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Ordinary trust income that is accumulated and is not initially
taxed to the beneficiaries is, under
present law, taxed to them on
ultimate distribution (but see Part 20 in March).
2. How Simple Trusts Are Taxed
The regulations divide all trusts into two types -
"simple" or "complex."(1) A simple trust is one
that,
under the terms of its governing instrument, is required to
distribute all of its "income" currently
and makes no
distributions from principal or to charities.
The term "income," without modifications,(2) is defined
in accordance with local trust law. For trust
(and estate) accounting
purposes, "income" receipts and payments are distinguished
from those
allocable to "principal." Thus, "income"
normally consists of dividends, interest and other types of
income
earned as the result of the investment of trust principal. Gains
realized on the sale of
principal assets, however, generally constitute
"principal" under local law.
In computing its taxable income, a simple trust is allowed a
deduction for distributions to
beneficiaries limited to the lower of -
the amount of "income" required (under local law) to
be
distributed currently (IRDC), or - the amount of "distributable net
income" (DNI).(3)
DNI is the trust's taxable income, with certain modifications
specified in Sec. 643(a): * The personal
exemption ($300 for a simple
trust, $100 for a complex trust and $600 for an estate) is not
allowed.
* The deduction otherwise allowable for distributions to beneficiaries
is not allowed. *
Undistributed capital gains or losses allocated to
principal are excluded. * Undistributed
extraordinary dividends and
taxable stock dividends allocated in good faith to principal
are
excluded.
Example 1: A simple trust, created on Feb. 17,19XX, realized
the following income and expenses
during its year ended
Dec. 31, 19XX.
Trust accounting
Tax
Income Principal Total
Dividends
$40,000 $ - $40,000
Interest 10,000 - 10,000
Capital gains 20,200 20,200
50,000 20,200
70,200
Trustee's commissions 5,000 3,000 8,000
Net $45,000 $17,200 $62,200
The deduction for
distributions is $42,000, computed as
follows:
Lesser of:
IRDC - required distributable income
for
trust accounting purposes $45,000
or
DNI - $62,200 $20,200 capital gains $42,000
Note: The
result of this computation is that principal expenses
inure to the benefit of the income beneficiary.
Items that are not included in gross income are not eligible for
the distributions deduction. Thus, in
computing the actual distributions
deduction, both IRDC and DNI are reduced by net tax-exempt
income.
3. Tax Character of Distributions
Under the conduit approach, the trust beneficiary must include in
gross income the amount the
trust is allowed as a deduction for
distributions.(4) The amount of the distributions deduction
allowed to a
simple trust will be taxed to the beneficiary whether or not the amount
was actually
distributed to him because the income was required to be
distributed.
When reported on the beneficiary's tax return, the trust
income retains the same character it had in
the hands of the trust
(e.g., dividend income, interest income, etc.).(5) Because the
computation of
DNI begins with the trust's taxable income, however,
all deductions - including those chargeable to
principal - are
automatically taken into account and only the net amount is reportable
by the
beneficiary.
In determining the character of the components of "net"
income, how are trust deductions allocated
against the various
components of "gross" income? The regulations provide specific
rules for
making the allocation: * Deductions directly related to
specific types of income reduce the
applicable income. For example, real
estate taxes and mortgage interest are offset against rental
income. *
Any deduction not specifically related to a particular type of income is
allocated among
the various classes of income in any manner chosen by
the trustee.(6)
Example 2: In Example 1, the income beneficiary should report
$42,000 as income from the trust on
his return. At the election of the
trustee, the beneficiary may reflect $40,000 of dividend income
and
$2,000 ($10,000 - deductions of $8,000) of other income. The deductions
allowed to the trust
can be apportioned between the dividend and
interest income in any manner (for example, in
proportion to the amounts
of gross income), at the trustee's option.
As a result of the DNI concept, the income beneficiary will usually
receive the entire benefit of
deductions paid from principal. To the
extent that deductible principal disbursements are made for
a tax year,
he will receive income free of tax.
