Final regs. define "income" under sec. 643.

• Author: Spoor, F. Gordon

EXECUTIVE SUMMARY

* Under the Sec. 643 regulations, income is determined under the governing instrument and applicable local law.

* The regulations recognize a reasonable apportionment of income, gains and appreciation between income and remainder beneficiaries under state law.

* Special rules are provided for computing (1) income for CRUTs and pooled income funds, (2) marital deductions and (3) gains or losses on property distributions.

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Sec. 643 regulations revised the definition of trust accounting income for tax years ending after Jan. 2, 2004, to recognize and respond to state law changes.

This article analyzes these regulations and examines how they affect the computation of fiduciary accounting income and distributable net income.

In December 2003, the IRS released final regulations revising the definition of trust accounting income under Sec. 643(b). (1) The regulations responded to the states' widespread adoption of the Uniform Principal and Income Act of 1997 (UPIA) (2) and "unitrust" provisions (3) that redefined trust accounting income under state law. This article analyzes the new regulations and examines their effect on fiduciary accounting income and distributable net income (DNI). The final regulations are generally effective for tax years ending after Jan. 2, 2004.

Background

Power to Adjust

The UPIA's centerpiece is the "power to adjust." It allows a disinterested trustee (4) to adjust from income to principal, or principal to income, if the trustee determines that traditional fiduciary accounting income provides too much or too little income for an income beneficiary after taking into account, among other things, the grantor's intentions, the trust's investments and the adjustment's anticipated tax consequences.

The power to adjust was provided in response to the difficulties trustees encountered in obtaining sufficient income for income beneficiaries when investing in times of declining interest and dividend income, while honoring their duty under the Prudent Investor Act, (5) to invest for "total return." If the trustee shifts to income-producing assets to provide sufficient income for the income beneficiary, this would ignore the duty to achieve portfolio growth for the remainder beneficiary. The power to adjust allows the trustee to share the trust's total return between the income beneficiary and the remainder interest holder, thereby complying with the prudent investor rule and still meeting the duty to both the income and remainder beneficiaries.

Unitrusts

A unitrust provides payment of a fixed percentage of a trust's assets to an income beneficiary on an annual basis (usually between 3% and 5%). Traditional concepts of fiduciary accounting income do not apply; rather, the unitrust amount is "fiduciary accounting income." For purposes of recognizing unitrust methods of computing fiduciary accounting income, Regs. Sec. 1.643(b)-1 requires the unitrust percentage to be no less than 3%, nor greater than 5%.

State Law

Regs. Sec. 1.643(b)-1 explains that it will respect state statutes that provide for a reasonable apportionment between the income and remainder beneficiaries of a trust's total return for the year, including ordinary and tax-exempt income, capital gains and appreciation.

Because the new regulations depend so much on state laws, careful thought should be given to choosing a trust's situs. It might even be prudent to consider shifting the trust situs, if permitted under the instrument. Such a shift, however, requires a thorough understanding of the state's principal and income statutes and trust code. An equally important element is the potential for exposing the trust and its beneficiaries to additional state income taxes.

Principal Invasions

Neither the power to adjust nor the unitrust provisions should be confused with the trustee's power to invade principal. Principal invasions are generally not eligible for a reallocation of principal to income, and the resulting inclusion of capital gains in DNI. An exception applies if, pursuant to the (1) governing instrument and applicable local law or (2) fiduciary's reasonable and impartial exercise of discretion, the fiduciary consistently treats such distributions on the trust's books, records and returns as including current-year capital gains. (6)

Income and DNI

Understanding the interplay of fiduciary accounting income and DNI is a minimum requirement for properly preparing a fiduciary income tax return. Tax advisers must be fully acquainted with the regulations to compute DNI correctly. Also, a full awareness of applicable state laws is required to properly compute fiduciary accounting income. Failure to compute either DNI or fiduciary accounting income correctly can result in an improper income distribution deduction and, possibly, in income being taxed to the wrong taxpayer.

Certain trusts, simple trusts, pooled income funds...