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 2004
Index (back)
Report 1B
Monday, January 5
2:10 - 5:15 p.m.
Recent Developments in Estate, Gift and Income Taxation
- 2003 Part One
Dennis I. Belcher
Carol A. Harrington
Jeffrey N. Pennell
Materials by Richard B. Covey and Dan T. Hastings
Reporter: Gene Zuzpann Esq.
IRC 643 Regulations:
Carol Harrington discussed the new 643 regs that were issued
last week in T.D. 9102. Excellent summaries of these are available
on the Leimberg LISI service (Archive Message 624 1/5/04 under
Free Resources at http://www.leimberg.com) and in the RIA
Newsstand for 1/6/04. As a bonus, a full text version of the
LISI message is posted below.
Date: Mon, 05 Jan 2004 23:13:42 -0600
From: stevesletters@leimbergservices.com
Subject: T.D. 9102 - Definition of Income for Trust Purposes
Steve Leimberg's Estate Planning Newsletter
Steve Leimberg's Estate Planning Email Newsletter - Archive
Message #624
Date: 05-Jan-04 07:13 PM
From: Steve Leimberg's Estate Planning Newsletter
Subject: T.D. 9102 - Definition of Income for Trust Purposes
If you are involved in sophisticated trust planning (private
or charitable), you'll be very interested in the following
report from Bob Wolf of Tener, Van Kirk, Wolf & Moore,
P.C. Pittsburgh, PA. It involves what in my opinion is one
of the single most important income tax Regulations of the
decade. And there's no question Bob Wolf is one of the most
knowledgeable, creative, and forward-thinking minds in the
country on the subject.
In a word, Bob says the new regulations are TRU-iffic! (To
learn more about TRUs - total return unitrusts - and their
pros and cons -
and the state laws recently enacted to enable conversion to
TRUs - and a sample TRU document, go to our sister site, http://www.leimberg.com/
Look under FREE RESOURCES.)
TRU-iffic! That's how one might describe the very planning-positive
Final Regulations issued December 30th, 2003 (effective January
2, 2004) governing the definition of income under Section
643(b), the composition of DNI under 643(a), a qualifying
income interest for the estate tax marital and QDOT deductions
under 2056(b)-7 and 2056A-5 and for the gift tax under 2523(e)(1).
The regulations alleviate concerns and protect the tax benefits
under recent state law changes providing for a unitrust definition
of income and/or the power to adjust between principal and
income.
In a very informal nutshell, these new rules make it clear
that - if the transaction falls within the very reasonable
parameters of the final regulations - a conversion of a classic
trust into a TRU or a trustee's exercise of a power to adjust
will NOT:
1. Cause a loss of the federal estate tax marital deduction,
2. Trigger a taxable transfer for gift tax purposes,
3. Result in a taxable sale or exchange (ala Cottage Savings),
and
4. Undo GST grandfathering.
EXECUTIVE SUMMARY:
The Treasury has released Final Regulations that expand upon
their Proposed Regulations issued February 15, 2001 allowing
for conversion of existing trusts into unitrusts pursuant
to state statute (available today in 17 states) or the use
of the power to adjust between principal and income where
such power is granted under state law (available today in
35 states plus D.C.). We are now free to use those statutes
without worrying about our marital deduction, our GST grandfathered
status, or that such use might be considered to be a sale
or exchange under the Cottage Savings doctrine.
COMMENT:
WHY WE COULDN'T RELY ON PROPOSED REGS:
While the Proposed Regulations were very favorable and suggested
that Treasury would look kindly on these new state laws adapting
our trust income and principal rules to the modern investment
era, the Proposed Regulations were not in effect, and we were
not free to rely on them - since by their express terms, they
were to go into effect the year after the Regulations were
made final.
So in some regards, the ability to confidently employ the
new state laws was still in the future. Well, the future is
now!
WHY THE CONCERN?
A surprising amount of the income tax law turns on state law
definitions of what is "income" and what is "principal".
