the Code and
Treasury Regulations require the executor to file with
the estate's income tax return a statement, in duplicate,
to the effect that the items have not been allowed as
deductions from the gross estate of the decedent under
Section 2053 or 2054 and that all rights to have such
items allowed at any time as deductions under
Section 2053 or 2054 are waived. Treas. Reg.
§ 1.642(g)-1. Some executors tentatively claim
expenses on both returns, filing the income tax return
waiver statement only after the estate has received a
closing letter and deductions on the estate tax return
have proven unnecessary. This approach can be
dangerous, however, if deductions are taken on the
estate tax return, and the estate receives a closing letter
without examination of or adjustment to the return.
Under these circumstances, presumably, the income tax
waiver statement could not lawfully be filed, since the
deductions in question will have been "allowed" as
deductions from the gross estate.
c. Payments From Income. Increased attention has
been focused on the interaction of state law and tax
rules in determining whether estate administration
expenses are chargeable to principal or income. The
importance of this issue is illustrated by Commissioner
v. Estate of Hubert, 117 S.Ct. 1124 (1997) where the
executor charged administration expense to estate
income for both state law and tax law purposes. The
IRS held that such an allocation constituted a "material
limitation" on the rights to income otherwise afforded
recipients of marital and charitable gifts, and denied
estate tax deductions for the gifts to which these
expenses were allocated. After litigating the issue all
the way to the United States Supreme Court, limited
guidance was given. The "plurality" opinion held that,
under the facts presented, the executor's decision to
charge expenses to income did not constitute a
"material limitation" on the interest passing to the
surviving spouse. In a somewhat more comprehensible
11
concurring opinion written by Justice O'Connor, she
noted that the measure of materiality is a matter within
the province of the Commissioner to set forth by
regulation. Since the regulations that were in force at
the date of death did not establish a test for materiality,
and since the Tax Court opinion in this case was
consistent with current law and regulations, no loss of
the marital deduction was appropriate in this particular
case. Justice O'Connor specifically noted, however
that "[t]here is no reason why this labyrinth should
exist, especially when the Commissioner is empowered
to promulgate new regulations and make the answer
clear. Indeed, nothing prevents the Commissioner from
announcing by regulation the very position she
advances in this litigation."
d. Regulatory Guidance. Not surprisingly, the
Treasury Department, responding to Justice O'Connor's
invitation, has announced new regulations providing
guidance on this issue. Treas. Reg. §§ 20.2013-4(b)(3),
20.2055-3; 20.2056(b)-4(d). Unlike the "material
limitation" rules under the prior regulations, the new
regulations permit deductions depending upon the
nature of the expenses in question. The regulation
provides that "estate management expenses" may be
deducted as an income tax deduction (but not as an
administrative expense for estate tax purposes) without
reducing the marital or charitable deduction. Expenses
that constitute "estate transmission expenses" will
require a dollar for dollar reduction in the amount of
marital or charitable deduction.
e. Estate Management Expenses. Estate management expenses are "expenses incurred in connection
with the investment of the estate assets and their
preservation and maintenance during a reasonable
period of administration. Examples of these expenses
include investment advisory fees, stock brokerage
commissions, custodial fees and interest." Treas. Reg.
§§ 20.2055-3(b)(1)(i) ; 20.2056(b)-4(d)(1)(i).
f.
Estate Transmission Expenses.
Estate
transmission expenses are all estate administration
expenses that are not estate management expenses.
These expenses reduce the amount of the marital or
charitable deduction if they are paid out of assets that
would otherwise pass to the surviving spouse or to
charity. Estate transmission expenses include expenses
incurred as a result of the "consequent necessity of
collecting the decedent's assets, paying the decedent's
debts and death taxes, and distributing the decedent's
property to those who are entitled to receive it."
Examples of these expenses could include executor
commissions and attorney fees (except to the extent of
commissions or fees specifically related to investment,
preservation, and maintenance of assets), probate fees,
expenses incurred in construction proceedings and
defending against Will contests, and appraisal fees.
12
Treas. Reg. §§ 20.2055-3(b)(1)(ii); 20.2056(b)4(d)(1)(ii).
g. Reduction for Unrelated Estate Management
Expenses. In addition to reductions for estate
transmission expenses, the final regulations require that
the marital deduction be reduced by the amount of any
estate management expenses that are "paid from the
marital share but attributable to a property interest not
included in the marital share." Treas. Reg §20.2056(b)4(d)(1)(iii)(4). Similar language is applied to charitable
gifts. Treas. Reg. § 20.2055-3(b)(4).
h. Special Rule for Estate Management Expenses
Deducted on Estate Tax Return. If estate management
expenses are deducted on the estate tax return, the
marital or charitable deduction must be reduced by the
amount of any estate management expenses "that are
deducted under section 2053 on the decedent's Federal
estate tax return." Treas. Reg. §§ 20.2055-3(b)(3);
20.2056(b)-4(d)(3). The justification for this position
is the language in Section 2056(b)(9) of the Code,
which provides that nothing in section 2056 or any
other estate tax provision shall allow the value of any
interest in property to be deducted for federal estate tax
purposes more than once with respect to the same
decedent.
Example 7: $150,000 of life insurance proceeds pass
to the decedent's child, and the balance of the estate
passes to the surviving spouse. The decedent's
applicable credit amount had been fully utilized prior to
death. If estate management expenses of $150,000
were deducted for estate tax purposes, the marital
deduction would have to be reduced by $150,000.
Otherwise, the estate "would be taking a deduction for
the same $150,000 in property under both sections 2053
and 2056." As a result, the deduction would have the
effect of sheltering from estate tax $150,000 of the
insurance proceeds passing to the decedent's child.
Treas. Reg § 20.2056(b)-4(d)(5), Ex.4.
i.
Effective Date. The new regulation apply to
estates of decedents dying on or after December 3,
1999. Treas. Reg. §§ 20.2055-3(b)(7); 20.2056(b)4(d)(6).
7. WHEN AN ESTATE OR TRUST ALLOCATES
"INCOME," THAT MEANS FIDUCIARY ACCOUNTING
INCOME, NOT TAXABLE INCOME. Estate planning
attorneys that spend too much of their time studying tax
rules sometimes forget that not every situation is
governed by the Internal Revenue Code. Nowhere is
this failure more prevalent that in the area of allocating
and distributing estate and trust "income." In general,
when a trust (or the income tax rules applicable to
estates and trusts) speaks of "income" without any
2007 DOCKET CALL IN PROBATE COURT
modifier, it means fiduciary accounting income, and not
taxable income. I.R.C. § 643(b). In measuring
fiduciary accounting income, the governing instrument
and local law, not the Internal Revenue Code, control.
Therefore, estate planners should have a basic
understanding of these state law rules.
a. Look to the Governing Instrument. Beginning
January 1, 2004, trusts and estates are governed by the
new Texas Uniform Principal and Income Act. The
new Act provides that allocations between income and
principal will be made in accordance with the specific
provisions of the governing instrument. Provisions in
the a Will or trust agreement should therefore control
allocations of income and expense, so long as they are
specific enough to show that the testator or grantor
chose to define a specific method of apportionment.