Example 3: The beneficiary in Example 1 is entitled to $45,000 of
income (the amount of IRDC) for
the year ended Dec. 31, 19XX. However,
he will be taxed on only $42,000 - the amount of the
distributions
deduction allowed to the trust. The $3,000 difference represents the
trustee's
commissions chargeable to principal. It is because of the
DNI concept that the income beneficiary
receives the benefit of this
principal deduction.
To the extent that they constitute taxable income, receipts that
are allocable to principal for
fiduciary accounting purposes are
normally taxed to the trust or estate. For example, capital
gains
realized on principal investments are ordinarily taxed to the trust or
estate.
Example 4: The $20,200 capital gain realized by the trust in
Example 1 will be taxed to the trust.
Although the capital gain
constitutes a principal receipt, the expenses paid out of
principal
(trustee's commissions) do not reduce the amount of the capital
gain that will be taxed to
the trust. Instead, as shown in Example 3,
these deductions inure to the benefit of the income
beneficiary.
Under the conduit principle of fiduciary income taxation, other
items flow through the trust or
estate to the beneficiary. For example,
depreciation and depletion deductions(7) are generally not
allowed to
the fiduciary of the property; instead, these deductions pass through to
the beneficiary
who is taxed on the income to which the deductions are
attributable. Foreign income received by
the trust or estate retains its
character as foreign income in the hands of the beneficiarydistributee
and he, not the fiduciary, is entitled to any credit allowable for
foreign tax paid on such
income.
4. When Beneficiary Must Report
Distribution
If a trust or estate and its beneficiary use the same tax year, the
beneficiary reports his taxable
share of income in the same year that
the fiduciary deducts the amount. When, however, an
executor and the
beneficiary use different tax accounting periods, however, the
beneficiary
includes in his gross income the amount of income taxable to
him for the tax year(s) of the estate
ending with or within his tax
year.(8) In effect, the amounts reported on the fiduciary income
tax
return as taxable to the beneficiary are deemed distributed as of the
last day of the trust's tax
year.
There is a once-in-a-lifetime exception to this general rule. In
the year of a beneficiary's death, any
income actually received by
him from a trust or estate up to and including the date of his
death
(limited, of course, to the DNI) is includible on his final income tax
return.(9) In other words,
the income of the trust or estate is not
treated as distributed to the deceased beneficiary on the last
day of
the trust's or estate's year, but instead, to the extent paid
to him before death, it is treated as
distributed to him as actually
paid.
Example 5: The income beneficiary of a calendar-year simple trust
died on Nov. 11, 19XX. The trust
received net income of $3,000 each
month. Since each month's income was distributed to the
income
beneficiary on the tenth day of the month following receipt, $30,000 (10
months) of the
19XX net income was distributed to the beneficiary before
his death.
Even though the beneficiary did not live until Dec. 31, 19XX (the
last day of the trust's 19XX year),
he will be taxed on all of the
year's income that he actually received during the period he was
alive
- Jan. 1 to Nov. 11, 19XX. The decedent beneficiary's final
income tax return will, therefore, include
$30,000 of income from the
trust.
Note that $3,000 received by the beneficiary on Jan. 10, 19XX,
representing the trust's income for
December of the prior year, was
reported on his prior year's return since all the trust income
was
required to be distributed currently.
The income distributable to the deceased beneficiary for the period
Nov. 1 to 11, 19XX, which was
paid to his estate on Dec. 10, 19XX,
represents. "income in respect of a decedent" under
Sec.
691(a), and will be taxed to the estate.
5. Current Distributions of Complex
Trusts and Estates
By definition, all trusts that are not "simple" trusts
are designated as "complex" trusts. Complex
trusts include: *
Trusts that are required to accumulate income. * Trusts that, under the
governing
instrument, may accumulate or distribute income at the
discretion of the trustee. * Trusts that make
a distribution from
principal or make charitable contributions from income during the year,
even
though they are required to distribute all income currently.