So when the Uniform Principal and Income Act was promulgated
in 1997 (7B U.L.A. 131,141 (2000) ("UPAIA"), allowing
the trustee to "adjust" from principal to income
or income to principal, there was a lot of concern as to whether
the IRS would allow the trustee to have or exercise that power,
by which one might either increase or decrease accounting
income, and still qualify for the marital deduction (you might
reduce the spouse's income interest), whether the exercise
of such a power might constitute a gift, or whether the grandfathered
status of GST trusts might be jeopardized.
And when a number of states started to consider allowing
trusts to be converted into unitrusts which paid out a set
percentage of the trust value, without regard to the accounting
income in the trust, a dialogue was started with Treasury
through the New York Legislative Committee, requesting guidance
from the Service prior to enacting its proposed new law allowing
an alternative unitrust definition of income and the power
to adjust as contained in the UPAIA.
PROPOSED REGS A VERY PROMPT AND POSITIVE START!
The Treasury responded promptly and helpfully with its Proposed
Regulations, which resulted in a dozen states enacting unitrust
conversion statutes in one 12 month period subsequent to the
announcement of the Proposed Regulations. This trend continued
at a slower pace thereafter despite the lack of Final Regulations
and a severe three year bear market in stocks.
WHAT'S AHEAD?
It is quite likely that that issuance of these Final Regulations
may prompt more state law changes, because it is now completely
clear that the benefits of the new rules only apply to those
states that have the newer more favorable statutes which grant
trustees the power to adjust and the power to convert to a
unitrust.
The Proposed Regulations, while extremely helpful guidance
that was largely followed and expanded upon in the Final Regulations,
were not law, and as such, many trustees and practitioners
were not yet using the new laws that had been enacted in many
states. This was particularly apparent in the case of Marital
Trusts and GST Exempt trusts, where practitioners and trustees
alike were afraid of losing the all-valuable GST grandfathering,
or having a Marital Trust disqualified or a "transfer"
having been made by the surviving spouse by converting the
trust to a unitrust or exercising the power to adjust.
The issuance of PLR 200231011 added another fearsome concern
where a trust modification into a 7% unitrust (along with
many, many other changes to the trust) was held to be a "sale
or exchange" under Cottage Savings. This caused other
practitioners to draw back from exercising these new powers
until the tax dust had cleared. That dust has now cleared.
THE GORY DETAILS OF THE NEW REGS:
Generally, federal tax law follows local state law with respect
to the definition of income, with the anti-games proviso that
trust provisions which depart fundamentally from traditional
principles of income and principal will not be recognized.
State law definitions of income which provide for a reasonable
apportionment between the income and remainder beneficiaries
of the total return of the trust for the year including ordinary
income and tax exempt income, capital gains, and appreciation,
will be respected.
SAFE PARAMETERS - AND UNCHARTED WATERS:
A state unitrust statute allowing the payout of no less than
3% nor more than 5% of the fair market value of the trust
assets will be respected.
However, the final regulations expressly left open what would
happen if the rate were less than 3% or more than 5%. Don't
count on the same blessing if you draw outside of these lines,
taking into account what trust interests are being protected
by the choice of rate. For example, if the rate were less
than 3%, the marital deduction might be in trouble because
you may have reduced the spouse's interest. If you converted
to an 8% rate, the marital deduction should be fine, but you
may have a gift transfer from the remainder beneficiaries
to the spouse.
The final regulations expressly allow for the use of a multi-year
valuation method. Most of the unitrust statutes have a 3 year
"smoothing rule" and this is O.K.
If a conversion is made to a unitrust under state law, without
the benefit of an express unitrust definition of income by
statute it is possible that you will qualify, but you will
have to satisfy the standard under the Bosch (387 U.S. 456
(1967)) decision (requirement of a decision of the highest
court of the state). In my opinion, that isn't likely.
