Proposal to Clarify Portion Rules That Determine When a Power Holder Other Than the Grantor Is Treated as the Owner of Trust Income

• Publication year: 2016
• Author: By Robert Denham

Proposal to Clarify Portion Rules That Determine When a Power Holder Other Than the Grantor Is Treated as the Owner of Trust Income1

By Robert Denham²

FIRST IMPRESSIONS, SECOND THOUGHTS

It is said that no battle plan survives contact with the enemy. This paper had been intended to explain that certain tax-driven formula withdrawal powers should not be permitted to determine ownership of trust income, but that other economic withdrawal powers should be respected. The draft paper analogized the formula withdrawal powers to income ordering rules for charitable lead trusts that are prohibited by regulation. In light of comments received in response to the draft, it now appears that such tax-driven formula withdrawal powers might actually work because they are sufficiently similar to the alternative economic powers and different from those income-ordering rules. Who says you never get a second chance to make a first impression?

EXECUTIVE SUMMARY

Taxpayers are always looking for ways to shift income from high tax brackets to low tax brackets. Sometimes in doing so they overstep the gray areas of the tax law. With the issuance of Treasury regulations concerning the application of the tax on undistributed net investment income of estates and trusts ("NIIT") under Internal Revenue Code ("IRC") section 1411(a)(2) came a renewed interest in utilizing IRC section 678 to shift income that would be in a trust's highest income tax bracket and subject to the NIIT to the trust beneficiaries whose income is subject to tax in a lower bracket. For trusts and estates, the NIIT is 3.8 percent on all undistributed net investment income in excess of the dollar amount at which the trust's highest tax bracket begins or $12,300 (in 2015). Thus, if a beneficiary were to hold a power exercisable solely by himself to vest in himself only the amount of trust income that would be subject to tax in the trust's highest tax bracket, proponents claim that IRC section 678 would dictate that the amount of income over which he had such power would be taxed to the beneficiary in his presumably lower tax bracket, rather than the trust in its highest bracket. Since there would be no undistributed net investment income in excess of the $12,300 threshold, the NIIT would not apply at the trust level and possibly not even at the individual beneficiary level.

Proponents of the plan assume that the portion rules of Treasury Regulation section 1.671-3 and related regulations apply to persons who hold powers over specified amounts of trust income (i.e., the amount that would be taxed in the trust's highest tax bracket) rather than either the income associated with a specified percentage or amount of trust assets or types of income associated with particular trust assets. The draft paper questioned that assumption, asserting that such a power over an amount of trust income does not refer to a cognizable portion of the trust, so that the power holder may be treated as the owner of all trust income under IRC section 678(a). Instead, the draft paper provided examples of valid withdrawal powers defined in terms of types of income, such as rents, royalties, and interest, to assist practitioners in crafting powers that properly shift the tax burden to the person entitled to the economic benefit of particular trust assets. On Internal Revenue Service ("IRS") advice and further reflection, the proposed distinction is not decisive. Properly understood, either form of withdrawal power may be used to define a portion of the trust in terms of a percentage of trust assets.

The draft paper further argued that such a power would be treated as a general power of appointment for estate and gift tax purposes with respect to the amount in excess of the greater of $5000 or five percent of the trust income that can be withdrawn each year, not the entire value of trust assets, despite the trustee's purported power to satisfy the amount out of any trust assets. Case law and IRS guidance do support that conclusion, limiting the practical utility of the plan.

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DISCUSSION

I. INTRODUCTION

Under IRC section 1411, an estate or trust is subject to an additional 3.8 percent tax, NIIT, on the lesser of its undistributed net investment income or its adjusted gross income ("AGI") in excess of the amount at which the top trust income tax bracket begins under IRC section 1(e) ($12,300 in 2015). Net investment income generally consists of rents, royalties, interest (including tax-exempt interest), ordinary dividends, and other forms of passive income as defined in IRC section 469 that normally are carried out to the beneficiaries as distributable net income ("DNI") under IRC section 643, as well as capital gains that normally are not carried out as DNI.

Under IRC section 678(a), a person other than the grantor is treated as the owner of "any portion of a trust with respect to which: (1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or (2) such person has previously partially released" such a power and, after the release, retains certain interests in the trust. Practitioners have expressed interest in using such powers to avoid the NIIT and to reduce the applicable income tax rate on such income.

For example, one account suggests that a beneficiary might be given a power to withdraw all or any portion of trust accounting income, excluding tax-exempt income and income that would otherwise be taxed at less than the general maximum federal income tax rate applicable to trusts, with the excluded portion to begin with qualified dividends, followed by any items of trust accounting income filling out the lower tax brackets which do not constitute net investment income, followed by any such items which constitute net investment income under IRC section 1411, provided that the amount of trust accounting income subject to the power each year shall not exceed five percent of the combined value of the principal and income of the trust under IRC section 2514(e).³

At first sight, a potential for abuse appears in the purported limitation of the withdrawal power to a portion of trust accounting income defined in terms of its character as taxable income. Assuming the power is not exercised except to the extent necessary to pay the resulting tax on the income subject to the lapsed power, the proposed technique seems to allow selective taxation of different types of accumulated trust income without independent economic effect...