In the year of termination, a simple trust is transformed into a
complex trust, since terminating
principal distributions are made. The
general rules applicable to complex trusts also govern the
taxation of
estates.
The amount of the deduction for distributions allowed to a complex
trust or an estate is limited to
the lower of - the aggregate of IRDC
and OAPC (other amounts paid or credited or required to be
distributed),
or - the amount of DNI.(10)
As in the case of simple trusts, beneficiaries of complex trusts
and estates must include in their
gross income the amounts for which the
trust or estate received a deduction for distributions.(11)
However,
complex trusts and estates may make distributions to more than one
beneficiary during a
particular tax year, and some beneficiaries'
rights to income may take precedence over others.
Therefore, to provide
priorities of taxability, the distribution rules establish what is known
as the
"tier" system.(12)
Under the tier system, the aggregate income that must be reported
by the beneficiaries is allocated
first to the beneficiaries who have
rights to current income - that is, those beneficiaries to whom
income
is to be distributed currently under the terms of the governing
instrument. The amount
taxed to the first-tier beneficiary(ies) is the
amount of IRDC, limited to DNI (computed without a
charitable
deduction). Such distributions are taxed to beneficiaries in the year
required to be
distributed.(13)
After allocating distributable income among the first-tier
beneficiaries, any remaining amount of
DNI is allocated among the
"second-tier" beneficiaries. This tier consists of those
beneficiaries who
are paid or credited with OAPC for the tax year.
Again, the amounts taxed to the second-tier
beneficiaries cannot exceed
the DNI, as reduced by first-tier distributions. Thus,
charitable
contributions inure to the benefit of second-tier beneficiaries.
Second-tier distributions
are taxed to the beneficiaries for the
trust's or estate's year in which the distributions were
made.
Second-tier distributions include discretionary distributions of income
and distributions of
principal.
Under the conduit theory, discussed above, the income items of
complex trusts and estates retain
the same character in the hands of the
beneficiaries as they had in the hands of the trust or
estate.(14) When
there is more than one beneficiary, the income is allocated pro rata among the
beneficiaries in each tier. And, like simple trusts, the
beneficiaries of complex trusts and estates
include in their gross
income the amounts distributed or distributable to them by the trust for
the
tax year(s) ending with or within the beneficiary's tax
year.(15) The special rule governing the
taxation of distributions
received by a deceased beneficiary of a simple trust in the year of
death
also applies to beneficiaries of complex trusts and estates.(16)
Example 6: H's will provided that the residue of his estate be
divided equally between his widow
and his children. The
will further provided that $100,000 of income was required
to be distributed
currently each year to the widow. During
19XX the estate had net income (DNI) of $800,000.
In
19XX the executor made the following distributions:
Widow Children
Income:
Required $ 100,000
$ 0
Discretionary 300,000 400,000
Principal 27,000,000 8,000,000
Total $27 400 000 $8 400 000
The reduced principal distribution to the children resulted
from the charge to their share of estate
taxes paid of
$19,000,000.
How should the $800,000 DNI be allocated between the
beneficiaries?
The distributions would be taxed as follows:
Total Widow Children
(thousands omitted)
1st tier
(IRDC) $ 100 $ 100 $ 0
2d tier - lower of:
Distributions
(OAPC) 35,700 27,300 8,400
DNI (76
1/2%/
23 1/2%) 700 535 165
Taxable - 2d tier 700 535 165
Total taxable $ 800 $ 635 $ 165
Mrs. H argued that the result was inequitable and that, although
she received only 50% of the
estate's $800,000 income for the year,
she was taxed on almost 80% (part of which actually had
been distributed
to her children).
The Court of Claims in Harkness(17) (on which this example is
roughly based) concluded that in so
taxing the beneficiaries, the IRS had properly interpreted the two-tier rules of Secs. 661 and 662.
6. Charitable Contributions
Separate rules govern trust and estate distributions to charitable
organizations. Such distributions
are not considered to be distributions
to beneficiaries.(18) Normally, a trust or an estate can take
a
deduction for amounts paid to a charity if the governing instrument so
provides.(19) There is no
percentage limitation on the amount, as in the
case of individual contributions to charity.
