Income tax planning for trust and estate distributions.

• Author: Barnett, Bernard
• Position: Part 2

Reducing Overall Taxes Through Established Planning Techniques

The tax adviser to a trust or an estate is in an excellent position to offer more than tax compliance services to its fiduciaries and beneficiaries. He will often be able to reduce the overall income taxes payable by the trust or estate and its beneficiaries by providing timely advice as to when, how and to whom income and/or principal should be distributed. These tax savings often substantially exceed the tax adviser's total fee, including the portion attributable to compliance services.

This two-part article reviews many of the established planning tools and techniques, in order to alert tax professionals to, or remind them of, income tax planning strategies that will be useful to their fiduciary clients during trust and estate administration.

The principles of the income taxation of trusts and estates and the related tax planning techniques have been broken down into the following 25 parts. Parts 1 through 13 were published in February; parts 14 through 25 are covered in this installment.

1. General scheme for taxation of fiduciary income.

2. How simple trusts are taxed.

3. Tax character of distributions.

4. When beneficiary must report distribution.

5. Current distributions of complex trusts and

   estates.

6. Charitable contributions.

7. Taxability of distributions of principal.

8. Taxation of current year's capital gains to beneficiary.

9. Treatment of net capital losses. 10. The "sixty-five day" rule. 11. The "separate share" rule. 12. The distributions deduction for alternative

   minimum tax. 13. Funding bequests with property in kind. 14. Distributions of interests in passive activities. 15. Distributions of income in respect of a decedent. 16. Phantom fiduciary taxable income. 17. Reducing and deferring taxes by distributing

   income. 18. Planning through distributions of principal. 19. Planning terminating distributions. 20. Distributions by complex trusts from accumulated

   income. 21. Taxation of multiple trusts. 22. Distributions of charitable remainder trusts. 23. Grantor trust taxation. 24. Distributions from foreign trusts. 25. Conclusion.

14. Distributions of Interests in Passive

    Activities

    Estates and trusts are subject to the same passive activity loss (PAL) deduction restrictions as are individual taxpayers.(60) Fiduciaries are not treated as flowthrough entities for PAL purposes.

    For both individuals and fiduciaries, a PAL(61) generated by one particular activity must first be used to off set income from other passive activities. For tax years beginning in 1991 no deduction is allowed for a net PAL against any other type of income - active (nonpassive) trade or business income or portfolio income. Such PALs that are disallowed currently are trapped in the estate or trust and are "suspended" and generally carried forward (on a separate activity by activity basis) as PALs to future years. This provision requires taxpayers, including fiduciaries, to maintain complete records for each activity for all suspended losses.

    Sec. 469(g)(1), however, provides that suspended PALS arising from a particular passive activity will be "triggered" (converted into an ordinary business loss fully deductible against nonpassive income) in the year in which a taxpayer disposes of his entire interest in the activity in a fully taxable transaction.

    When an individual transfers an interest in a passive activity by a gift, the income tax basis of the transferred interest is increased by the amount of any suspended PALs. No deduction is allowed for such suspended PALs by the donor.(62)

    When an individual's interest in a passive activity is transferred by death, a prior year's suspended PAL will be converted into an ordinary loss on the decedent's final income tax return, but only to the extent that it exceeds the step-up in the basis of the related property interest under Sec. 1014.(63)

    Example 19: D died on Dec. 31, 1991. D had been a limited partner in the WXY Real Estate Partnership for 10 years prior to death. As of that date, D had a negative $200,000 income tax basis for his partnership interest. He had also accumulated unused suspended PALs for 1991 and prior years of $150,000. On Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, D's executor had valued the WXY partnership interest at $30,000.

    How much, if any, of D's suspended PALS will be recognized on his 1991 final income tax return? What will happen to the balance of his suspended PALs?

    None of D's unused suspended PALs will be recognized on his final Form 1040. The $150,000 suspended losses will be recognized only to the extent they exceed the step-up in the basis of his partnership interest. The step-up, however, is $230,000 (from a $200,000 negative partnership basis to a $30,000 basis under Sec. 1014). Therefore, no suspended PALs will be recognized on D's final return.

    D's unused suspended PALs will expire at his death. The Code contains no provision enabling his estate to benefit from this carryover.