And it's even more unlikely that you could obtain the benefits
of the power to adjust principal to income or income to principal
without enacting UPAIA Section 104. The state law background
just isn't there. But if your state has adopted the power
to adjust, variations in the exact requirements under state
law should not present a problem from a tax perspective. So
the lack of the word "Equitable" in a state statute,
or the absence of an express requirement that the trustee
be investing as a "prudent investor" does not create
a tax problem. The trustee must meet whatever state law requirements
are imposed; state laws are not required to be homogenized
as a matter of tax policy.
Both the power to adjust and the power to convert to a unitrust
can be applied to sprinkle or spray trusts, as well as the
more traditional "hold the principal and pay the income"
style trusts.
Where there are alternative methods of determining income
under applicable state law, a change in method can be made
in either direction without fear of a recognition event or
the loss of grandfathering. Since there are currently a dozen
states that expressly allow both the power to adjust and the
unitrust as alternatives, this is important.
The Final Regulations governing the application of Chapter
13 (GST Tax) to trusts expressly provide that the conversion
of a trust into a unitrust or using the power to adjust under
a state statute specifically does not prejudice GST grandfathering.
SITUS SHOPPING MAKES SENSE!
Attention K Mart Shoppers! The Final Regulations do not stop
at assuring us we lose no GST grandfathering, that there is
no taxable sale or exchange, and that there is no gift: In
two examples the final regs make clear that if the situs of
a trust is moved to another state with a different state law
in this regard, that is fine also. So if you are in Massachusetts
or North Dakota, where you don't have a favorable total return
trust law, you can move your trust next door to Maine or South
Dakota, which have unitrust legislation, and take advantage
of their laws to convert the trusts to unitrusts.
This should significantly increase the pressure on states
which do not have total return legislation to put it on their
agenda or suffer the financial consequences to their trust
industry.
Portability has never been greater.
WHAT ELSE IS NEW?
In sync with the changes to the definition of income for trust
purposes, the ability of trustees to include capital gains
in Distributable Net Income has also changed from the traditional
to allow ordering rules in state statutes and the power of
the trustee to either allocate capital gains to a distribution
to an "income" beneficiary or not, provided that
the exercise of the power is done consistently. In some regards,
this is the most complicated and least significant of the
changes.
The Reg provides-"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 discretionary for a unitrust,
the power must be exercised consistently]. . .
(2) Allocated to corpus but treated consistently by the fiduciary
on the trust's books, records, and tax returns as part of
the 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."
SAY WHAT?
Part of the theory of total return trusts and total return
investing is that the trustee will be free to invest for capital
gains or interest or dividends, whichever will produce the
most return. But if the income beneficiary is getting an increased
payout because of the application of a unitrust statute or
the power to adjust, it stands to reason that the recipient
ought to pay the capital gains tax on the distribution, at
least if there are capital gains to distribute.
But the hang-up is that capital gains are not traditionally
a part of distributable net income unless the amount distributed
is determined by the amount of capital gains, or let's say
the capital gains are actually distributed (and this may not
be obvious, since cash is, as they say, cash.)
WHY DOES THIS MATTER?
If the capital gains taxes are all paid by the trust, the
trust cannot afford to pay out as much to the beneficiary
as if the beneficiary were paying his or her fair share of
the taxes. So if the trust is paying the tax freight, the
value of the trust is more likely not to keep up with inflation
than if capital gains can be distributed to the income beneficiary
along with his or her increased income share. In addition,
the beneficiary is more likely to be in a lower tax bracket
than the trust, since the top tax bracket is reached in a
trust or estate at only $9,550.
Also, if the capital gains taxes are paid by the trust, it
produces a conflict between choices for achieving total return
as between bonds and stocks more commonly than if it is allocated
to the income beneficiary as much as possible, after the ordinary
income after expenses is distributed (and for an equity oriented
account, the net dividend income won't be much).
WHAT DOES IT MEAN?
If you live in a state that has an ordering rule as part of
your total return legislation, such as in Alaska, Pennsylvania,
Oregon and Washington, to name a few, then capital gains will
come out of the trust first, with short term gains coming
out before long term gains (the Regs don't expressly state
that short term gains can be ordered out first, but Example
11 under 1.643(a)-3(e) includes such a statute without adverse
comment).