The deduction for charitable contributions is not limited to U.S.
charities.(20) In addition, amounts
permanently set aside for charitable
organizations are allowable as deductions only in the case of an
estate,
or a trust that was created before Oct. 9, 1969.(21)
Example 7: Under the terms of a trust instrument dated
1967, the income must be distributed
currently, 60% to a
public charity and 40% to the grantor's son. In the year 2000,
the trust is to
terminate and the principal is to be distributed
to the public charity.
During its 19XX calendar
year, the trust reported the following
on its return:
Dividend income $50,000
Capital gain
10,000
$60,000
The trust's 19XX charitable contribution deduction is
$40,000, computed as
follows:
Income paid to charity (60% of $50,000) $30,000
Amount permanently set aside for
charity
(increase realized in trust principal) 10,000
$40,000
Of course, if the trust had been set up after Oct. 8, 1969, it
could not deduct the $10,000
permanently set aside for charity. This
gain would be taxed to the trust. In contrast, an estate is
entitled to
a charitable contribution deduction for amounts set aside regardless of
the date of
creation.
7. Taxability of Distributions of Principal
As discussed in Part 5, a complex trust or estate is entitled to a
deduction for both IRDC to
beneficiaries and for OAPC. Thus, items of
principal that are paid or credited or required to be
distributed can,
under certain circumstances, carry with them income tax consequences.
Not all distributions of principal to beneficiaries will result in
taxable income. Sec. 663(a)(1)
specifically provides that any amount of
principal that, under the terms of the governing instrument,
is properly
paid or credited as a gift or bequest of specific property or a specific
sum of money
(which is payable in not more than three installments) is
not deductible by the trust or taxed to the
beneficiary. If the will or
other governing instrument does not specify a time for the payment of
the
gift or bequest, any payments are treated as required to be paid in
a single installment.(22)
Example 8: A will provides for the distribution of a specific
bequest of principal securities to a
legatee. The distribution of the
specified securities would not involve any tax consequences.
Similarly, the payment, pursuant to a trust instrument, of $10,000
of principal in one lump sum
when a beneficiary, for example, reaches
age 21, will come within the exception and will be neither
deductible by
the trust nor taxed to the beneficiary.
In order to qualify under this exception, however, the identity of
the specific property or the amount
of the specific sum of money
"must be ascertainable under the terms of a testator's will as
of the
date of his death, or under the terms of an inter vivos trust instrument as of the date of the inception
of the trust."(23)
Example 9: A trust instrument requires income to be distributed
currently to daughter D. She is also
to receive distributions of $10,000
of principal at age 21, $10,000 at age 35 and $40,000 at age 40.
When D
reaches 40, the remaining principal is to be paid to son S and the trust
is to terminate.
Only the payments of principal to D will not carry tax
consequences. Although the principal payable
to S might be considered a
specific sum of money, it was not ascertainable when the trust
was
created since it will consist of a residual amount that cannot be
predetermined.
Part 18, in March, will point out how planning for the
distributions of principal can result in
substantial tax savings. Part
13, below, will discuss the often unusual income tax consequences
or credited to the beneficiary during
the trust's tax year. A trustee may elect, however, to treat
any
portion of a distribution to a beneficiary made within the first 65 days
of the trust's tax year as
if it had been paid or credited to the
beneficiary on the last day of the preceding tax year.(27)
This
election,(28) which must be attached to the fiduciary income tax return,
is made on an annual
basis, and becomes irrevocable after the due date
of the return, including extensions. The "sixty-five
day" rule
does not apply to estates or to simple trusts.
The election can be valuable, for example, when a trustee has the
discretion to distribute or
accumulate income and wishes to distribute
all of the trust's income for a particular year. As a
practical
matter, however, it may be difficult to determine the trust's total
income until after yearend when the books can be closed. Thus, the
trustee can use the election to distribute
"retroactively" the
undistributed balance of income for a preceding year by treating the
first
payments made (within 65 days) in a trust's tax year as the
preceding year's income.