See Interfirst Bank v. King, 722 S.W.2d 18 (Tex. App.
-- Tyler 1986, no writ). In the absence of specific
provisions in the instrument, the provisions of the Act
control allocations between income and principal. Tex.
Prob. Code Ann. § 378B(b); Tex. Prop. Code Ann. §
116.051. Former Section 113.101(b) of the Texas Trust
Code provided that if the governing instrument gave the
trustee the discretion to allocate income or expenses,
the exercise of that discretion in a manner contrary to
the terms of Trust Code was not actionable. Former
Tex. Prop. Code Ann. § 113.101(b). The discretion
was not, however, unlimited. A trustee must not act
outside the bounds of reasonable judgment. Thorman
v. Carr, 408 S.W.2d 259, 260 (Tex. Civ. App.--San
Antonio 1966) aff'd per curium, 412 S.W.2d 45 (Tex.
1967).
b. "Fair and Reasonable" Allocations. The Act now
requires that the fiduciary must make allocations based
upon what is "fair and reasonable" to all beneficiaries,
and further provides that (i) a determination in
accordance with the Act is presumed to be "fair and
reasonable," and (ii) to the extent that the neither the
terms of the governing instrument or the Act provide a
rule for allocating a receipt or disbursement between
principal and income, it is to be allocated to principal.
Tex. Prop. Code § 116.004.
The Texas Bar
Commentary for this section states that the new rule
provides greater protection for fiduciaries by
establishing a certain presumption for "fair and
reasonable" allocations. A court may overturn a
fiduciary's allocations only upon a showing of an abuse
of discretion. Tex. Prop. Code. Ann. § 116.006.
c.
Specific Trust Code Provisions.
(1) A Not-So-Unified Principal and Income Act.
Prior to 2004, principal and income allocations in Texas
were based upon a highly customized version of the
1962 Revised Uniform Principal and Income Act. In
2002, a special legislative committee of the Real Estate,
Income Tax Matters
Probate, and Trust Law Section of the Texas Bar began
studying the 1997 version of the Uniform Principal and
Income Act ("UPIA") promulgated by the Uniform
Laws Commission. This statute has as its stated
purpose to "support the now widespread use of the
revocable living trust as a will substitute, to change the
rules in those Acts that experience has shown need to
be changed, and to establish new rules to cover
situations not provided for in the old Acts, including
rules that apply to financial instruments invented since
1962." The State Bar committee identified a number of
concerns with UPIA, and provided a number of
recommended changes to UPIA prior to its adoption by
the 2003 Texas Legislature. Because of the extent of
the departure from prior law, and the uncertainty that
might arise if the Act were effective in the middle of an
accounting year, the legislature deferred its effective
date until January 1, 2004.
(2) Allocations in General. Section 116.004 of the
Texas Trust Code provides the outline for income and
principal allocations, with detailed guidance on specific
forms of property and activities being provided by
Sections 116.151 through 116.206. Section 116.004
provides five rules for determining how allocations are
to be made:
i.
Terms of the Instrument. Under the first rule, a
fiduciary must administer the trust or estate in
accordance with the terms of the trust instrument or
Will, even if the statute provides some different
provision.
ii. Grants of Discretionary Authority. If the trust
instrument or Will grants the fiduciary the power to
make discretionary allocations, the fiduciary may
administer a trust or estate by the exercise of that
discretionary power of administration, even if the
exercise of the power produces results different from
the results required or permitted under the Act.
iii. Application of the Act. If the governing
instrument does not contain a contrary provision or
grant discretion to the fiduciary, the provisions of the
Act must be follow.
iv. When in Doubt, It's Principal. If no provision of
the governing instrument or the Act controls, the receipt
or disbursement must be allocated to principal.
v. Fair and Reasonable Allocation. Finally, in
exercising a "power to adjust" as outlined below, or a
discretionary power of administration, whether granted
under the governing instrument or the Act, the fiduciary
"shall administer a trust or estate impartially, based on
what is fair and reasonable to all of the beneficiaries,
except to the extent that the terms of the trust or will
clearly manifest an intention that the fiduciary shall or
13
may favor one or more of the beneficiaries." As noted
above, a determination in accordance with the Act is
presumed to be fair and reasonable to all of the
beneficiaries. Tex. Prop. Code Ann. § 116.004.
d.
Accrued Income.
i.
General Rule. Items accrued on the day before the
date of death, such as rent, interest and annuities, are
treated as principal under the Texas Trust Code, even if
those items are considered income (presumably, income
in respect of a decedent) under the tax law. Tex. Prop.
Code § 116.102(a). However, if the income is derived
from an asset that is specifically bequeathed, the
income is distributable to the recipient of that asset.
Tex. Prop. Code § 116.051(l).
ii. Trapping Distributions. A trust which must
distribute all of its "income" (i.e., fiduciary accounting
income measured under the Texas Trust Code) would
be entitled to retain income accrued before the date of
death, since these items are principal under local law.
Tex. Prop. Code § 116.101(b). The effect of retaining
such property may be to trap the taxable income
attributable to this property within the trust. This
trapping of income presents an opportunity to use an
otherwise simple trust as a taxpayer in the year it is
funded. Naturally, since the trust's tax rates reach 35%
at only $10,450.00 in income (for 2007), the tax savings
generated by this technique are limited. In 2007, a
simple trust with $10,750.00 in income ($300.00 of
which would be excluded by the trust's allowance in
lieu of personal exemption) would pay a tax of
$2,701.00 instead of $3,762.5 if the entire $10,750.00
were taxed to a beneficiary in the 35% bracket– a
savings of only $1,061.50.
iii. Post-Death Accruals. Although income accrued
before the date of death is principal, funds received by
a trustee from an estate that constitute the estate's
income under Section 378B of the Texas Probate Code
is treated as trust income under Section 116.152 of the
Texas Trust Code. Tex. Prob. Code Ann. § 378B(g).
Tex. Prop. Code § 116.101(b)(2). Accordingly, this
post-death income passing from the estate to the trust
will not be "trapped."
e. Receipts from Entities. Under the former rules,
cash dividends from corporations were clearly income,
as were distributions of, or rights to subscribe to,
securities of corporations other than the distributing
corporation. Former Tex. Prop. Code Ann. § 113.104.
Distributions from other entities, such as partnerships
and LLCs, were more problematic. Under the Act,
however, all distributions from any "entity" are treated
similarly. Tex. Prop. Code § 116.151.
14
i.
Application to "Entities". For purposes of this
provision, an "entity" includes corporations,
partnerships, limited liability companies, mutual funds,
REITs, common trust funds, and any other entity except
an estate, a trust, or a proprietorship.
ii. General Rule–Distributions are Income. In
general, distributions of money are allocated to income.
A
iii. When Distributions are Not Income.
distribution is allocated to principal if it is (i) property
other than money; (ii) money paid in a single or series
of distributions in redemption of the trust's interest in
the entity; (iii) money received in a total or partial
liquidation of the entity; (iv) or money received from a
mutual fund or REIT characterized as a "capital gain
dividend" for federal income tax purposes. Tex. Prop.