    Sec. 469(j)(12) contains a special rule covering distributions of passive activities by estates and trusts:

    If any interest in a passive activity is distributed by an estate or trust -

    (A) the basis of such interest immediately before such distribution

    shall be increased by the amount of any passive activity

    losses allocable to such interest, and

    (B) such losses shall not be allowable as a deduction for any

    taxable year.

    This provision completely ignores the rule enunciated in Sec. 469(g)(1). As previously discussed, that section provides that when a taxpayer disposes of his entire interest in any passive activity in a "fully taxable transaction," unused suspended PALs will be triggered, unless the disposition involves a related party.(64) Although a trustee and a trust beneficiary are related parties,(65) an executor and an estate beneficiary are not.

    As discussed previously (in Part 13 of this article in February), distributions by an executor to fund a pecuniary bequest and distributions to fund a residuary or fractional bequest when a Sec. 643(e) election is made to realize a gain or loss are unquestionably "fully taxable transactions."

    It seems clear, therefore, that the special limitation of Sec. 469(j)(12) should become operative only when an interest in a passive activity is distributed by an estate to a beneficiary and the general rules of nonrecognition of gain or loss on property distributions by executors apply, e.g. (see discussion in Part 13): 1. Distributions to fund a specific bequest. 2. Distributions to fund residuary or fractional bequests when the executor does not make a Sec. 643(e)(3) election to recognize a loss. 3. Distributions to fund certain types of fixed-dollar bequests that are not treated as fully taxable transactions (e.g., to satisfy a "fairly representative" or a "minimum worth" formula pecuniary bequest).

    Example 20: On Jan. 1, 1994, D's executor (from Example 19) distributed to D's surviving spouse the estate's entire interest as a limited partner in the WXY Real Estate Partnership in partial satisfaction of a residuary (or fractional) marital bequest. The estate's interest in the WXY partnership had a $15,000 fair market value (FMV) on the date of transfer. (During the two years that the estate held the limited partnership interest, it had sustained an additional $20,000 of PALs, which, although they reduced the estate's adjusted basis of the partnership interest (to $10,000) were not, of course, deductible against other income on the estate's 1992 and 1993 Forms 1041, U.S. Fiduciary Income Tax Returns. On the date of distribution, Jan. 1, 1994, D's estate, therefore, had accumulated unused suspended PALs of $20,000.) The executor made no distributions to beneficiaries during 1994 other than the limited partnership interest. During the estate's 1994 calendar tax Year its only income was $50,000 of dividends received and it was entitled to no ordinary deductions.

    How will the distribution of the limited partnership interest be reported on the estate's 1994 fiduciary income tax return? What income will be reportable by Mrs. D as the result of the distribution? What will be her income tax basis of the WXY limited partnership interest?

    The determination of the estate's taxable income for 1994, the income reportable by Mrs. D and the tax basis of the limited partnership interest in her hands will depend on whether D's executor chooses to make a Sec. 643(e)(3) election.

    Sec. 643(e)(3) election No Yes Estate's Form 1041: Dividend income 50,000 50,000 Capital gain realized on distribution of limited partnership interest 0 5,000(c) Suspended PALs triggered on taxable transfer 0 (20,000) Total income 50,000 35,000 Less deduction for distributions, lower of: DNI 50,000 30,000(d) Distribution 15,000(a) 15,000(e) Lower 15,000 15,000 35,000 20,000 Less personal exemption 600 600 Taxable income 34,400 19,400 Income taxable to surviving spouse 15,000 15,000 Mrs. D's income tax basis for WXY partnership 30,000(b) $15,000(f) (a) Lower of estate's new $30,000 basis ($10,000 basis + suspended PALs of $20,000, per Sec. 469(j)(12)) or $15,000 FMV. (b) New adjusted basis $30,000. (c) $15,000 FMV- $10,000 adjusted basis. (d) $35,000 income - $5,000 capital gain. (e) $15,000 FMV. (f) $10,000 basis + $5,000 gain realized. The distribution of the WXY partnership interest to Mrs. D to partially fund a "true worth" formula pecuniary bequest rather than a residuary bequest would produce essentially the same results as under the Sec. 643(e)(3) election, as shown above.

    Since a passive activity involves the conduct of a trade or business, triggering unused suspended PALs as the result of distributing interests in passive activities to fund either a pecuniary bequest or a residuary or fractional bequest (coupled with a Sec. 643(e)(3) election by the executor) may create a net operating loss (NOL)(66) in a particular year. Any excess unused NOL for that year may...