11. The "Separate Share" Rule
For certain purposes, the substantially separate and independent
shares of different beneficiaries of
a trust are treated as separate
trusts.(29) This "separate share" rule applies to both simple
and
complex trusts. Although most of the income tax provisions
applicable to complex trusts also govern
the taxation of estates, there
is no similar separate share rule for estates. The following
example
demonstrates the purpose of this separate share rule.
Example 12: M creates a trust for her two children, S and D. Each
has a 50% separate interest in
the trust. The trust instrument provides
that income is to be accumulated until each beneficiary
reaches age 21.
when each child reaches that age, the accumulated income is to
distributed and,
thereafter, income is required to be distributed
currently.
In 19XX, S becomes 21 while D is still under 21. The trust income
accumulated before S reaches age
21 totals $40,000. The trust's DNI
for 19XX totals $4,000.
Under the separate share rule, S is taxed on only $2,000 of the
trust's 19XX income, the DNI
applicable to his separate share. The
remaining $2,000, which represents D's one-half share, must
be
accumulated for her benefit. Without the separate share rule, S would be
taxed on the full
$4,000 of the current year's income.
Under the separate share rule, the DNI is computed separately for
each share. This rule is not
elective;(30) if separate shares exist, the
rule must be applied. Moreover, application of the rule
does not depend
on whether the trust's books are maintained separately and the
assets are actually
segregated.(31)
12. The Distributions Deduction for AMT
Estates and trusts have to compute DNI and the distributions
deduction twice - once under the
regular income tax rules and again by
applying the provisions of the alternative minimum tax
(AMT).(32) In
order to compute the income distributions deduction for AMT purposes,
the fiduciary
must first compute the estate's or trust's
"distributable net alternative minimum taxable
income"
(DNAMTI).(33)
The fiduciary's DNAMTI concept and the DNAMTI income
distributions deduction calculation for
AMT purposes are the analogs of
the distributable net income (DNI) concept and income
distributions
deduction computation needed to determine the amount of the
estate's or trust's
regular income tax liability. The concept
constitutes the essence of the conduit principle underlying
the income
taxation of estates and trusts.
DNI will often differ from DNAMTI for reasons unrelated to AMT
preference items. And since the
fiduciary's AMT income
distributions deduction must be calculated on Schedule H of Form
1041,
U.S. Fiduciary Income Tax Return, and the beneficiaries' shares of
DNAMTI must be entered
on their Schedules K-1 (Form 1041), many estates
and trusts that have no AMT tax preference items
(but only adjustment
items) will nevertheless have to prepare Schedule H of Form 1041.
Examples of items that are not technically AMT preference items
(i.e., adjustment items), but which
will cause a beneficiary's
share of DNAMTI to vary from the amount of his share of DNI, include
a
variety of deductions and losses allowed for regular tax purposes, but
not for AMT purposes.
These include state and local income and property
taxes,(34) "miscellaneous itemized deductions" in
excess of 2%
of adjusted gross income (AGI),(35) any allowed portion of excess
investment interest
and "personal" interest cost36 and any
passive activity losses(37) allowed in computing the
fiduciary's
regular income tax. And, of course, any AMT preference or other
adjustment item
incurred by the fiduciary would also cause DNI and
DNAMTI to differ.
As previously discussed, in order to compute the income
distributions deduction for regular income
tax purposes, the trustee of
a simple trust must determine (1) the amount of IRDC and (2) DNI.
The
trustee's distributions deduction(38) is equal to the lower of
these two amounts.
On the other hand, the fiduciary of a complex trust or an estate
calculates the allowable regular
income tax deduction for distributions
to beneficiaries(39) as the lower of (1) the aggregate of IRDC
and OAPC
or (2) DNI. These computations should be made on Schedule B on page 2 of
Form 1041.