So if you have a direction that requires the ordering in
your trust document and applicable state law, the unitrust
amount will include capital gains.
Other states, such as Delaware, give the trustee express
discretion to decide whether to include capital gains in DNI,
and there, for the unitrust, the exercise must be consistent,
once the opportunity to exercise the discretion is presented.
The Regs expressly allow this exercise if the trustee is given
the power under state law, such as in Delaware, or by the
trust instrument, if it is not prohibited by state law.
So if you do have discretion given to the trustee to make
this determination, then the trustee can go either way. But
the Regs clearly require that, as respects a unitrust, the
exercise of discretion has to be consistent, since the allocation
of the capital gains to a unitrust distribution does not affect
the amount of the distribution.
WHAT ABOUT THE POWER TO ADJUST?
If the trustee has the discretion to decide whether to include
capital gains in a distribution, it is likely that the exercise
will have to be consistent, unless the allocation of capital
gains to a distribution actually determines the payout, which
is not normally the case for the power to adjust. The power
to adjust is not the power to distribute capital gains, but
the power to adjust from principal to income and vice versa.
It is not clear whether the Regulation writers understood
this nuance.
DISTRIBUTIONS MADE IN KIND :
If distributions are made in kind to satisfy a unitrust payout,
the property is deemed to have been sold for its fair market
value on the date of distribution, just as if a distribution
were made to satisfy an "income" obligation.
IMPACT ON POOLED INCOME TRUSTS AND NIM-CRUTS :
Here the news is not as favorable. For a pooled income trust,
the charitable deduction is unavailable under 642(c)-2 if
under the governing instrument and applicable state law, the
income beneficiary's right to income may be satisfied by the
payment of a unitrust amount or that takes into account unrealized
appreciation in the value of the funds assets.
Strangely, the definition of a pooled income fund does not
prohibit a unitrust definition of income or the power to adjust
under applicable state law, but the Regulation requires that
in exercising the power to adjust, the trustee has to allocate
to principal the proceeds from the sale or exchange of any
assets contributed or purchased in the fund to the extent
of basis. This is an odd requirement, because to my knowledge,
no state law has that provision in it. In fact, the UPAIA
itself, and all of the state laws adopting it so far prohibit
the use of the power to adjust to pay "(4) from any amount
that is permanently set aside for charitable purposes under
a will or the terms of a trust unless both income and principal
are so set aside".
It would seem however, that one could retain the status of
a pooled income trust, without the benefit of the charitable
deduction for capital gains tax purposes, but only with the
power to adjust, which does not seem to be available under
the Uniform Act, unless state laws were changed to allow it.
And for the NICRUT and NIMCRUT twins to continue to qualify
for their special tax treatment, they must have an alternative
definition of income that is not a unitrust definition, either
in the document or applicable state law. This seems reasonable,
since the payout of a lesser of two unitrust amounts makes
little conceptual sense. Post contribution gains may be defined
to be part of income, and the Reg states that a discretionary
power to determine that allocation of capital gains to income
may be given to the trustee under the governing instrument,
but only to the extent that the state statute permits the
trustee to make adjustments between income and principal to
treat beneficiaries impartially.
If state law would allow a unitrust definition of income
which would disqualify the pooled income fund's charitable
deduction, the trust will have 9 months to reform the governing
instrument to eliminate this definition from applying the
trust starting from January 2, 2004, or such later date of
a state statute authorizing determination of income in such
a manner. Since so far as I know, no state has such a law,
that shouldn't be much of a problem, unless your faithful
reporter is missing something!
Bob Wolf
Edited by Steve Leimberg
CITE AS:
Steve Leimberg's Estate Planning Newsletter # 623 at http://www.leimbergservices.com
Copyright 2004 LISI Reproduction Prohibited Without Express
Permission
CITES:
T.D. 9102 (To view the actual text of this ruling, click on
Recent Entries and look under Actual Text for Final Regulations
on Definition of Trust Income). Cottage Savings doctrine.
(499 U.S. 554 (1991).
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