Trusts owning partnership interests and the revised UPIA.

• Author: Cantrell, Carol A.
• Position: Uniform Principal and Income Act

Recently, The Tax Adviser published a very timely and informative item on trusts owning partnership interests (Bazley and Hills, "Trusts Owning Partnership Interests," Tax Clinic, 40 The TaxAdviser 577 (September 2009)). In it, the authors discuss a special problem facing trustees whose principal or sole asset is a partnership that does not distribute all its taxable income. The problem arises because partnership distributions not in liquidation are "trust income" payable to the income beneficiary. Yet if the trustee pays the income beneficiary the full amount of the partnership distribution, the trust may not have sufficient cash to pay the trust's own tax liability. The authors looked to Sections 505 and 506 of the Uniform Principal and Income Act (UPIA) to analyze solutions to the problem. This item follows up on that September item to examine how recent revisions to Section 505 of UPIA clarify how that problem should be handled. The revised Section 505 has so far been adopted in only 15 states, but practitioners should expect that number to grow.

Illustration of the Problem

In the September item, the authors provide an example to illustrate a trust that receives $40,000 from a partnership that is designated as trust income. The trust also receives a Schedule K-1 from the partnership reflecting $100,000 of taxable income. The partnership is the trust's only asset. The trust also incurs $5,000 of administrative costs, which are allocated half to income and half to principal. After deducting $2,500 of administrative expenses from the $40,000 partnership distribution, the trustee has $37,500 of trust income to pay the beneficiary. After deducting a $37,500 payment to the beneficiary ($40,000 - $2,500 = $37,500), the trust has an income tax of approximately $19,000 (($100,000 - $5,000 - $37,500) x 33% = $19,000, assuming the trust is in the 33% tax bracket). However, the trust will have no cash to pay its tax if it pays the beneficiary $37,500.

To solve the problem, the authors look to Section 505(c) of UPIA, which, they say, "directs the trustee to pay the income tax on income from a passthrough entity 'proportionately' from income and principal." Based on that, they allocate 40% of the trust's tax to income and 60% to principal because 40% of the partnership's income was distributed and allocated to trust income. When that does not solve the problem because the trust still has insufficient cash to pay its tax, they turn to Section 506 of...