For AMT purposes, the formulas required to determine the amount of
the distributions deductions
(and the beneficiary's share of
income(40)) are similar, except that the applicable amount of
DNAMTI
should be substituted for the amount of DNI. For example, the AMT
formula to calculate
the allowable distributions deductions for a simple
trust would be the lower of IRDC or DNAMTI,
and for a complex trust or
estate the lower of the aggregate of IRDC and OAPC or DNAMTI. Note:
the
amounts of "income required to be distributed currently" and
"other amounts paid or credited,"
as concepts under local law
- not tax law, are generally identical(41) whether the
distributions
deduction is being determined for regular tax or AMT purposes. It is the
amounts of
DNI and DNAMTI that will normally differ.
These computations are made on Part II of Schedule H on page 4 of
Form 1041.
Example 13: A simple trust having one beneficiary reports
the following income and deductions for
19XX:
Dividend income $100,000
Deductions:
Trustee's income
commissions $ 5,000
State
income taxes
paid on capital gains
(charged to principal) 35,000
$40,000
How should the trust's
DNI, DNAMTI and the related income
distribution deductions for 19XX be computed?
The
deductions would be calculated as follows:
Regular
income tax AMT
Dividend income $100,000
$100,000
Deductions for
expenses and taxes 40,000 5,000
DNI/DNAMTI 60,000 95,000
IRDC
95,000 95,000
Distributions
deduction - lower $ 60,000 $ 95,000
Note: The result would be the same if aggregate AMT preference
items replaced the amount of
state income tax payments, as would the
substitution of other deductions disallowed for AMT
purposes such as
passive activity losses, personal and excess investment interest,
"miscellaneous
itemized deductions" exceeding 2% of AGI, etc.
The amounts of the fiduciary's income distributions deductions
allowed under Secs. 651 and 661 for
both regular income tax and AMT
purposes are the identical amounts that must be reported as
gross income
under Secs. 652 and 662 by the beneficiary of the estate or trust. When
there is more
than one beneficiary, DNAMTI is allocable among them in
the same manner as income was
allocated for regular income tax DNII
purposes. Each beneficiary's share of both DNI and DNAMTI
must be
shown on the Schedule K-1 (Form 1041).
Example 14: The beneficiary of the simple trust in Example
13 would receive a 19XX Schedule K-1
(Form 1041) from the
trustee that would reflect the following:
Income for minimum tax purposes
$95,000
Income for regular tax purposes 60,000
Adjustment for minimum tax
purposes 35,000
The difference between these two amounts is reportable by the
beneficiary as an adjustment for
computing his 19XX AMT on Form 6251,
Alternative Minimum Tax - Individuals (or on Schedule H
of Form 1041, if
the beneficiary is an estate or another trust).
13. Funding Bequests With Property In Kind
For income tax purposes, all gifts and bequests can be categorized into the following types: 1. Gifts
and bequests of specific property. 2.
Pecuniary (fixed-dollar) gifts and bequests:
a. simple (nonformula) pecuniary, or
b. formula pecuniary. 3. Fractional and residuary gifts and
bequests.
The income tax consequences of funding each of these types of gifts
and bequests with appreciated
(or depreciated) property in kind can
differ tremendously. For example, the distributions by an
executor or
trustee of such property in kind can, only in certain instances, do the
following: 1.
Trigger a gain or loss (based on the difference between
the fair market value (FMV) of the property
and its adjusted tax basis).
2. Permit the fiduciary to qualify for a Sec. 661 deduction
for
distributions to beneficiaries based on the FMV of the property
distributed in some instances,
and the adjusted basis of the property in
others. 3. Subject the distributee/beneficiary to income tax
on ordinary
estate or trust income under Sec. 662 (limited to DNI). 4. Result in a
step-up (or stepdown) in the adjusted basis of the property in the
hands of the beneficiary to its FMV on
distribution.
This part will discuss and illustrate the general income tax
consequences of funding gifts and
bequests with stocks and other types
of securities and capital assets. The income tax consequences
of funding
bequests with interests in passive activities (Part 14) and with income
in respect of a
decedent (Part 15) will be covered in March.
