Sec. 643 prop. regs. redefine trust income.

• Author: Cantrell, Carol

In response to many states' adoption of the 1997 Uniform Principal and Income Act, the IRS issued proposed regulations permitting the inclusion of capital gains in distributable net income. The new rules, when final, will affect many different types of trusts; CPAs, attorneys and trustees may all incur additional responsibilities. This article examines the proposed regulations and offers planning suggestions.

On Feb. 15, 2001, Sec. 643 proposed regulations(1) were issued in response to state law changes to trust code income definitions. The new regulations' centerpiece is the ability to include capital gains in distributable net income (DNI) for trusts using the modern "power to adjust" or the "unitrust" concept embodied in the 1997 Uniform Principal and Income Act (UPIA). Fifteen states have already adopted versions of the UPIA; at least 15 more have either proposed (or plan to propose) similar legislation.(2) The proposed changes may soon affect more than three and a half million trusts and their advisers annually.(3)

The linchpin Code section most directly affected by these state law changes is Sec. 643; however, many other Code sections hinge on the Sec. 643 definition of fiduciary accounting income. These changes will affect all simple trusts, all complex trusts using trust income as a benchmark, and all qualified terminable interest property (QTIP) marital deduction trusts (1) in states that have adopted versions of the UPIA or (2) governed by the terms of a document that contains a power to adjust or a unitrust amount: They will also affect any charitable remainder unitrust (CRUT) in a state that has adopted a default unitrust definition of income (such as the New York proposal, before its recent amendment).(4) This article will analyze the proposed regulations and offer practical suggestions to trustees and their advisers.

Traditional Concepts of Fiduciary Income and DNI

Most state probate and trust codes are modeled after the 1962 Uniform Principal and Income Act.(5) Dividends and interest are income and allocated to the income beneficiaries; capital gains are corpus and allocated to principal beneficiaries. If no distributions are made to beneficiaries during a particular year, the taxable income remains a part of (and is taxed to) the trust. If distributions are made during the year, they will carry out some or all DNI under Secs. 651 and 661. Sec. 643(a) defines DNI as the trust's taxable income computed with certain modifications (i.e., excluding capital gains and including tax-exempt interest).

Under the current regime, distributions to beneficiaries carry out an estate's or trust's DNI--i.e., the fiduciary's taxable income with certain modifications (most notably, the exclusion of capital gains). Thus, beneficiary distributions (regardless of whether characterized as income or principal) carry out the estate's or trust's taxable income, leaving capital gains inside the trust for taxation at that level. In effect, the remainder beneficiary incurs the capital gain tax. This is fair; supposedly, the remainder beneficiary ultimately receives the benefit of the capital gains remaining in the trust on termination.

Modern Investment Portfolio Theory

This DNI carryout system worked fairly well, until the prudent-investor standard for managing trust assets allowed trustees to consider different types of investment alternatives that blurred the traditional distinction between income and principal.6 For example, trust portfolios may now include limited partnership interests, annuities, IRAs, options and other derivatives, regulated investment companies (mutual funds) and many other types of investment vehicles previously unheard of in a trust portfolio. Most state trust codes do not describe how to separate income from principal for such assets.

In addition to more modern investment vehicles, there is a growing trend to shift trust investments toward growth and equity strategies. This has an adverse effect on income beneficiaries, who traditionally are entitled only to dividends and interest. In response to the need to invest for growth, yet also protect the income beneficiary's interest, the National Conference of Commissioners on Uniform State Laws drafted the UPIA.

Its centerpiece is the Section 104 "power to adjust" between income and principal, which is granted if three conditions are met: (1) the trustee must be subject to the prudent-investor standard; (2) the computation of trust income must affect beneficiary distributions; and (3) the trustee must determine that full compliance with the first two criteria leads to noncompliance with his duty of impartiality among beneficiaries. Use of this power allows a trustee to allocate between income and principal if necessary to balance the interests of the income and remainder beneficiaries, regardless of the investment strategy.

Many states have revised their traditional definitions of income and principal to conform with this power, such as California.7 Other states, such as New York, have enacted either a power to adjust or an elective alternative "unitrust" concept of income for all trusts.8

Mismatch of Income Tax and Trust Distributions

While modern investment and distribution trends attempt to balance the income and remainder beneficiaries' rights, they play havoc with the existing income tax rules designed under traditional fiduciary standards. Under the old definition of fiduciary income, it made sense to tax an income beneficiary on income actually distributed, but not on capital gains retained by the trust. However, under the new power-to-adjust or unitrust distribution standards, income beneficiaries may obtain a tax windfall when they receive distributions reclassified by trustees as "income" but deemed "principal," and may be taxable to the trust as capital gains under Federal income tax rules.

For example, if a trustee distributes a three-percent unitrust payment to a current income beneficiary when ordinary income represents only two percent of trust asset value, the income beneficiary will receive the last one-percent distribution tax-free. This happens because the trust's capital gains incurred during the year remain in the trust for taxation at that level. In a sense, the remainder beneficiary pays capital gain tax on a portion of the distributions paid to the income beneficiary.(9)

Sec. 643 Prop. Regs.

Recognizing these modern investment trends, changes in state law income definitions and the resulting income tax inequities, the IRS sought to overhaul Sec. 643's definition of fiduciary income as least as far back as its 2000 business plan. The proposed changes will affect any trust that relies on income to determine amounts properly payable to its beneficiaries and is subject to a power to adjust or unitrust amount under state law or its governing document; this includes simple trusts, complex trusts that measure distributions relative to trust income, QTIP trusts, CRUTs, pooled income funds and trusts grandfathered from generation-skipping transfer (GST) taxes. These changes are proposed to apply to trusts and estates, for tax years beginning on or after the date final regulations are published in the Federal Register.

These proposals affect not only fiduciaries in states that have already adopted the new state law income definitions, but trust instruments that contain unitrust payouts or fiduciary discretion to adjust income or principal.

While the IRS's original aim was to conform the Federal tax definition of income to the evolving state law definition, as the update of Sec. 643 progressed, it became obvious that other Code sections needed to be included in the project. Also at stake were marital, charitable and generation-skipping trusts, all of which rely on Sec. 643 for their definition of fiduciary income in determining their critical Federal tax consequences. Thus, the list of regulations requiring revision expanded, resulting in changes under Regs. Secs. 1.642(c)-2 (pooled income fund charitable set-asides), 1.643(a)-3 (capital gains included in DNI), 1.643(b)-1 (state law income definitions), 1.651 (a)-2 and 1.661 (a)-2(f) (in-kind distributions), 1.664-3(a)(1)(i)(b)(3) (CRUTs to provide their own definition of income), 20.2056(b)-5(f),-7 and 25.2523(e)-1 (income for marital trusts), and 26.2601-1(b)(4)(i)(D)(2) (GST-exempt trust modifications).

Including Capital Gains in DNI

Current income tax laws normally exclude capital gains from DNI, following state law that generally excludes such gains from trust accounting income. A review of the current rules on inclusion of capital gains in DNI will enable appreciation of the proposed changes.

Current Rules

Capital gains are generally excluded from DNI, except in three very limited situations. First, under Regs. Sec. 1.643(a)-3(a)(1), capital gains may be specifically included in income under local law or the governing instrument. This situation is rare; state laws (and most trust instruments) do not usually include capital gains in income. However, Letter Ruling 8728001(10) permitted trustees to use discretion granted them in the trust instrument to allocate some, but not all, of a trust's capital gains to income.

Second, capital gains otherwise allocable to corpus may be actually distributed to the beneficiaries. According to Regs. Sec...