Subchapter J: the Proposed Section 643(b) Regulations, the Definition of Income and the Allocation of Capital Gains

• Publication year: 2002
• Author: By James R. Chisholm, Esq.

SUBCHAPTER J: THE PROPOSED SECTION 643(B) REGULATIONS, THE DEFINITION OF INCOME AND THE ALLOCATION OF CAPITAL GAINS1

By James R. Chisholm, Esq.^*

Sections 641 thro ugh 668 of the Internal Revenue Code ("IRC" or the "Code")², known as Subchapter J, set forth the basic rules for taxing the income of estates and many trusts.³ Estates and trusts are generally taxed like individuals with the fiduciary responsible for the payment of the tax, but numerous special rules apply to trusts that do not apply to individuals. The most important difference between the income taxation of estates and trusts and the income taxation of individuals is that estates and trusts deduct certain distributions made to beneficiaries who, in turn, are required to include such distributions in gross income. This article discusses the basic concepts of what is considered income of an estate or ordinary trust under Subchapter J and the impact of the new proposed regulations under § 643(b).

I. FIDUCIARY ACCOUNTING INCOME

The concept of "income" occupies a central role in Subchapter J. At the very heart of Subchapter J are the rules governing characterization of distributions. These rules determine the distribution deduction available to an estate or trust and limit the amount on which a beneficiary is subject to taxation. In essence, these rules allocate liability for payment of the taxes, if any, on the entity's income between the entity and its beneficiaries. Under IRC § 651 or § 661, a trust that is required to distribute "income" currently is entitled to a distribution deduction equal to the amount of such income.⁴ Similarly, in certain situations, IRC § 652 or § 662 provides that the amount on which a trust beneficiary is subject to taxation cannot exceed the amount of "income" to which he or she is entitled.⁵ Therefore, an entity's "income" must be determined.

In this regard, IRC § 643(b) provides as follows.

"(b) Income. For purposes of this subpart and subparts B, C, and D, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income."

As seen above, IRC § 643(b) states that the term "income," when not preceded by the specified adjectives, means the amount of income determined under the terms of the governing instrument and applicable local law. During the normal administration of an estate or trust, the executor or trustee receives various items of income and pays for various items of expense. These receipts and expenditures are then allocated in accordance with the provisions of the will or trust document. Where the governing document is silent, state law provides the appropriate allocation. To state it another way, income will typically be determined in accordance with the principal and income act of the governing state⁶ unless the governing document overrides the provisions of the principal and income act. Therefore, "income" will normally mean the income determined under the principal and income act of the governing state. Such income is typically referred to as "fiduciary accounting income" ("FAI").

A. Initial Treasury Regulations

Treas. Reg. 1.643(b)-1, enacted in 1956⁷, provides as follows:

"For purposes of Subparts A through D, Part I, Subchapter J, Chapter 1 of the Code, the term "income" when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of an estate or trust for the taxable year determined under the terms of its governing instrument and applicable local law. Trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for this purpose. For example, if a trust instrument directs that all the trust income shall be paid to A, but defines ordinary dividends and interest as corpus, the trust will not be considered one which under its governing instrument is required to distribute all its income currently for purposes of section 642(b) (relating to the personal exemption) and section 651 (relating to "simple" trusts)." [Emphasis added]

The first sentence of the regulation simply repeats the language of the first sentence of the statute. The second sentence of the regulation is not contained in the statute and appears to give the Service the ability to determine if planners are playing games with the determination of FAI. It is not clear, however, what this sentence actually means and neither the current nor the Proposed Regulations answer the question.⁸ Notwithstanding the apparent ability of the Service to revisit the determination of FAI, it appears the Service has very seldom done so since the regulation was enacted.⁹

B. The Prudent Investor Act and the Uniform Principal and Income Act

The initial federal fiduciary income tax rules were based upon the traditional state law concepts of "income" and "principal." Historically, trustees simply distributed only income to the income beneficiaries and retained the principal and all capital gains realized by the trust for the ultimate benefit of the

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trust's remainder beneficiaries. As a result, even where the trustee is granted discretion to distribute principal to the income beneficiary, the existing federal income tax rules restrict the ability of the trustee to include capital gains in the income to be distributed to the beneficiaries.¹⁰ In recent years, however, the modern portfolio theory of investing, the Revised Uniform Principal and Income Act, the Uniform Principal and Income Act of 1997 ("UPAIA"), and the Prudent Investor Act have caused practitioners to consider the use of total return trusts.¹¹ UPAIA provides authority for trustees to make investment decisions following these new principles while allowing greater flexibility in the allocation of investment return between income and principal. Specifically, UPAIA § 104 permits a trustee, under certain circumstances, to "adjust" the financial returns actually achieved with respect to the trust portfolio between income and principal in order to enable the trustee to administer the trust "impartially, based on what is fair and reasonable to all of the beneficiaries," except to the extent that the governing instrument manifests a contrary intention. This adjustment power has the greatest significance when applied to trusts that require or permit the trustee to distribute only the FAI. If discretionary powers to distribute principal are conferred on the trustee, the trustee can supplement the income distribution by making supplemental distributions from principal, as appropriate. Many states, such as California, have revised their definitions of income and principal to conform to this power.¹² Other states, such as New York, have enacted either a power to adjust or an elective alternative "unitrust" concept of income for all trusts.¹³

C. New Proposed Regulations

The Proposed Regulations dramatically change the definition of income under § 643(b). It is proposed to revise Treas. Reg. §1.643(b)-1, set forth above, to read as follows:

"For purposes of subparts A through D, part I, subchapter J, chapter 1 of the Internal Revenue Code, income, when not preceded by the words "taxable," "distributable net," "undistributed net," or "gross," means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Trust provisions that depart fundamentally from traditional principles of income and principal, that is, allocating ordinary income to income and capital gains to principal, will generally not be recognized. However, amounts allocated between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary income, capital gains, and appreciation. For example, a state law that provides for the income beneficiary to receive each year a unitrust amount of between 3% and 5% of the annual fair market value of the trust assets is a reasonable apportionment of the total return of the trust. Similarly, a state law that permits the trustee to make equitable adjustments between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust. These adjustments are permitted when the trustee invests and manages the trust assets under the state's prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust's income, and the trustee after applying the state statutory rules regarding allocation of income and principal is unable to administer the trust impartially. In addition, an allocation of capital gains to income will be respected if the allocation is made either pursuant to the terms of the governing instrument and local law, or pursuant to a reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law." [Emphasis added]

The first sentence of the proposed regulation is the same as the current existing regulation. The second sentence appears to restate the "fundamental departure" rule. One commentator suggests that this rule be clarified.¹⁴ The remaining sentences are new. The proposed changes will affect any trust that relies on income to determine amounts properly payable to its...