In December 2003, the Internal Revenue Service issued new regulations governing the definition of trust income for federal tax purposes. These regulations create significant planning opportunities as well as some potential pitfalls. There are times when it is advantageous for a trust to have a considerable amount of income, as with a qualified domestic trust (QDOT). Other times, it's preferable for a trust to have very little income, as with a qualified sub-chapter S trust (QSST). The regulations create a new level of flexibility to adjust trust income to meet these kinds of needs.
Trust income (alternatively known as fiduciary accounting income or FAI) impacts the allocation of income tax liability between the beneficiaries of a trust and the trust itself. Moreover, the Internal Revenue Code provides special benefits for a variety of trusts, as long as they distribute all “income” annually. QSSTs, QDOTs and qualified terminable interest property trusts (QTIPs) are three of these kinds of trusts. Ensuring that a trust's definition of FAI is respected for federal tax purposes is critical — which is what the regulations govern.
Throughout the 1990s, the traditional sources of trust income, primarily interest and dividends, became increasing difficult to generate. Trust beneficiaries grew more sophisticated as low cost brokers emerged and the number of individuals who owned stock increased. Trustees felt caught between the conflicting investment objectives of income beneficiaries and remainder beneficiaries. They needed the ability to invest for total return, regardless of whether a particular investment generated trust income. The Uniform Prudent Investor Act (UPIA) and the Uniform Principal and Income Act (UPAIA) responded to these needs. In turn, the regulations have brought the definition of trust income for federal income tax purposes, which had not been modified since 1956, into the era of modern portfolio theory.
STATE LAW CHANGES
The National Conference of Commissioners on Uniform State Laws issued the UPIA in 1994 and the UPAIA in 1997. Over time, these two acts have been adopted by a large number of states, leading to the promulgation of the regulations.
The UPIA directs trustees to “invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.”1 In reviewing a trustee's investment choices, investments are “evaluated not in isolation but in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.”2
While the UPIA was intended to encourage trustees to invest trust portfolios for total return, it sets forth an important caveat: “If a trust has two or more beneficiaries, the trustee shall act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries.”3 Because of this “duty of impartiality,” if a beneficiary is only entitled to trust FAI, under the UPIA trustees are still obligated to consider whether the portfolio investment returns would provide an appropriate benefit to such beneficiary.
UPAIA further addresses the issue of impartiality. A prefatory note to the 1997 UPAIA states that one of the primary purposes given for revising the Uniform Principal and Income Acts of 1931 and 1962 was “to provide a means for implementing the transition to an investment regime based on principles embodied in the Uniform Prudent Investor Act of 1994, especially the principle of investing for total return rather than a certain level of ‘income’ as traditionally perceived in terms of interest, dividends and rents.” The specific method the UPAIA uses to implement this transition is to grant trustees the power to adjust between principal and income (to the extent necessary) if:
the trustee invests and manages trust assets as a prudent investor;
the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust's income; and
the trustee determines the adjustment is required so that the trust can be administered impartially based on what is fair and reasonable to all of the beneficiaries (that is to say, the power to adjust).4
Essentially, this means that a trustee can determine what is a reasonable payout to the income beneficiary and adjust FAI accordingly. In addition to the power to adjust, the UPAIA also recognizes that a unitrust may be an appropriate method for allocating trust property between income and remainder beneficiaries under the UPIA's total return scheme. Accordingly, certain states, including New York, have authorized the creation of unitrusts and define a trust's “net income” to be the applicable unitrust amount.5 In such cases, the UPAIA is clear that the power to adjust cannot be used to vary a unitrust interest.6
In the regulations under Section 643, FAI is defined as “the amount of income of…[a] trust for the taxable year determined under the terms of the governing instrument and applicable local law.”7 Yet the regulations also state: “Trust provisions that depart fundamentally from traditional principles of income and principal will generally not be recognized.”8 In other words, the starting point for computing a trust's FAI continues to be the traditional definition of income (for example, interest, dividends and rents). A trust can deviate from the traditional definition of income only if applicable local law provides for a “reasonable apportionment” of the total return of the trust between the income and remainder beneficiaries. To determine whether a trust may deviate from the traditional definition of income, two questions must be answered:
What is “applicable local law”?
What constitutes a “reasonable apportionment”?
APPLICABLE LOCAL LAW
A trust that deviates from traditional standards of income and principal will not have its income allocations respected for federal income tax purposes unless the deviation is authorized under applicable local law. Determining whether a particular state rule constitutes “applicable local law” is, therefore, critical. The regulations explicitly provide that applicable local law includes state statutes.9 Furthermore, the preamble to the regulations states that applicable local law also includes “a decision by the highest court of the state announcing a general principle or rule of law that would apply to all trusts administered under the laws of that state.”10 However, a court order applicable only to the trust in question will not constitute applicable local law.11 This narrow definition of applicable local law is likely to produce renewed interest in forum shopping, as trustees seek the flexibility available in states that have adopted the UPIA and UPAIA.