Code § 116.151(c). According to the Uniform Act
comment, a "capital gain dividend" is the excess of the
fund's net long-term capital gain over its net short-term
capital loss. As a result, a capital gain dividend does
not include any net short-term capital gain, and cash
received by a trust because of a net short-term gain is
income under the Act.
iv. Partial Liquidations. Money is received in partial
liquidation if the entity so indicates, or if the total
distribution is greater than 20% of the entity's gross
assets. Tex. Prop. Code § 116.151(d). However,
money will not be treated as a partial liquidation (or be
taken into account in measuring "20% of the entity's
gross assets") to the extent of the trust's income tax on
the distributing entity's taxable income. Tex. Prop.
Code § 116.151(e).
v. Information from the Entity. If the distributing
entity provides the trustee with a statement at or near
the time of the distribution setting forth information
about the source or character of a distribution, the
trustee is entitled to rely on that statement. Tex. Prop.
Code § 116.151(f).
f.
Business and Farming Operations. If a fiduciary
operates a business or farming operation owned as a
sole proprietorship, he or she may elect, if it is in the
best interest of all beneficiaries, to account separately
for the business or activity, instead of accounting for it
as part of the trust's general assets. Tex. Prop. Code
Ann. § 116.153.
i.
Treatment as a Business. Treatment as a business
would mean, for example, that a interest earned in a
money market account used to hold rents from a
shopping center would not necessarily be income, but
would be added to other receipts and disbursements of
the shopping center business to measure "net" income.
2007 DOCKET CALL IN PROBATE COURT
ii. Cash Flow vs. Income. If a separate accounting is
undertaken, the trustee may determine the extent to
which its net cash needs to be retained for working
capital, acquisition or replacement of fixed assets, or
other reasonably foreseeable needs of the business, and
the extent to which the remaining net cash receipts are
to be allocated to principal or income. If the assets of
the business are sold outside the ordinary course of
business (and the sales proceeds are no longer required
in the conduct of the business) the proceeds are
allocated to principal. Tex. Prop. Code § 116.153(b).
iii. Types of Businesses. The activities to which this
provision apply include retail, manufacturing, service
and other traditional businesses; farming; raising and
selling livestock; management of rental properties;
mineral extraction; timber operations; and derivative
operations.
iv. Comparing Former Law. Under former law,
business and farming operations (presumably including
partnerships) were to be accounted for using generally
accepted accounting principals ("GAAP"). This
requirement gave rise to a host of questions, including
how a trustee who couldn't justify the expense of
GAAP financial statements was to base allocations,
how an interest in a partnership was to be treated, and
how a trustee might to compel a partnership to provide
GAAP accounting information.
g. Interest and Rents. As under prior law, rents are
treated as income, including amounts received for
cancellation or renewal of a lease. Tex. Prop. Code
Ann. § 116.161. Interest is also income, whether
denominated as fixed, variable, or floating. If a
fiduciary sells a note or other obligation to pay money
more than one year after it is acquired, the sales
proceeds must be allocated to principal, even if the
obligation was acquired for less than its value at
maturity. If the obligation is disposed of within one
year after it is acquired, an amount received in excess
of its purchase price or value when acquired must be
allocated to income. Tex. Prop. Code Ann. § 116.163.
Income Tax Matters
h. Deferred Compensation, Annuities, and Similar
Payments.
i.
Prior Law. In 1993, the Texas legislature rewrote
Section 113.109 of the Texas Trust Code to deal
specifically with "deferred payment rights," including
qualified and non-qualified employee benefit plans.
Under the statute as rewritten, proceeds received were
credited to income up to five percent of the "inventory
value" of the right, with the balance constituting
principal. In the first year, the "inventory value" was
defined to mean the cost of property purchased by a
trustee, the market value of the property at the time it
became subject to the trust, or, in the case of a
testamentary trust, the value used by the trustee as
finally determined for estate tax purposes. Once the
initial value was assigned, the inventory value was
adjusted by the five percent accrual, as though it were
a promissory note bearing interest at five percent
compounded annually. Unfortunately, this approach
ignored changes in the market value of the retirement
assets.
ii. New Rules. The Act now provides that (i) to the
extent that the payer characterizes a payment as
interest, a dividend, or equivalent payment, the payment
is allocated to income; and (ii) if no part is so
designated, and if all or any part of the payment is
require to be made, an allocation is made to income to
the extent of four percent of the "fair market value of
the future payment asset," less the amount allocated to
income for a previous payment in the same accounting
period. Fair market value is measured on the day the
asset first becomes subject to the trust, or after the first
year, on the first day of the trust's year. Tex. Prop.
Code Ann. § 116.172.
i.
15
ii. New Rules. For assets acquired on or after
January 1, 2004, the trustee is to allocate ten percent of
each receipt (not ten percent of the inventory value) to
income, and the balance to principal. For assets on
hand on January 1, 2004, the trustee may allocate
receipts "in the manner provided by this Chapter or in
any lawful manner used by the trustee before January 1,
2004 to make the same allocation." Tex. Prop. Code
Ann. § 116.173.
j.
Minerals, Water and Other Natural Resources.
i.
Specific Allocations. The Texas Trust Code
provides that nominal delay rentals are income, but
production payments are principal except to the extent
of any factor for interest provided for in the governing
instrument.
ii. "Equitable" Allocations. With respect to royalties,
shut-in-well payments, take-or-pay payments, bonuses,
or delay rentals that are more than nominal, the trustee
must allocate receipts "equitably." Receipts from
working interest or other amounts not expressly
provided for must also be allocated "equitably."
Amounts received for water are income if the water is
renewable. If the water is not renewable, the proceeds
must be allocated "equitably."
iii. Compare Prior Law. Under former law, the
trustee was required to maintain a reserve for most
mineral royalties equal to the lesser of 27.5% of the
gross proceeds or 50% of the net proceeds. Former
Tex. Prop. Code Ann. § 113.107(d). For assets on hand
on January 1, 2004, the trustee may allocate receipts "in
the manner provided by this Chapter or in any lawful
manner used by the trustee before January 1, 2004 to
make the same allocation." Tex. Prop. Code Ann §
116.174.
Liquidating Assets.
i.
Prior Law. Under former law, proceeds from
depletable property other than minerals (for example,
leaseholds, patents, copyrights and nonmineral
royalties) acquired by a trust on or after September 1,
1993, constituted income to the extent of five percent of
the inventory value, adjusted in the same manner as a
promissory note bearing interest at five percent
compounded annually. Former Tex. Prop. Code Ann.
§ 113.109. All proceeds from depletable property
acquired before September 1, 1993, constituted income
unless the trustee had a duty to change the form of the
investment. If the trustee was required, either under
local law or under the terms of the trust instrument, to
alter the form of the investment, up to 5% of the value
of the asset disposed of is income, and the balance was
allocable to principal. Id.
iv. "Deemed" Equitable Allocations. So how does a
fiduciary make sure that an allocation is being made
"equitably"? The statute provide no specific guidance
expect that an allocation of a receipt is presumed to be
equitable if the amount allocated to principal is equal to
the amount allowed by the Internal Revenue Code as a
deduction for depletion (generally, 15%). Id.
v. Affect on Depletion Deduction. Under current tax
rules, a depletion deduction is used by the trust or estate
to the extent that the entity maintains a reserve, so all of
the depletion deduction would be trapped in the trust. If
the grantor or testator wants all royalty income to be
paid to the income beneficiary, this provision should be
altered by the terms of the will or trust. The effect of
such an alteration is to cause the tax depletion to follow
the trust income. See I.R.C. § 611(b)(3); Treas. Reg. §
1.611-1(c)(4).
