A Question of Trust: Capital Gains in Trusts: Who Pays the Tax?

• Author: Downs, Bill
• Position: Estateplanning

Capital gains on fiduciary income tax returns can mean income tax at maximum rates.

In recent years, we have seen some pretty impressive capital gain distributions from mutual funds, as well as gains realized on sales of appreciated securities. Many CPAs who prepare trust income tax returns are taking a closer look at how those gains are taxed in a trust. A federal tax rate of 23.8 percent can apply to capital gains if trust taxable income is more than $12,400.

The trust pays tax on capital gains that are considered principal under the Uniform Principal and Income Act (UPIA), because gains are not included in accounting income or in Distributable Net Income on trust income tax returns. And that includes distributions from mutual funds that are designated as long-term capital gain on 1099-DIV forms [see UPIA Sec. 16350(c)(4)].

First off, we have to read the trust document to find out if the trust is complex or simple. If the trustee is given discretion to determine how much, if any, to distribute to a beneficiary, the trust will be classified as "complex" under income tax law, and the trustee uses judgment to determine how much to distribute, whether or not the amount is more than accounting income.

If the trustee is required to distribute the income (fiduciary accounting income), the trust is considered "simple" according to the IRC--but that does not mean the return form is simple to prepare!

The Simple Details

The rest of this article will focus on simple trusts, since those are more common. Whoever gets the money pays the tax.

I have clients who are up in years, are surviving spouses and often arc sole trustee and sole beneficiary of a trust (or trusts) set up after the death of their spouse. These trusts commonly include wording indicating the trust must distribute the accounting income each year. The trust instrument may have language describing accounting income, refer to UPIA or merely mention that the income is to be distributed without providing details. In all these cases, fiduciary accounting income as defined in the UPIA is the measure of the amount to be distributed.

But let's not leave it at that.

Check the trust document. You may find a provision that allows the trustee some judgment in allocating receipts to income or principal, instead of strictly following UPIA. Or there may be provision for additional distributions, beyond the accounting income. In recent years, with very low interest rates, accounting income may have...