Trusts owning partnership interests.

• Author: Bazley, Thomas E.

Partnership interests held in trusts create unique dilemmas for trustees and advisers. When a trust document requires that all income be paid to the beneficiary, this refers to trust accounting income (TAI), not taxable income. Therefore, if the taxable income generated by the partnership exceeds the amount the partnership distributes to its partners (including the trust), the simple trust will often owe income tax. In this situation, the trustee should work closely with the tax adviser to determine how much cash to withhold from the trust's income beneficiary in order to pay this tax.

Background

Typically, a simple trust will pay income tax only on its net capital gains because of two trust tax concepts:

* Amounts that the trust document "requires to be distributed" are, for tax purposes, deemed to have been distributed to the beneficiary even if the amount actually paid is smaller; and

* Amounts distributed (whether actually or deemed paid) to the beneficiary shift taxable income to the beneficiary only up to a maximum cap called distributable net income (which is basically taxable income other than capital gains).

Therefore, typically all taxable income of a simple trust (other than capital gains) is shifted to the beneficiary via a Form 1041, U.S. Income Tax Return for Estates and Trusts, Schedule K-l, leaving only capital gains taxed to the trust.

What some return preparers may not realize, however, is that under Sec. 643(b) the amount required to be distributed is measured by TAI, which may (particularly if the trust owns a partnership) have no correlation whatsoever with the amount of taxable income of the trust. If a tax return preparer does not properly understand and compute the TAI (and thus recognize the situations in which TAI is less than the taxable income), the tax liability may ultimately be borne by the incorrect beneficiaries of the trust.

Trust Accounting Income

Ultimately, a trustee's duty is to administer the trust impartially, based on what is fair and reasonable for all beneficiaries, including not only the current income beneficiaries but also the remainder beneficiaries. As an oversimplification, if the trust holds only marketable securities, the interest and dividend "income" (net of expenses) is payable to the income beneficiary, but the proceeds (also net of expenses) from the sale and reinvestment of the assets are considered principal and are instead retained for eventual distribution to the remainder beneficiaries.

The determination of whether receipts (or disbursements) are included in (or charged against) income versus principal could conceivably be stipulated in the trust document itself. However, since most trust documents are silent on this issue, the decision is generally determined based upon state statutes. Even if the trust's terms provide the trustee with a discretionary power of administration (allowing the trustee to exercise discretion in allocating receipts and disbursements between principal and income), most trustees are reluctant to stray too widely from the state statutes governing the trust. Most state statutes will generally adhere to some variation of the 1997 version of the Uniform Principal and Income...