16
k.
2007 DOCKET CALL IN PROBATE COURT
Timber.
i.
Prior Law. Former law provided that receipts
from the disposition of timber were allocated "in
accordance with what is reasonable and equitable to the
income and remainder beneficiaries of the trust." No
specific guidance was given, and the trustee was left to
devise a fair allocation. Former Tex. Prop. Code Ann.
§ 113.108. This provision was presumably designed to
deal with the bunching of income that arises when a
large stand of timber is cut and sold in a single year
after many years of growing time. The flexibility in the
Trust Code was presumably designed to allow the
trustee the ability to normalize income regardless of the
management technique used. In contrast to mineral
allocations, which went from specific to "equitable,"
timber allocations now have specific rules.
ii. New Rules. The fiduciary is now required to
allocate net receipts: (i) to income to the extent the
amount of timber removed does not exceed the rate of
growth of timber during the accounting period in which
a beneficiary has a mandatory income interest; (ii) to
principal to the extent that the amount of timber
removed exceeds the rate of growth of timber, or the
net receipts are from the sale of standing timber; (iii) to
or between income and principal if the net receipts are
from the lease of timberland or from a contract to cut
timber, applying the rules of (i) and (ii) above; and (iv)
to principal to the extent that advance payments,
bonuses and other payments are not allocated by the
foregoing rules. Tex. Prop. Code § 116.175.
iii. Applying Prior Law. Again, for timber on hand
on January 1, 2004, the trustee may allocate receipts "in
the manner provided by this Chapter or in any lawful
manner used by the trustee before January 1, 2004 to
make the same allocation." Tex. Prop. Code Ann. §
116.175(d).
l.
Underproductive Property.
i.
Prior Law. Former law provided that property
which did not produce an average net income, ignoring
depreciation and obsolescence, equal to 1% of its value
was considered "underproductive" property. If the
trustee was under a duty to change the investment, and
was delayed from disposing of the investment for one
year after the property became underproductive, and if
the property was sold for a profit prior to distribution,
the income beneficiary was allocated the lesser of the
profit on the sale of the property or the amount of the
net sales proceeds sufficient to bring the return on the
property up to 4% simple interest during the delay
period. Former Tex. Prop. Code Ann. § 113.110.
ii. New Rules. The Act eliminates this provision and
provides instead only that if an estate tax marital
deduction was allowed for property passing to a trust,
and the property does not provide the spouse with
sufficient income (and if the power to adjust discussed
below does not cure the problem), the spouse may
require the trustee to make the property productive of
income, convert the property within a reasonable period
of time, or exercise the power to adjust. The trustee can
decide which of these steps to take. Tex. Prop. Code
Ann § 116.176.
m. Other Sales Proceeds. Proceeds from the sale of
or other disposition of property not classified as
underproductive are considered principal, and
accordingly, capital gains are allocable as principal to
the trust absent provisions of the trust instrument to the
contrary. Tex. Prop. Code Ann. § 116.161.
n. Equitable Adjustments. The Act now permits a
fiduciary to make adjustments between principal and
income to offset the shifting economic interests or tax
benefits between income beneficiaries and remainder
beneficiaries that arise from (i) elections that the
fiduciary makes from time to time regarding tax
matters; (ii) an income tax imposed upon the fiduciary
or a beneficiary as a result of a distribution; or (iii) the
ownership by an estate or trust of an entity whose
taxable income, whether or not distributable, is
includable in the taxable income of the estate, trust or
a beneficiary. Tex. Prop. Code § 11.206(a). A
mandatory adjustment must be made from income to
principal to the extent an election would otherwise
decrease an estate tax marital or charitable deduction.
Tex. Prop. Code § 116.206(b). Prior to the adoption of
this section, Texas had no provision for equitable
adjustment, although it had been a part of the common
law in other jurisdictions for some time.
Example 8: Equitable adjustments can be illustrated
by Estate of Bixby, 140 Cal. App. 2d 326, 295 P.2d 68
(1956). There, the executor elected under Section
642(g) to take deductions for income tax purposes,
which reduced income taxes by $100,000.00, at the cost
of $60,000.00 in estate tax savings. Based upon the
terms of the Will, the income tax savings inured to the
benefit of the income beneficiary, while the loss of
estate tax savings came at the expense of the remainder
beneficiaries. The court required the benefitted estate
to pay $60,000.00 in damages to the remainder
beneficiaries as an "equitable adjustment." As a result,
the remainder beneficiaries were unharmed, and the
income beneficiaries received the net $40,000.00 tax
savings.
Income Tax Matters
o.
Allocation of Disbursements.
i.
Allocations to Income.
(1) Trustee Fees. Trustee fees are required by statute
to be allocated 50% against income (and 50% against
principal.) Tex. Prop. Code Ann. §§ 116.201(a)(1);
116.202.(a)(1). Previous law allowed the trustee to
allocate compensation as the trustee deemed to be just
and equitable.
Former Tex. Prop. Code Ann.
§ 113.111(a)(6). The new mandatory allocation can be
detrimental, as in the case of a marital deduction trust,
with income required to be paid, against which the
generation skipping exemption has been applied. If the
spouse does not require the income for support, the
family would be better served to have the trustee fees
charged 100% against income. The mandatory rule
does, however, give the fiduciary certainty about how
the apportionment is to be made.
(2) Other Fees. Investment advisory, custodial
services and expenses for accountings, judicial
proceedings, or "other matters that involve both the
income and remainder interest" are also charged 50%
against income and 50% against principal. Tex. Prop.
Code Ann. §§ 116.201(a); 116.202(a).
ii. Administration Expenses. Ordinary expenses
incurred for the administration, management or
preservation of trust property and the distribution of
income are allocated against income, including (i)
interest; (ii) ordinary repairs; (iii) regularly recurring
taxes assessed against principal; (iv) expenses of a
proceeding that concerns primarily the income interest;
and (v) recurring premiums on insurance coving loss of
principal (property and casualty insurance, but not title
insurance. Tex. Prop. Code § 116.201.
p.
Allocations to Principal.
i.