* Funding specific bequests
No gain or loss is triggered when the specific property is
transferred, even though the value of the
property on the distribution
date is higher or lower than its adjusted basis. The estate or
trust
cannot claim a deduction for the distribution - it is a gift or bequest
of specific property
excluded under Sec. 663(a)(1). The recipient
succeeds to the estate's or trust's income tax basis for
the
property.(42)
Example 15: In 19XX, an executor distributed stock having
an income tax basis of $175,000 in
partial satisfaction of a
specific bequest to the surviving widower. The value of the
stock on the
distribution date was $230,000. No other distributions
were made to other beneficiaries during the
year.
During 19XX the estate's only income consisted of $80,000
of dividends received and it had
paid no deductible expenses.
The executor (or his accountant) must determine the estate's
taxable
income for 19XX, the income reportable by the
widower and the income tax basis of the stock
distributed in
the hands of the surviving spouse.
The estate's 19XX fiduciary income tax return
would
show:
Dividend income $80,000
Total income 80,000
Less deduction for
distributions,
lower of:
DNI $80,000
Distribution 0
Lower 0
80,000
Less personal exemption 600
Taxable
income $79,400
The surviving spouse would report no income from the estate for
19XX. The income tax basis of the
stock distributed in the
widower's hands would be $175,000, its basis to the estate.
* Funding pecuniary bequests
The inclusion in a will or trust instrument of a bequest or gift of
a flat fixed-dollar (pecuniary)
amount, in trust or otherwise (for
example, a bequest to a surviving spouse of $1 million, or a
bequest in
trust to children for $600,000 to "sop up" the unified
credit), may not be advisable for a
number of obvious tax and nontax
reasons. Nevertheless, this type of gift or legacy may be
encountered.
Whether the funding of such a gift or bequest with cash will result
in a deduction to the estate, and
income to the beneficiary, depends on
whether the bequest qualifies as "a gift or bequest of a
specific
sum of money or of specific property" under Sec. 663(a)(1): 1. If
under the terms of the
governing instrument it is to be paid in three or
fewer installments, any payment to the legatee will
not constitute an
"other amount paid or credited" (OAPC), which will carry out
DNI. 2. If under the
terms of the will or other instrument it is to be
paid in four or more installments, each payment
(even if in fact it is
paid in a lump sum) will be deemed OAPC and will carry out DNI to
the
legatee.(43) 3. If under the terms of the will, "no time of payment
... is specified.... [it is]
considered as required to be paid or
credited in a single installment."(44)
The funding of such a fixed dollar gift or bequest with appreciated
(or depreciated) capital asset
property valued at the date of
distribution will result in the realization by the trust or estate of
a
capital gain (or loss).(45) Such a bequest is treated as a cash bequest
equal to the property's
FMV, followed by a deemed sale of the
property to the beneficiary for cash.
The beneficiary will receive a stepped-up basis equal to the
property's FMV on the transfer
date.(46)
If ordinary income property is distributed to satisfy a
fixed-dollar obligation, ordinary income will be
triggered. For example,
the distribution of the right to receive future Sec. 691 income in
respect of
a decedent (IRD) in satisfaction of a pecuniary bequest will
trigger a capital gain or ordinary income
to the estate, depending on
the type of IRD.(47) Depreciation recaptured under Sec. 1245 or
1250
will also result in a distribution of ordinary income.
Example 16: Assume the same facts as in Example 15, except
that the stock distributed was in
partial satisfaction of a non-formula
(simple) pecuniary marital bequest, rather than a
specific
bequest. No number of payments was specified in
the will. The will provided that the pecuniary
amount of the
bequest was to be satisfied with cash or property valued at
the date of distribution
(the so-called true worth funding
approach).
The estate's 19XX fiduciary income tax return
would
show:
Dividend income $ 80,000
Capital gain realized
on the distribution
($230,000 $175,000) 55,000
Total income 135,000
Less deduction for
distributions, lower of:
DNI
$80,000
Distribution 0
Lower 0
135,000
Less personal exemption 600
Taxable income
$134,400
The widower would report no income from the estate for 19XX. The
income tax basis of the stock
distributed to him would be $230,000, its
FMV on distribution.
