Trustees of nongrantor trusts and, to a lesser extent, executors of estates often desire to treat distributions to beneficiaries as including realized capital gains, so that these gains are passed, along with any associated tax liability, to the beneficiaries of the trust or estate. A fiduciary may seek such an outcome when, for example, the beneficiary has capital losses that can be used to shelter the gains from tax, or the beneficiary is in a lower marginal tax bracket with respect to capital gains than is the trust or estate. The American Taxpayer Relief Act of 2012 (ATRA), enacted in January 2013 to help avert the so-called “fiscal cliff,” has given this latter situation considerably more importance, and it’s likely to occur with substantially greater frequency.1 ATRA includes provisions raising the top rates on long-term and short-term capital gains for taxpayers whose taxable incomes are above certain thresholds. These thresholds are much lower for trusts and estates than for individuals.
A fiduciary who intends to include capital gains in a distribution must contend with the restrictive provisions of the Internal Revenue Code and regulations issued by the Internal Revenue Service that limit the ability to include capital gains in estate or trust distributions and, thus, in distributable net income (DNI). Most of these instances require that the fiduciary consistently treat capital gains as either having been distributed or not having been distributed from one year to the next.
The final alternative in the regulation, however, which allows the fiduciary to include capital gains in DNI when the gains are “utilized by the fiduciary in determining the amount that is distributed or required to be distributed,” doesn’t mention this rule. A 2004 amendment appears to have eliminated the consistent practice requirement for circumstances in which inclusion of the gains in a distribution has economic effect apart from income tax consequences. This detail, which fiduciaries and their advisors don’t always recognize, seems to provide trustees of nongrantor trusts (or executors) who have the authority to make discretionary principal distributions and who meet the regulation’s other requirements with considerable flexibility in determining when capital gains will be included in DNI, even if they haven’t included them previously.2
The Rate Differential
Prior to ATRA, most long-term capital gains (that is, gains on the disposition of assets held for more than one year) were subject to a 15 percent federal tax rate.3 For 2012, the thresholds of taxable income above which this rate became applicable were $35,350 for a single individual and $70,700 for a married couple filing jointly.4 For trusts and estates, on the other hand, the threshold for the 15 percent capital gains rate was only $2,400.5 Short-term gains were taxed as ordinary income at a top rate of 35 percent when taxable income exceeded $388,350 for a single individual or married persons filing jointly and $11,650 for a trust or estate.
Under ATRA, while most of these rules remain in effect with slightly higher thresholds for 2013,6 a new
20 percent capital gains rate and an ordinary income rate of 39.6 percent are now imposed when taxable incomes exceed $400,000 for single individuals and $450,000 for married couples filing jointly.7 In the case of a trust or estate, however, these new rates apply when taxable income exceeds $11,950.8 These substantial differences have expanded considerably the situations in which a beneficiary’s taxable income will be below the threshold required for imposition of the higher tax rates, while the trust’s or estate’s taxable income will be above that threshold. In those cases, a trustee or executor now has an added incentive to seek to have the trust’s or estate’s capital gains treated as distributed to the beneficiaries, so as to allow the lower tax rates to apply to the gains.
The Regulation’s Provisions
IRC Section 643 sets forth various rules for determining the DNI of an estate or trust in each taxable year. Under this section, gains on the sale or exchange of capital assets are excluded from DNI . . .
to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for [charitable purposes].9
The Treasury regulation promulgated under this statute, Section 1.643(a)-3, states explicitly that capital gains “are ordinarily excluded from” DNI and aren’t ordinarily considered to be part of a distribution.10 Subsection (b) of the regulation goes on to describe three alternatives in which capital gains can be deemed included in DNI, namely, when the gains are either: (1) allocated to income, with additional requirements, including that “a discretionary power to allocate gains to income . . . be exercised consistently,” if income is a unitrust amount (subsection (b)(1)); (2) “[a]llocated to corpus but treated consistently by the fiduciary” in the trust’s records and tax returns “as part of a distribution to a beneficiary” (subsection (b)(2)); or (3) “[a]llocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary” (subsection (b)(3)).11
Our focus is on subsection (b)(3) and, more particularly, the portion that allows capital gains to be treated as includible in DNI when the fiduciary uses them to determine the amount of the distribution. Note, a trustee or executor who fits within this provision isn’t making a non-traditional allocation to income of gains on the disposition of principal assets; these gains remain principal. In those cases, most of which presumably involve older instruments, in which there’s doubt about the trustee’s or executor’s power to allocate capital gains to income, this distinction can be important.