Trustee and Other Fees. The 50% of trustee and
other fees not allocated to income are allocated to
principal.
ii. Expenses that Affect Principal. Also allocated to
principal are those expenses that primarily affect
principal, including (i) title insurance premiums; (ii)
environmental expenses; and (iii) estate , inheritance
and other transfer taxes. Tex. Prop. Code § 116.202.
iii. Depreciation. Under the Act, the trustee may
transfer to principal "a reasonable amount of the net
cash receipts from a principal assets that is subject to
depreciation," but may not transfer any amount for
depreciation (i) for a residence and its contents
available for use by a beneficiary; (ii) during the
administration of a decedent's estate; or (iii) for
proprietorship assets accounted for as a business
17
activity. As with depletion, the effect of this provision
is to establish a reserve for depreciation, which will trap
the tax depreciation deduction within the trust to the
extent of the reserve so maintained. If the testator
wishes to have depreciation deductions follow income,
a different allocation of depreciation must be provided
for in the will or trust instrument. Tex. Prop. Code Ann.
§ 116.203.
iv. Reserves for Extraordinary Expenses. Section
116.204 of the Act permits the trustee to transfer to
principal amounts to reimburse principal for
extraordinary expenses or to provide a reserve for
expected expenses. This provision permits the trustee
to "regularize distributions if charges against income
are unusually large, by using reserves to withhold sums
from income distributions."
v. Taxes. Section 116.205 of the Act provides for
express allocation against income taxes.
vi. Taxes Attributable to Receipts. Income tax
payments are charged against the account to which the
receipt is allocated.
vii. Taxes from Pass-Through Entities. Taxes in
excess of receipts from an entity are charged against
principal. For example partnership or S corporation
taxable income allocable to the trust, if in excess of
distributions made to the trust, will create tax liability
in excess of the receipts. The excess tax liability is
charged against principal.
viii. Equitable Adjustments. As noted above, equitable
adjustments are permitted to offset the shifting of
economic interests or tax benefits between income
beneficiaries and remainder beneficiaries which arise
from elections and other decisions regarding tax
matters.
q.
Unitrusts and the Power to Adjust.
The Uniform Principal and Income Act establishes
two entirely new rules for measuring income. The first
permits the use of a so-called "unitrust" amount. The
second is a broad "power to adjust" granted to the
trustee in certain instances.
i.
Unitrusts. The Uniform Principal and Income Act
grants a trustee the power to convert an "all income"
trust into one that pays a fixed percentage of trust
property to the beneficiary each year. The Texas
legislation chose not to grant to trustees the discretion
to convert existing trusts, but still authorizes a grantor
or testator the ability to draft a trust that measures
income in this fashion.
18
(1) Payout Percentages. Consistent with the new
Regulations under Section 643 of the Code, the Trust
Code permits the payout percentage to be a fixed
percentage of not less than three or more than five
percent per year, valued at least annually. Tex. Prop.
Code § 116.007(b)(2). The percentage may be applied
to trust values in one year or more than one year.
(2) Payout Deemed "All Income". In order to ensure
that Texas non-charitable unitrusts satisfy IRS
regulations, the Texas statute specifically provides that
the distribution from a unitrust complying with the
statute "is considered a distribution of all of the income
from the unitrust and shall not be considered a
fundamental departure from state law." Tex. Prop.
Code § 116.007(c).
(3) Ordering Rules. Unless the governing instrument
provides otherwise, unitrust distributions are treated
first as distributions of net accounting income, then
from "ordinary accounting income not allocable to net
accounting income," then from short-term capital gains,
then from long-term capital gains, and finally from
principal. Tex. Prop. Code § 116.007(d).
ii. The Power to Adjust. The hallmark of the
Uniform Principal and Income Act is the much-vaunted
"power to adjust." Most comments criticizing various
provision of the Act have been met with the simple
reply, "But that's okay. If that doesn't work out fairly,
the trustee always has the power to adjust." This
simplistic response ignores the substantial limitations
placed upon this power.
iii. Statement of the Power. In its clearest form,
Section 116.005(a) of the Texas Trust Code provides,
that a trustee may adjust between principal and income
to the extent that the trustee considers necessary if the
trustee determines, after applying the rules requiring the
trustee to administer the trust in accordance with the
governing instrument and the Act, that the trustee is
unable to administer the trust or estate impartially,
based on what is fair and reasonable to all of the
beneficiaries.
iv. Availability of the Power. The power to adjust
arises only if the trustee invests and manages trust
assets as a prudent investor, and the terms of the
governing instrument describe the amount that may or
must be distributed to a beneficiary by referring to the
trust's income. Since the Uniform Prudent Investor Act
now applies in Texas to all trusts unless the governing
instrument otherwise so provides, the power to adjust
should apply whenever the trust requires or permits the
trustee to distribute trust income to a beneficiary. Thus,
presumably, a trust that provides that the trustee "may
distribute so much of the income as the trustee
determines advisable, plus so much of the principal as
2007 DOCKET CALL IN PROBATE COURT
the trustee determines necessary for health, education,
maintenance and support" would seem to qualify.
v. Limitations of the Power. The power to adjust
was initially designed to allow a trustee investing
according to modern portfolio theory to adjust capital
gains to the income account in a portfolio otherwise
weighted toward growth assets. However, the power to
adjust is not available in a number of circumstances. In
particular, a trustee cannot make an adjustment:
(1) that diminishes the income interest in a
trust that requires all of the income to be paid at least
annually to a spouse and for which an estate tax or gift
tax marital deduction would be allowed, in whole or in
part, if the trustee did not have the power to make the
adjustment;
(2) that reduces the actuarial value of the
income interest in a trust to which a person transfers
property with the intent to qualify for a gift tax
exclusion;
(3) that changes the amount payable to a
beneficiary as a fixed annuity or a fixed fraction of the
value of the trust assets;
(4) from any amount that is permanently set
aside for charitable purposes under a will or the terms
of a trust unless both income and principal are so set
aside;
(5) if possessing or exercising the power to
make an adjustment causes an individual to be treated
as the owner of all or part of the trust for income tax
purposes, and the individual would not be treated as the
owner if the trustee did not possess the power to make
an adjustment;
(6) if possessing or exercising the power to
make an adjustment causes all or part of the trust assets
to be included for estate tax purposes in the estate of an
individual who has the power to remove a trustee or
appoint a trustee, or both, and the assets would not be
included in the estate of the individual if the trustee did
not possess the power to make an adjustment;
(7) if the trustee is a beneficiary of the trust;
or
(8) if the trustee is not a beneficiary, but the
adjustment would benefit the trustee directly or
indirectly.
If items (5), (6), (7), or (8) applies to a trustee and there
is more than one trustee, a co-trustee to whom the
provision does not apply may make the adjustment
unless the exercise of the power by the remaining
Income Tax Matters
trustee or trustees is not permitted by the terms of the
trust.
vi. Comments on the Power. Since most clients
prefer to have their spouses or children serve as the
trustee of the trusts created under their wills, and since
the power does not apply if the trustee is a beneficiary
of the trust, it seems unlikely that many trustees will be
eligible to use the power unless a co-trustee who is not
a close family member is willing to serve and make the
adjustment.
8. NON-PRO RATA DIVISIONS OF COMMUNITY
PROPERTY. Can an executor and the surviving spouse
make tax free non-pro rata divisions of community
property, so that the beneficiaries own 100% of a
community property asset while the spouse succeeds to
100% of other community property assets of equal
value? Two 1980 technical advice memoranda suggest
that such a tax-free division is permissible. Both rely
on Revenue Ruling 76-83, 1976-1 C.B. 213, a ruling
involving similar issues in the divorce context, which
has since been rendered obsolete by the enactment of
Section 1041 of the Code which expressly provides for
non-recognition in the divorce context. Tech. Adv.
