New sec. 643 trustee capital gain and loss carryout regs.

• Author: Cantrell, Carol A.

Effective for tax years ending after Jan. 2, 2004, new capital gain and loss carryout rules (1) apply to all estates and trusts. Regs. Sec. 1.643(a)3(b) is a response to the large number of states that adopted the new "power to adjust" and "unitrust" definitions of income in their version of the Uniform Principal and Income Act of 1997 (UPIA). (2)

Under UPIA Section 104, a power to adjust allows the trustee to transfer amounts between trust income and principal, so that both classes of beneficiaries are allocated reasonable amounts of the total return (including both traditional income and capital appreciation) when a trust invests under the "prudent investor" rule. (3) A unitrust accomplishes the same result, but defines income as a fixed percentage of the trust assets determined annually. (4)

According to the regulations' preamble, the IRS was concerned that these new state laws would encourage settlors to begin defining income in ways that depart fundamentally from traditional trust income (the foundation on which Subchapter J was built). In addition, it was concerned that allowing existing trusts to default or "opt" into these new definitions of income would adversely affect their tax status as qualified terminable interest property trusts qualifying for the estate tax deduction, charitable remainder unitrusts, qualified S corporation trusts, grandfathered generation-skipping trusts or intentionally defective grantor trusts. Finally, the Service was bothered that without a change to the existing rules, an income beneficiary could receive tax-free distributions of, essentially, a portion of the trust's capital gain, while the remainder beneficiary pays the tax thereon. This item discusses the last concern.

Before the new regulations, capital gain was normally excluded from distributable net income (DNI), because most state laws excluded capital gain from trust income. Thus, such gain was taxed to the remainder beneficiary who actually received it. However, when income beneficiaries began to receive a portion of the capital gain through the trustee's power to adjust or a unitrust payment, the landscape changed.

Example 1: Trust T is a unitrust that pays beneficiary B 4% of the fair market value of its assets annually. C is the remainder beneficiary. Neither the trust instrument nor state law characterizes T's payment to B as capital or ordinary for tax purposes. T's assets are valued at $1 million; thus, it pays B $40,000: T has $30,000 dividends and interest and $50,000 long-term capital gain. Under the prior regulations, T's $40,000 payment to...