Unlike both the unitrust option discussed in subsection (b)(1) and the alternative in subsection (b)(2), the third provision contains no requirement by its terms that the fiduciary’s exercise of the discretion in question be consistent from one year to the next. Rather, at least based on the regulation’s language, a fiduciary who properly uses subsection (b)(3) to treat capital gains as includible in a distribution in any one tax year isn’t locked in to following the same course in future years if, for example, the beneficiary’s taxable income in a subsequent year is expected to be high or if other economic reasons make it undesirable for the beneficiary to bear the liability for the capital gains tax in that year.
The opening language of subsection (b) requires that including capital gains in DNI under any of the three alternatives be done either “pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary.”12 The “reasonable and impartial exercise of discretion” must be “in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law.”13
Assuming that the fiduciary is acting reasonably and impartially, the question of whether either the governing instrument or state law authorizes the fiduciary to use capital gains in determining the amount distributed when (as is likely true in most cases) either the instrument or the applicable statute doesn’t explicitly reference this issue depends on the law of the state in question. However, as a general proposition, a fiduciary who has unlimited discretion under the terms of the governing instrument with respect to determining whether and in what amount principal distributions will be made, should be deemed to possess the power to fix the amount of a principal distribution by reference to the trust’s or estate’s capital gains for the year, even if that authorization isn’t explicit. Cases in which the fiduciary’s discretion is limited in some fashion, such as when a trustee is authorized to make principal distributions only for specified purposes, are more difficult to assess, and the fiduciary and his counsel need to analyze the governing instrument and the relevant circumstances.
If the trustee or executor doesn’t know the exact amount of capital gains attributable to the trust or estate by the end of the tax year, he can use the 65-day election. (See “Gains Under the 65-Day Election,” this page.)
Until 2004, the provision of the regulations that’s now found in subsection (b)(3) stated that capital gains would be deemed includible in DNI when the gains were “[u]tilized (pursuant to the terms of the governing instrument or the practice followed by the fiduciary) in determining the amount which is distributed or required to be distributed.”14 An example contained in the former regulation reinforced the concept that a fiduciary had to have a practice of using capital gains for the purpose of determining the amount of a distribution, as did several rulings issued by the IRS.15
What became the current regulation originally appeared as part of proposed regulations issued by the IRS in February 2001.16 The proposed regulation contained a new subsection (b) that again set forth three alternatives for when capital gains would be included in DNI, including a subsection (b)(3) that was similar to that of the current regulation. However, the introductory portion of the proposed subsection (b) made it a requirement of all three alternatives that the inclusion of capital gains in DNI be either “pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and consistent exercise of discretion by the fiduciary.”17
Nearly three years later, the IRS issued Treasury Decision 9102 (T.D. 9102), which contained the final version of the regulations.18 Apart from including an alternative reference to a situation when capital gains are “actually distributed to the beneficiary,” the text of subsection (b)(3) itself is the same as that contained in the proposed regulation. However, the requirement in the beginning of subsection (b) that all three of the situations described in the subsection be pursuant to a “consistent exercise of discretion by the fiduciary” was omitted. Although this language, or a version of it, now appears in the first two provisions of subsection (b), it’s absent from subsection (b)(3).19
A few of the examples contained in subsection (e) of the final regulation, in particular Example 5, reinforce the view that a consistent practice requirement no longer applies to subsection (b)(3).
Example 1 of the regulation concerns a situation in which a trustee, who’s given discretionary powers both to distribute principal and to deem such distributions to be made from capital gains, distributes $12,000 from principal in a year when the trust recognized $10,000 of capital gains that the trustee allocated to principal. The trustee “does not exercise the discretionary power to deem the discretionary distributions of principal as being paid from capital gains realized during the year.” The example concludes that not only are that year’s capital gains excluded from DNI, but “[i]n future years, Trustee must treat all discretionary distributions as not being made from any realized capital gains.”20
Examples 2 and 3 of the regulation both state that, “[t]he facts are the same as in Example 1,” and refer to the trustee’s intent to follow a regular practice of including capital gains in principal distributions, with Example 2 concluding that “[i]n future years Trustee must treat all discretionary distributions as being made first from any realized capital gains.”21
Finally, Example 5 provides that:
The facts are the same as in Example 1, except that Trustee decides that discretionary distributions will be made only to the extent Trust has realized capital gains during the year and thus the discretionary distribution ... is $10,000, rather than $12,000.