Mem. 8016050; Tech. Adv. Mem. 8037124. A more
recent ruling seems to confirm this analysis, so long as
the division is if permitted by the governing instrument
or by local law. Tech. Adv. Mem. 9422052. Does
Texas law permit such a non-pro rata division?
Remember that under Section 177(b) of the Texas
Probate Code, the executor of an estate takes possession
of both halves of the community property of the
decedent and the decedent's spouse. Section 385 of the
Texas Probate Code provides that when a husband or
wife die leaving community property, the surviving
spouse may, at any time after the grant of letters
testamentary and the filing of an inventory, make
application to the court for a "partition" of the
community property into "two equal moieties, one to be
delivered to the survivor and the other to the executor
or administrator id the deceased. The provisions of this
Code respecting the partition and distribution of estates
shall apply to such partition so far as the same are
applicable." Tex. Prob Code § 385 (Vernon 2003). At
least one court has described equal moieties in this
circumstance to be either two groups alike in
magnitude, quantity, number or degree, or two groups
alike in value or quality. Estate of Furr, 553 S.W.2d
676, 679 (Tex. Civ. App.–Amarillo, 1977, writ ref'd
n.r.e.). Section 373 of the Probate Code deals with
partitions and distributions of estate assets generally.
This section does not require the court to make a pro
rata partition of each and every asset of the estate, but
permits the court to allocate assets among beneficiaries
to achieve a "fair, just and impartial" distribution of
estate assets. Similar powers perhaps apply to
independent executors acting without court supervision.
19
For example, in the context of a community
administrator, there appears to be no requirement to
account for specific assets upon the conclusion of the
administration. Rather, the responsibility of the
survivor is only in the aggregate. See Leatherwood v.
Arnold, 66 Tex. 414, 416, 1 S.W. 173, 174 (1886). Cf.
Gonzalez v. Gonzalez, 469 S.W.2d 624, 630 (Tex. Civ.
App.–Corpus Christi 1971, writ ref'd n.r.e.) (power of
an executor to distribute an estate does not include the
right to partition undivided interests, absent express
grant of authority in the Will). As to partitions
generally, Texas courts in establishing the rights of coowners of property subject to partition have adopted the
concept of "owelty." The classic definition of "owelty"
is an amount paid or secured by one co-tenant to
another for the purpose of equalizing a partition.
Although originally designed to address minor
variations in value, the concept has been expanded to
the situation where one co-tenant acquires all of the
commonly owned property, and the other takes only
cash. See, e.g., McGoodwin v. McGoodwin, 671 S.W.
2d 880 (Tex. 1984). For an excellent discussion of
partition issues in general, see Jenkins, Drafting Real
Estate Documents for the Estate Planning and Probate
Practitioner, State Bar of Texas Advanced Drafting:
Estate Planning and Probate Court (1993).
9. DEDUCTION OF INTEREST PAID ON PECUNIARY
BEQUESTS. Section 116.051(3) of the Texas Trust
Code provides that the devisee of a pecuniary bequest
is entitled to interest on the bequest beginning one year
after the date of death at the legal rate on open accounts
(currently, six percent). Payment of this interest is
treated for tax purposes not as a distribution of income,
but as an interest expense to the estate and interest
income to the beneficiary. Rev. Rul. 73-322, 1973-2
C.B. 44. Under Section 163(h) of the Code, interest is
non-deductible "personal interest" unless it comes
within an exception, none of which expressly relates to
interest on a pecuniary bequest. Section 163(d)(3) of
the Code defines "investment interest" as interest paid
or accrued on indebtedness properly allocable to
property held for investment. Property held for
investment is described by reference to Section
469(e)(1) of the Code, and includes property that
produces interest, dividends, annuities, or royalties not
derived in the ordinary course of a trade or business.
No case or ruling addresses the allocation of interest
expense when an estate incurs an expense as a result of
a delay in funding a pecuniary bequest. However, IRS
Notice 89-35, 1989-13 I.R.B. 4, provides temporary
guidance on allocating interest expense on a debt
incurred with respect to certain pass-through entities.
Under that Notice, the debt and associated interest
expense must be allocated among the assets of the
entity using a reasonable method. Reasonable methods
of allocating debt among assets ordinarily include pro
rata allocation based upon fair market value, book
20
value, or adjusted basis of the assets. Although this
Notice does not apply by its terms to indebtedness
incurred by an estate in funding a bequest, perhaps
these principles can be applied by analogy to estates.
This analysis would probably require the executor to
examine the activities of the estate. One could argue
that a "debt" was incurred because the estate failed to
distribute its assets to fund the pecuniary bequest within
one year after letters testamentary were issued. As a
result, the estate was able to retain assets, including
assets that generate portfolio income, as a result of its
delay in funding the bequest. In effect, the estate could
be said to have "borrowed" these assets from the
beneficiary during the period that the distribution was
delayed, and it is as a result of this borrowing that the
interest is owed under the provisions of the Texas
Probate Code. This analysis would mean that to the
extent that the assets ultimately distributed to the
beneficiary (or sold to pay the beneficiary) were assets
of a nature that produced interest, dividends, annuities,
or royalties not derived in the ordinary course of a trade
or business, the interest expense would be deductible to
the estate as "investment interest." It should be noted,
however, that in an example contained in the Proposed
Treasury Regulations issued regarding the separate
share rules, the IRS states (without explanation) that
interest paid on a spouse's elective share that is entitled
to no estate income, but only statutory interest, is
income to the spouse under Section 61 of the Code, but
non-deductible to the estate under Section 163(h).
Prop. Treas. Reg. § 1.663(c)-5, Ex. 3. The focus of this
regulation is on the amount of DNI that will be carried
out by the distribution; it properly rules that no DNI is
carried out. Its characterization of the interest expense
as nondeductible under Section 163(h) is gratuitous,
and in this author's view, erroneous.
10. UNDERSTANDING THE GRANTOR TRUST RULES.
Part E of Subchapter J provides a set of rules that
overrides the general trust taxation rules and causes the
income of the trust to be taxed to the grantor (or
someone treated as the grantor) to the extent that he or
she has retained prohibited enjoyment or control of trust
income or principal. The key to the inquiry is whether
the grantor enjoys trust benefits, has retained so much
control, or has left so many "strings" attached to the
trust as to be fairly treated as the true owner of the trust
property for income tax purposes.
a. Reversions. Section 673 of the Code treats the
grantor as the owner of the trust if the principal or
income thereof will revert to the grantor if, as of the
inception of the trust, the value of the reversion exceeds
five percent of the value of the trust. An exception is
provided for reversions occurring only upon the death
of a minor beneficiary who is a descendant of the
grantor. For trusts established on or before March 1,
1986, reversions resulted in grantor trust treatment if
2007 DOCKET CALL IN PROBATE COURT
they took place, or might reasonable be expected to take
place, within ten years of the trust's creation. Some of
these grandfathered so-called "Clifford trusts" are still
in existence. The new permitted reversion rule does not
specify how to value the reversion for purposes of the
five percent safe harbor test. If the "value of such
interest" is determined actuarially under principles such
as those in Treasury Regulation Section 20.2031-7, the
exception in Code Section 673(a) gives rise to what
might loosely be called a "21/45" rule. That is, with
applicable discount rates near seven percent, a grantor
can retain a reversion if the trust property would not
return to the grantor except on the death of a beneficiary under age 21 at the time of the trust's creation, or if
the reversion would not occur for at least 45 years.
