Removing capital gains from trusts.

• Author: Whitehair, Andrew L.

With more assets held in trust and higher marginal tax rates, many clients and advisers are now considering distributions from trusts to beneficiaries as a way to shift the tax burden to individuals in lower tax brackets. However, under the traditional definition of fiduciary accounting income (FM), capital gains are typically excluded from distributable net income (DN1) and, thus, are taxed at the trust level.

The implementation of the Uniform Principal and Income Act of 1997 (UPAIA) and the 2004 revisions to the regulations under Sec. 643 have provided fiduciaries with some flexibility in making distributions of capital gains to beneficiaries. Tax advisers should understand the options available under state law, including the "power to adjust" and "unitrust" provisions, and how those provisions intersect with Regs. Sec. 1.643(a)-3. Additionally, advisers should consider the grantor trust rules and how they may provide further options for income shifting.

Background

FAI, also referred to as trust accounting income, is determined by the governing instrument and applicable local law. Although it is not a tax concept, FAT is important in determining whether the fiduciary or beneficiaries pay tax on the trust's income. When the Internal Revenue Code refers to "income," the reference is to the definition of FM in the governing instrument and applicable local law (Sec. 643(b)).

If the governing instrument is silent as to the treatment of capital gains for FAT purposes, the fiduciary should look to applicable local law. Currently, 46 states and the District of Columbia have adopted some form of the 1997 UPAIA (see RIA Checkpoint, "List of States Following One of the Revised Uniform Principal and Income Acts,"Table T309). Three states (Georgia, Illinois, and Louisiana) currently operate under the 1962 TJPAIA. Rhode Island has not adopted any form of the UPAIA. The UP'AIA typically allocates money or property received from the sale, exchange, or liquidation or an asset to principal (UPAIA [section]404). For fiduciary accounting purposes, this means that capital gains are generally excluded from income absent another exception.

However, the LTPAIA was adopted in part to update the current income and principal rules to reflect the concept of total return investing, which includes the gain or loss that the asset realizes. Total return "encourages investors to seek the highest overall return (given a certain risk tolerance and within the bounds of prudent investing), without being needlessly hampered by how that return is created" (Lee, Implementing Total Return Trusts, p. 4 (2003)). For trusts with a payout to a current beneficiary based on income, a fiduciary relying on total return investing (particularly in the current low-yield environment) may not generate sufficient cash from sources typically considered income, such as interest and dividends, thus inadvertently reducing the payout due to the income beneficiary.

Example 1: A Trust is a marital trust required to distribute all income to the surviving spouse, B, during his life, with the remainder to the decedent's children. The governing instrument is silent regarding treatment of capital gains, but the governing state has adopted the 1997 UPAIA. The trustee invests for total return with a 70/30 allocation between equities and fixed income. In 2014, the trust has $10,000 of dividend income and $25,000 of realized long-term capital gain income. FM is $10,000, which is the total amount the fiduciary should distribute to B for 2014. The trust receives an income distribution deduction of $10,000, and the remaining $25,000 of capital gain income is taxed to the trust since capital gains are generally excluded from DNI and are unavailable for distribution to any beneficiary (Regs. Sec. 1.643(a)-3(a)).

The Problem

Given that the top marginal tax rate of 39.6% and the 3.8% net investment income tax apply to estates and trusts with taxable income in excess of only $12,150 in 2014 (not to mention state income taxes), the tax impact of retaining capital gains in a trust can be severe. In Example 1, $12,850 of longterm capital gains will be subject to a total federal tax rate of 23.8% (20% top marginal long-term capital gains rate plus the 3.8% net investment income tax). If the beneficiary is in a lower tax bracket and not subject to the 3.8% net investment income tax, what options does a fiduciary have to minimize tax on undistributed capital gains?

The Regulations

Generally, capital gains are excluded from DNI to the extent they are allocated to corpus and are not paid, credited, or required to be distributed to any beneficiary during...