The regulations provide two examples of what is considered a “reasonable apportionment,” suggesting that other methodologies may qualify as a reasonable apportionment between income and principal. First, a unitrust amount between 3 percent and 5 percent of the fair market value of trust assets is a reasonable apportionment of the total return of a trust and, therefore, would be respected for federal income tax purposes.12 The fair market value of the trust may be determined annually or averaged on a multiple year basis.13 (The multi-year average mitigates some of the potential fluctuations in portfolio values.)
Second, a trustee may use his power to adjust to determine a trust's FAI, provided that such power allows the trustee to fulfill his duty of impartiality between the income and remainder beneficiaries.14 The fact that the regulations describe these situations as merely “examples” indicates that other methodologies also may be used as a reasonable apportionment between income and principal. Of course, any methodology would have to satisfy the applicable local law requirement if it is to be respected for federal income tax purposes.
Trusts that are not currently governed by the UPIA and UPAIA may ultimately become so in one of two ways: the state whose law governs the trust may adopt one or both of the uniform acts; or the trustees may, in accordance with the terms of the trust and state law, change the governing law of the trust. Regardless of how the change is effected, the regulations expressly provide that a change in the method of determining trust income that is authorized by state statute will not constitute a recognition event for purposes of IRC Section 1001, nor will it result in a taxable gift.15 On the other hand, a change in the manner of computing trust income to a method not specifically authorized by state statute — but valid under state law — may constitute a recognition event under Section 1001, and may result in a taxable gift, depending on the relevant facts and circumstances.16
It's also important to bear in mind that the administration of a trust pursuant to a unitrust standard or the power to adjust will not shift a beneficial interest in the trust. Consequently, a pre-1986 generation skipping transfer (GST) exempt trust will not become de-grandfathered as a result of administering a trust in this manner.17 Presumably, this also holds true when a trust changes its current method of allocating income to a unitrust or power to adjust method.
The federal income tax rules governing trusts allocate the tax burden associated with trust income between current and remainder beneficiaries. The computation of distributable net income (DNI), the characterization of trust distributions, and the deduction in computing a trust's taxable income for distributions of DNI are the mechanisms by which such allocation is made.18 The rule that capital gains generally are not included in the DNI of a U.S. trust remains unchanged in the regulations.19 This rule reflects the theory that capital gains represent an increase in trust principal and, therefore, ultimately benefits a trust's remainder beneficiaries, who should bear any associated tax.
Historically, this view has been appropriate because capital gains were not included in FAI, which meant that such gains were not available for distribution to a trust's income beneficiaries. Under the regulations, however, gains from the sale or exchange of capital assets will be included in the DNI if both of two tests are met. We refer to these tests as the “authorization test” and the “allocation test.”
The authorization test can be satisfied in one of two ways. First, it will be met if a trust instrument and local law allocate capital gains to the DNI. Second, it's satisfied if a trustee is given discretion under either local law or the trust instrument to allocate capital gains to the DNI and the trustee exercises that discretion in a reasonable and impartial manner.20
Assuming the authorization test is satisfied, the allocation test is satisfied in one of four ways: first, if capital gains are actually allocated to FAI. Note that if income is defined as a unitrust amount and the authorization test is satisfied based on the trustee's discretionary power to allocate capital gains to FAI, the trustee's power must be exercised consistently. Pursuant to the regulations, this means that if a trustee chooses to allocate capital gains to the unitrust recipient, he must do so every year.21
Second, the allocation test is satisfied if gains from the sale of capital assets are allocated to the corpus but consistently treated by the trustee on the trust's books, records and tax returns as distributed to one or more income beneficiaries. Once again, if the trustee chooses to include capital gains as part of the trust's income for purposes of making trust distributions, the trustee will be required to continue such treatment in all future years.22
Third, the allocation test is satisfied if capital gains are allocated to the corpus but actually distributed to a beneficiary or used by the trustee in determining the amount that is distributed, or required to be distributed, to a beneficiary. This provision does not require consistent application.23 The theory behind this approach appears to be that, if proceeds from a specific sale are actually distributed to a beneficiary, such proceeds should be treated as included in DNI. Under this test, a trustee can choose to make distributions based on the sale of an asset in some years, but, in other years, can choose not to make such a distribution.
Finally, if capital gains are paid, permanently set aside, or to be used for charitable purposes, the allocation test is satisfied.24
Unfortunately, the regulations do not provide any examples concerning the inclusion of capital gains in DNI when a trustee exercises the power to adjust. According to the preamble, state statutes and trust terms vary too widely to make such examples meaningful.25
Under the regulations, both a QTIP and a QDOT continue to be valid even if trust income is defined as a unitrust amount (assuming such a definition conforms to applicable local law) or if the trustee has a power to adjust.26 (It's not necessary to require the trustee of a QTIP or QDOT to distribute the greater of trust income or the unitrust amount in order to preserve the benefits of the marital deduction, nor is it necessary to prohibit a trustee from using the power to adjust to diminish the income of a QTIP or QDOT.)27
Nevertheless, the UPAIA explicitly prohibits a trustee from using the power to adjust to diminish the income of a trust that requires the annual distribution of such trust's income to a surviving spouse (and for which an estate tax or gift tax marital deduction would be allowed).28 Caution dictates that the governing law of each trust should be reviewed to see if this provision has been included in the relevant state's version of the UPAIA.