The example concludes that “[b]ecause Trustee will use the amount of any realized capital gain to determine the amount of the discretionary distribution to the beneficiary,” that gain is included in DNI for the year.22
By contrast, the corresponding example of the proposed regulation came to the same conclusion because the “[t]rustee will consistently use the amount of any realized capital gain to determine the amount of the discretionary distribution.”23 The omission of the word “consistently” from the final regulation’s example further strengthens the conclusion that a trustee who relies in any tax year on the provisions of subsection (b)(3) to treat realized capital gains as includible in DNI for that year need not do so on a consistent basis thereafter (and need not have done so previously).
The IRS doesn’t use the phrase “economic effect” in either T.D. 9102 or the final regulations themselves. However, both the text of the final version of subsection (b)(3) and other provisions of the final regulations, including subsection (b)(1), reflect an intention of allowing capital gains to be treated as having been distributed to a beneficiary, and so as forming part of the trust’s DNI for the tax year, when that treatment has economic effect apart from the tax consequences that result. T.D. 9102’s analysis of the circumstances under which capital gains may be allocated to income when income actually is a unitrust amount also supports this view.24
In addition, in reviewing a commentator’s suggestion “that a discretionary power to allocate capital gains to income should not have to be exercised consistently,” the IRS stated that, “[t]he exercise of the power generally affects the actual amount that may or must be distributed to the income beneficiaries,” and agreed “that the power does not have to be exercised consistently, as long as it is exercised reasonably and impartially.”25
Although this discussion was concerned primarily with allocations of capital gains to income, the same rationale should be applicable when the fiduciary varies the amount of a principal distribution based upon the amount of the trust’s or estate’s capital gains for the year.
Some wording in T.D. 9102 can be read as supporting a more restrictive view of subsection (b)(3), as can Example 1 of the regulation.26 This interpretation, however, conflicts with both the language of subsection (b) and with the thrust of Example 5 and would render the 2004 revisions to the regulation on this point meaningless. It seems, rather, that in both situations the IRS was addressing subsection (b)(2) of the regulation, which applies when the trustee doesn’t use capital gains in determining the amount of the distribution. This reading avoids making both the regulation itself internally inconsistent and the analysis in T.D. 9102 in conflict with the regulation. (For other examples of the requirement that the treatment of income items have economic effect aside from tax considerations, see “Economic Effect in the IRC,” this page.)
The IRS’ issuances interpreting Section 1.643(a)-3(b) since adoption of the final regulation on Jan. 2, 2004 have been sparse and don’t address the meaning of revised subsection (b)(3).27 There have been no reported court decisions on this issue. Thus, as of yet, fiduciaries lack official guidance, other than T.D. 9102 and Section 1.643(a)-3 itself, on how to implement subsection (b)(3).
However, it’s advisable for a trustee or executor who intends to treat capital gains allocated to principal as included in a distribution to a beneficiary under subsection (b)(3) to make a record, before the distribution if possible, of the decision to do so. Such a record may consist, for example, of a memorandum to file with annexed copies of calculations on which the decision has been based (principal amounts that may be distributed without inclusion of capital gains, the amount of capital gains for the tax year and the amount by which the distribution is altered as the result of inclusion of capital gains).
As we saw above in Example 5 of the regulation, a trustee decides to distribute only the trust’s realized capital gains and, further, makes a distribution that’s equal to the entire amount of the trust’s realized capital gains. Logically, the same result—inclusion of the gains in DNI—should follow if the trustee either: (1) adds the amount of realized capital gains to a principal amount that otherwise was to be distributed (and so, in the example, distributes $22,000 rather than $10,000 or $12,000), or (2) distributes an additional amount that’s less than the full amount of the trust’s or estate’s realized capital gains, so long as the amount of the trust’s realized capital gains for the year was used to determine the amount of the distribution.
In a doubtful situation, particularly if the amounts of capital gains and the taxes at issue are substantial, the fiduciary may wish to seek a private letter ruling from the IRS on the question of whether the fiduciary may properly treat DNI as including realized capital gains based on subsection (b)(3).
1. American Taxpayer Relief Act of 2012, Pub. L. No. 112-240 (2013) (ATRA).
2. A grantor trust for this purpose is one for which the income is taxed to the grantor or, sometimes, to another person, and not to the trust, generally without regard to whether there’s a distribution. See generally Internal Revenue Code Sections 671-679. Consequently, the regulation we’re considering typically would be inapplicable to such a trust.
3. IRC Section 1(h). This provision of the IRC sets different rates for certain specialized kinds of capital gains, such as collectibles or “unrecaptured Section 1250 gain.” We won’t be considering these provisions here.