Since the discount rate used under Treasury Regulation
Section 20.2031-7 varies monthly, the exact age or
duration for a permitted reversion will vary depending
upon interest rates applicable in the month of the trust's
creation.
b. Power to Revoke. Section 676 of the Code treats
the trust as a nullity if the grantor retains a revocation
power, unless the power to revoke does not arise until
after a "safe" Section 673 period. Under Texas law, a
grantor may revoke the trust unless it is made
irrevocable by the express terms of the instrument
creating it. Tex. Prop. Code Ann. § 112.051(a)
(Vernon 1995). Note that Section 676 of the Code
applies also to a power of revocation held by a non-adverse party. Accordingly, inter vivos trusts with a
power of appointment should perhaps include a
provision precluding the power holder from exercising
the power in favor of the grantor or the grantor' spouse.
c. Retention of Income. Section 677 of the Code is
the most commonly involved grantor trust provision,
and is often invoked intentionally, as in the context of
revocable inter vivos trusts used as Will substitutes (to
which Section 676 applies as well). Code Section 677
applies grantor trust treatment to trusts the income of
which, without the consent of an adverse party, either
must be paid to the grantor or his spouse, or may, in the
discretion of the grantor or a non-adverse party, be paid
currently to the grantor or the grantor's spouse. Section
677 will also be invoked if trust income may be
accumulated for future payment to the grantor or the
grantor's spouse. Income must be available for the
direct or indirect benefit of the grantor, but even a
relatively insubstantial "benefit" may give rise to
grantor trust treatment. Section 677 is raised, for
example, merely by the use of trust income to pay
premiums of life insurance on the life of the grantor or
the grantor's spouse, regardless of the ownership or
beneficiary of the policy. In addition, payments that
discharge a legal or contractual obligation of the grantor
(or the grantor's spouse) are treated as indirect
payments to the grantor. Section 677(b) provides an
Income Tax Matters
exception to this latter rule by limiting taxability only
to amounts actually distributed in the proscribed
manner. The exception applies to discretionary
distributions of income for the support or maintenance
of someone that the grantor is obligated to support.
Note that the distributions needn't "discharge" the
grantor's legal obligations of support. Rather, Section
677(b) applies to all actual distributions for support of
someone whom the grantor is legally obligated to
support.
d. Retention of Control. Section 674 of the Code is
probably the most complex of the grantor trust
provisions, but its direct application is relatively well
understood by most practitioners. Unfortunately, many
draftsmen fear its more subtle applications. A Section
674 problem usually arises when a grantor demands the
broadest powers, with even broader powers granted to
"independent" trustees. Too often, practitioners fear
that the powers granted are a bit too broad, or that the
"independent" trustee's powers will somehow be
attributed back to the grantor. (But see, Rev. Rul.
95-58, 1995-36 I.R.B. 16, revoking Rev. Rul. 79-353,
1979-2 C.B. 325, as modified by Rev. Rul. 81-51,
1981-1 C.B. 458 -- these revoked rulings held that for
transfer tax purposes, a grantor's right to replace a corporate trustee conferred upon the grantor the powers of
the trustee). As a result, many practitioners fail to take
advantage of the considerable flexibility permitted
under Code Section 674. The exceptions to Section
674 are numerous. In summary, anyone can have the
powers described in Section 674(b). Most drafters get
the flexibility and control required by grantors in most
situations under Section 674(b)(5)(A) (discretionary
distributions of corpus pursuant to an ascertainable
standard) and (B) (advancement treatment) yielding
adequate control over corpus; and Section 674(b)(6)
(withholding income during minority) and (7)
(withholding income during disability) for fiduciary
accounting income. Section 674(d) of the Code
provides that anyone except the grantor and the
grantor's spouse can have the power to make
distributions of income or principal limited by an ascertainable standard. Finally with no more than half of the
trustees related or subordinate to the grantor, anyone
(other than the grantor and the grantor's spouse) can
have unlimited discretion under Section 674(c). Note
that the exceptions contained in Section 674 do not
generally apply if the grantor or a nonadverse party
retains the right to add beneficiaries to the trust (other
than after-born descendants). As a result, persons
drafting trusts designed to intentionally invoke grantor
trust treatment frequently add a power in someone other
than the grantor or a beneficiary to add a beneficiary
(often a charity) to the trust. This power causes the
trust to be a grantor trust for income tax purposes, but
does not cause the property to be included in the estate
of the grantor for federal estate tax purposes. In
21
addition, if the person holding the power cannot add
himself or herself as a beneficiary, the power does not
cause income or estate tax inclusion to the power
holder.
e. Certain Administrative Powers.
Generally
speaking, Section 675 powers are either non-fiduciary
powers over closely held business stock, or powers in
the grantor or a non-adverse party to self-deal with the
trust. More specifically, the prohibited powers are a
power in the grantor, spouse, or non-adverse party
(without the consent of an adverse party) to deal with,
dispose of, or exchange either income or principal for
less than full and adequate consideration, even if the
grantor cannot benefit thereby; a power in the grantor
or spouse to borrow, or a power in a non-adverse party
to lend to the grantor or spouse, on less than adequate
interest and security (see, e.g., PLR 9446008) (but the
power to lend is permitted if it includes the broad power
to lend without regard to interest or security); the actual
borrowing of any portion of the trust by the grantor of
spouse, except loans made but repaid in prior years, and
loans made for adequate security and interest if made
by an independent trustee; a power in the grantor,
spouse, or non-adverse party (without the consent of the
trustee) to act in a non-fiduciary capacity, to vote or
direct voting in a corporation in which the aggregate
holdings of voting stock by the grantor, the spouse, and
the trust are "significant," or to invest or veto
investment, or to direct either, to the extent that the trust
holds securities in a corporation in which the aggregate
holdings of voting stock by the grantor, the spouse, and
the trust are "significant"; and a power to reacquire the
trust corpus by substituting property of equivalent
value. Again, in the context of trusts drafted to
intentionally invoke the grantor trust rules, a power
may be added permitting the grantor, in a non-fiduciary
capacity, to reacquire trust property by substituting
property of equivalent value.
Since any such
substitution requires the payment by the grantor of full
and adequate consideration, this power causes the trust
to be a grantor trust for income tax purposes, but does
not cause the trust's property to be included in the estate
of the grantor for federal estate tax purposes.
f.
Section 678. Internal Revenue Code Section 678
may apply rules similar to the grantor trust rules to
persons other than grantors. This Code section is
applied in two parts, the first relating to the existence of
a power, and the second relating to the release or
modification of a power.
i.