The expanded flexibility for defining income in a QTIP or QDOT provides certain planning opportunities. For example, income distributed from a QDOT is not subject to estate tax at the time of distribution. However, any assets remaining in the trust as of the surviving spouse's death will be subject to estate tax at that time. As a result, it may be desirable to use a power to adjust to increase the amount of distributable “income” or use a 5 percent unitrust amount. Indeed, while the regulations provide a safe harbor for a unitrust amount between 3 percent and 5 percent, they do not explicitly state that a unitrust amount greater than 5 percent will not be respected for purposes of defining trust income.
With regard to a net income charitable remainder unitrust (NICRUT), which requires the trustee to distribute the lesser of trust income or the unitrust amount, the regulations provide that only gain associated with post-contribution appreciation can be allocated to trust income.29 That being said, the regulations explicitly authorize the trustee of a NICRUT to use the power to adjust when determining trust income.
The regulations also impact pooled income funds (PIFs). For example, a PIF is not entitled to a charitable deduction under Section 642(c) for any long-term capital gains that would otherwise be considered permanently set aside for charitable purposes if it's possible for the trustee of the PIF to define FAI as a unitrust amount, or exercise a power to adjust. Depending on the state law that governs the PIF, it may be necessary to reform the PIF's controlling instrument to specifically prohibit such powers.
The regulations also have confirmed that if a trust is required to make a distribution of a specific amount (whether a specific dollar amount under the terms of the trust or by reference to some standard, such as mandatory distributions of all trust income), satisfying that specific distribution requirement with appreciated property will be treated as a sale of the property and a distribution of the proceeds.30 Given that a grantor and his grantor trust are not treated as separate taxpayers, this rule does apply to a grantor trust when the distribution is made to the trust's grantor.31
The UPIA and UPAIA represent a significant evolution of the state law governing trusts. Together, they provide trustees the discretion needed to implement modern theories of portfolio management while properly balancing the needs of current and future beneficiaries. In most instances, the regulations are largely positive for trustees, beneficiaries and their tax advisors. The regulations embrace the new definitions of income being crafted by state legislatures, as well as provide certain planning opportunities.
Nonetheless, they also create new traps that could lead to the unintended incurrence of tax or the failure to qualify for desirable tax benefits, such as the estate or gift tax marital deduction. It's important that the application of the regulations be considered as practitioners administer existing trusts and consider how to draft new ones.
- UPIA Section 2(a).
- UPIA Section 2(b).
- UPIA Section 6.
- UPAIA Sections 104(a) and 103.
- See, for example, EPTL Section 11-2.4.
- UPAIA Section 104(c)(3); see also EPTL Section 11-2.3(b)(5)(C)(iii).
- Treas. Reg. Section 1.643(b)-1.
- T.D. 9102.
- Treas. Reg. Section 1.643(b)-1.
- Ibid. IRC Section 1001.
- Treas. Reg. Section 26.2601-1(b)(4)(i)(D)(2).
- See, for example, Code Sections 643, 652 and 661.
- Treas. Reg. Section 1.643(a)-1(a).
- Treas. Reg. Section 1.643 (a)-3(b).
- Treas. Reg. Section 1.643(a)-3(e), Ex. (12) and Ex. (13).
- Treas. Reg. Section 1.643(a)-3(e), Ex. (1) and Ex. (2).
- See Treas. Reg. Section 1.643(a)-3(e), Ex. (6) and Ex. (9).
- Treas. Reg. Section 1.643(a)-3(c).
- T.D. 9102.
- Treas. Reg. Sections 20.2056(b)-7(d)(1), 20.2056A-5(c)(2), and 25.2523(e)-1(f)(1).
- Ibid. It is an oddity of the regulations that Treas. Reg. Section 20.2056A-5(c)(2) specifically states that income may be defined as a unitrust amount in the context of a QDOT, while Treas. Reg. Sections 20.2056(b)-7(d)(1) and 25.2523(e)-1(f)(1) merely reference Treas. Reg. Section 1.643(b)-1, which authorizes both the power to adjust and the use of a unitrust definition of income. It seems unlikely that this inconsistency was intended to reflect a material difference between the definition of income for purposes of a QDOT and a QTIP.
- UPAIA Section 104(c)(1).
- Treas. Reg. Section 1.664-3(a)(1)(i)(b)(3).
- Treas. Reg. Sections 1.651(a)-2 and 1.661(a)-2.
- See, for example, Rev. Rul. 85-13, 1985-1 C.B. 184.
Jean-Michel Basquiat: “Flexible,” an acrylic and oil on paintstick painted by Basquiat in 1984, is part of the artist's private estate and is currently on display at Brooklyn Museum's exhibition of the artist's work.
Jean-Michel Basquiat: This acrylic and oilstick on canvas, “Spike,” painted by Basquiat in 1984, was sold to a private collector in Monaco for $534,400 at Sotheby's “Contemporary Art” auction in New York on May 13, 2004.