4. Revenue Procedure 2011-52, 2011-2 C.B. 701, Section 3 (Oct. 20, 2011).
6. Rev. Proc. 2013-15, 2013-5 I.R.B. 1, Section 2.01 (Jan. 11, 2013).
7. IRC Section 1(h)(1) and Section 1(i)(3), as amended by ATRA Sections 101 and 102. Other thresholds are $425,000 for heads of households and $125,000 for married persons filing separately.
8. Rev. Proc. 2013-15, Section 2.01, Table 5.
9. IRC Section 643(a)(3).
10. Treasury Regulations Section 1.643(a)-3(a).
11. Treas. Regs. Section 1.643(a)-3(b)(1)-(3). The full text of the regulation is as follows:
Section 1.643(a)-3. Capital gains and losses. . . .
(b) Capital gains included in distributable net income.—Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law) –
(1) Allocated to income (but if income under the state statute is defined as, or consists or, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph § 1.643(a)-3(b));
(2) Allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary, or
(3) Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.
12. Treas. Regs. Section 1.643(a)-3 (b).
14. Former Treas. Regs. Section 1.643(a)-3(a)(3).
15. Former Treas. Regs. Section 1.643(a)-3 (d), Ex. 1 (providing that capital gains would be deemed included in distributable net income (DNI) under this provision “if the trustee follows a regular practice of distributing the exact net proceeds of the sale of trust property.”); see, e.g., Rev. Rul. 68-392, 1968-2 C.B. 284 (July 1968); Private Letter Rulings 8506005 (Nov. 7, 1984), 8324002 (Feb. 16, 1983); Technical Advice Memoranda 8122022 (Feb. 25, 1981), 8105028 (Oct. 28, 1980). In some of these rulings, the Internal Revenue Service claimed that a practice couldn’t be established in the first year of a trust’s or estate’s existence.
16. REG-106513-00, Notice of Proposed Rulemaking and Notice of Public Hearing, 66 Federal Register 10396 (Feb. 15, 2001) (2001 Notice). The 2001 Notice’s primary focal point was the manner in which the IRS was proposing to address changes that then had been underway for some time to state law concepts of trust principal and income that were following from state adoption of total return investment theories and versions of the Prudent Investor Rule and Uniform Principal and Income Act. With respect to capital gains, the main concern was whether and to what extent the IRS would recognize a discretionary allocation by a fiduciary of capital gains to trust income, including when income is a unitrust amount, an allocation that ran contrary to the traditional concept of capital gains being treated as part of trust principal.
17. Prop. Regs. Section 1.643(a)-3(b), which read in pertinent part as follows:
Section 1.643(a)-3. Capital gains and losses. . . .
(b). Capital gains included in distributable net income. Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and consistent exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law). . . .
(3) Allocated to corpus but utilized by the fiduciary in determining the amount which is distributed or required to be distributed to a beneficiary.
18. T.D. 9102, 69 Federal Register 12 (Dec. 30, 2003). The final regulations were effective for tax years ending after Jan. 2, 2004.
19. T.D. 9102; Treas. Regs. Section 1-643(a)-3(b).
20. Treas. Regs. Section 1.643(a)-3(e), Ex. 1.
21. Treas. Regs. Section 1.643(a)-3(e), Exs. 2, 3. Ex. 4 addresses a situation in which capital gains are allocated to income pursuant to what appears to be a mandatory provision of the governing instrument and isn’t relevant to our discussion. See Treas. Regs. Section 1.643(a)-3(e), Ex. 4.
22. Treas. Regs. Section 1.643(a)-3(e), Ex. 5.
23. Prop. Treas. Regs. Section 1.643(a)-3(e), Ex. 4.
24. T.D. 9102 (“[h]owever, if the amount of income is determined by a unitrust amount, the exercise of this discretionary power has no effect on the amount of the distribution, but does affect whether the beneficiary or the trust is taxed on the capital gains. Under these circumstances, a discretionary power must be exercised consistently”); Treas. Regs. Section 1.643(a)-3(b)(1) (“if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently”).
25. T.D. 9102.
26. T.D. 9102, after referring to situations when “the trustee is authorized by the trust instrument to make discretionary distributions of principal or . . . to pay the income beneficiary a unitrust amount,” broadly states that “[i]n these circumstances, the amount of realized capital gain during the year does not affect the amount distributed.” Ex. 1, as noted, concludes that henceforth the trustee “must treat all discretionary distributions as not being made from any realized capital gains.” In addition, in Ex. 5, as in Ex. 1, the trustee uses capital gains to determine the amount of a discretionary trust’s principal distribution in the first year of the trust.
27. See PLRs 200617004 (Jan. 6, 2006)) (discussing exclusion of capital gains from DNI under subsection (b)(2)), 200448001 (July 21, 2004) (quoting a previous version of the regulation).