Power to Vest Trust Property in One's Self.
Section 678(a)(1) describes a power to vest income or
corpus in one's self. This power held in conjunction
with another person, even if that person is not an
adverse party, is acceptable. The statute singles out for
grantor trusts treatment only those powers exercisable
22
2007 DOCKET CALL IN PROBATE COURT
solely by the power holder. Section 678 issues
typically arise in the context of testamentary trusts
when a beneficiary is the sole trustee of a complex trust
as, for example, when the surviving spouse is the sole
trustee of the bypass trust. In the context of inter vivos
trusts, a common source for exposure to this sort of
power is a Crummey withdrawal right, granted to
ensure that a trust beneficiary has a present interest
qualifying for an annual exclusion under Section
2503(b) of the Code. See PLR 9535047.
(a)
(b)
Direct and Indirect Powers. Treasury
Regulation Section 1.678(a)-(1)(b) expands
Section 678(a)(1) of the Code to include any
power, directly or indirectly, to apply
income or principal to the person's individual benefit. This rule is analogous to the
grantor trust rule regarding retained income
in Section 677 of the Code, and is subject to
similar exceptions. Thus, under Section
678(c) of the Code (the sibling to Code
Section 677(b)) a power to apply income to
the support or maintenance of a person the
power holder is obligated to support or
maintain will not cause all trust income to be
taxed to the holder of the power. Rather,
only amounts actually applied for the
support or maintenance of someone that the
power holder is obligated to support will be
taxed to the power holder.
Limitation by Ascertainable Standard.
Unlike the transfer tax rules, Section 678 of
the Code does not contain an express
exception for powers limited by an ascertainable standard. A number of cases
decided prior to the adoption of Section 678
suggest that such an exception should be
read into the statute. See Smither v. U.S.,
108 F. Supp. 772 (S.D. Tex. 1952), aff'd,
205 F.2d 518 (5th Cir. 1953); Funk v.
Commissioner, 185 F.2d 127 (3d Cir. 1950);
See also, U.S. v. De Bonchamps, 278 F.2d
127 (9th Cir. 1960) (holding that an
ascertainable standard caused capital gains
to be taxed to an implied trust and not to the
life tenant holding the power).
ii. Releases of Powers. The second component of
Section 678(a) of the Code relates to releases or
modifications of powers described in Code Section
678(a)(1). Generally, Section 678(a)(2) of the Code
imposes grantor trust treatment on the power holder for
any power released or modified in a fashion that would
give rise to the application of the grantor trust rules
were the release a transfer by the grantor. For example,
if a beneficiary has a power to withdraw income from
a trust, but allows that power to lapse, so that the
unwithdrawn income is added to principal, the
beneficiary will be treated as the "owner" of the lapsed
income. If the unwithdrawn income had been property
transferred to the trust by the grantor, the right to the
income therefrom would generate grantor trust
treatment pursuant to Code Section 677(a)(1).
Therefore, the continuing withdrawal right will cause
the person to be treated as the owner of lapsed property,
and continued lapses may cause the person to be treated
as the owner of an increasing portion of the trust each
year. See, e.g., Mallinckrodt v. Nunan, 146 F.2d 1 (8th
Cir. 1945).
iii. Renunciations of Powers. Section 678(d) of the
Code provides an exception to both inclusion rules of
Code Section 678(a) by permitting the power holder to
renounce or disclaim the tainted power within a
"reasonable time" after the power holder becomes
aware of its existence. Neither the statute nor the
regulations define "reasonable time." Presumably, the
disclaimer rules in force prior to the adoption of Code
Section 2518, or perhaps the more objective rules
adopted thereby, would be helpful as an analogy. Does
the renunciation rule permit a beneficiary holding a "5
or 5" power to avoid application of Section 678 of the
Code by notifying the trustee of his declination to
withdraw funds each year within a "reasonable time"
after the trustee advises him of a contribution?
Revenue Ruling 81-6, 1981 C.B. 385, which holds that
a holder of a withdrawal right is taxed on the income
associated therewith under Code Section 678(a), does
not address the disclaimer rules associated with a
renunciation of the right.
g. Gift and Estate Taxation of Grantor Trusts. For
years, practitioners have advocated the use of
"intentionally defective" grantor trusts to shift wealth.
Such a trust is designed to be excluded from the estate
of the grantor for federal estate tax purposes, while
remaining a grantor trust solely for federal income tax
purposes. One use of such a trust is to allow income
earned by trust assets to be taxed to the grantor, instead
of the trust, thereby increasing wealth transfer by the
amount of the tax liability, with no additional gift tax.
Another use is to transfer S corporation stock to a trust
for younger generation family members with
jeopardizing the S election.
Example 9: H transfers stock, worth $1 million (with
a basis of $1,000) into trusts for his children, reserving
a power that causes the trust to be a "grantor trust"
solely for income tax purposes. Thereafter, the trustee
sells the stock and invests in a diversified portfolio that
produces $50,000 in taxable income each year. Since
the trust is a grantor trust, H must pay capital gain tax
of $149,850 on the sale of the stock, and must pay
income tax of $17,500 on the ordinary income of the
trust each year. The trust can retain the $1,000,000
Income Tax Matters
sales proceeds and the $50,000 in income each year,
undiminished by federal income taxes.
Commentators have questioned whether the IRS might
take the position that the taxes paid by the grantor of a
grantor trust constitute an additional indirect gift to the
trust beneficiaries. Most practitioners have felt that
since the grantor is simply paying his or her own tax
bill, no gift tax should result.
In July of 2004, the IRS finally ruled that payment by
the grantor of the taxes of a grantor trust is not treated
as a gift, since the grantor is merely paying his or her
own tax liability. Rev. Rule 2004-64, 2004-27 I.R.S. 7.
The ruling goes on to hold, however, that if the trust
instrument contains language requiring the trustee to
reimburse the grantor for taxes, the reimbursement right
will cause the full value of the trust to be included in
the grantor's estate pursuant to Section 2036(a)(1) of the
Code. If instead of a mandatory provision, the trust
agreement grants the trustee discretionary authority to
reimburse the grantor, no Section 2036(a) inclusion will
result to the grantor, so long as "there is no
understanding, express or implied, between [the
grantor] and the trustee regarding the trustee's exercise
of discretion.
The estate tax inclusion rules articulated in Revenue
Ruling 2004-64 apply to trusts created on or after
October 4, 2004. This prospective application is
especially important in the context of grantor trust
designed to hold S corporation stock, since it appears
that the IRS would generally not rule favorably on
requests to ascertain the eligibility of these trusts to
hold S corporation stock unless the trust instrument
included reimbursement rights.
IV. CONCLUSION
Federal income tax issues applicable to estates and
trusts are complex. Obviously, it is impossible to
discuss with each client the issues raised in this outline,
and craft a document uniquely suited to the goals of the
client. Such a task would be so demanding of the time
of professionals that the costs of providing estate
planning services would be prohibitive for all but the
most wealthy clients. As a result, estate planners are
required to exercise considerable professional
judgment. Familiarity with the rules discussed in this
outline should give you a good framework to use in
assisting clients with these matters.
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