If, however, the will provided that the simple pecuniary bequest
was to be satisfied in four or more
installments, the surviving spouse
would be taxed on $80,000 of estate income for 19XX, the
estate's
distributions deduction (and the surviving spouse's reportable
income) would be limited to
the estate's $80,000 of DNI. The tax
basis of the stock distributed would still be $230,000 in the
hands of
the widower.
The provisions of the governing instrument will determine the
income tax consequences of funding
formula pecuniary gifts and bequests.
* In a true worth pecuniary gift or bequest, property
distributed in
kind is valued at the distribution date. This is the most commonly used
funding
approach. State law generally provides that the FMV of the
property on the distribution date is used
to measure the extent to which
a distribution satisfies the pecuniary amount, absent a
specific
valuation provision in the governing instrument.(48) Unless specifically
noted, the
discussion in this article, and the examples used, presume that the pecuniary bequest is funded with
property valued at the date of
transfer - the true worth pecuniary gift or bequest. * In 1964, the
IRS
issued Rev. Proc. 64-19,(49) which effectively outlawed the use of the
adjusted income tax basis
of property distributed in kind to measure the
funding of a pecuniary bequest by denying the estate
tax marital
deduction for such a bequest. The ruling did, however, give rise to two
permitted
alternatives to the true worth funding approach: 1. A fairly
representative pecuniary gift or bequest
under which each asset is
generally valued for funding purposes at its basis for Federal income
tax
purposes, provided that the assets used to satisfy the bequest are
"fairly representative" of the
depreciation or appreciation of
the estate's assets as a whole, and 2. A minimum worth
pecuniary
gift or bequest under which each asset is valued for funding at the
lesser of its
distribution date value or its Federal income tax basis,
if the total value of the assets distributed is
equal to the amount of
the marital deduction.
When an executor distributes property in kind in satisfaction of a
true worth pecuniary gift or
bequest: 1. The transfer constitutes a sale
or exchange. 2. Gain or loss is recognized by the estate to
the extent
that the property's FMV on the transfer date exceeds or is less
than the amount of the
bequest. 3. Since the legatee is considered, in
effect, to have purchased the property on the
"deemed sale,"
he gets a stepped-up basis equal to the property's FMV on the
transfer date.(50)
Nevertheless, Treasury regulations state that such a fixed dollar
pecuniary formula bequest "is
neither a bequest of a specific sum
of money or of specific property" (emphasis added) within
the
meaning of Regs. Sec. 1.663(a)-1 because "[t]he identity of the
property and the amount of
money specified ... are dependent both on the
exercise of the executor's discretion and on the
payment of
administration expenses and other charges, neither of which are facts
existing on the
date of the decedent's death." In addition,
"[i]t is immaterial that the value of the bequest is
determinable after the decedent's death before the bequest is satisfied (so that
gain or loss may be
realized by the estate in the transfer of property
in satisfaction of it)."(51)
Therefore, a distribution to fund such a gift or bequest will carry
out income to the beneficiary. The
amount of the income distribution
will be equal to the FMV of the property distributed, limited to
DNI.
If the Sec. 2032 alternate valuation election can be made, no gain
will be recognized on the
distribution of appreciated property to fund
bequests within the six-month period.
Example 17: Assume the same facts as in Example 15, except
that the stock distributed was in
partial satisfaction of a
true worth formula pecuniary marital bequest, rather than
a specific
bequest.
The estate's 19XX fiduciary income tax return would
show:
Dividend income $ 80,000
Capital gain realized on the
distribution of property
($230,000 - $175,000) 55,000
Total income
135,000
Less deduction for
distributions, lower of:
DNI $ 80,000
Distribution 230,000
Lower
80,000
55,000
Less personal exemption 600
Taxable income $ 54,400
The surviving spouse in 19XX would report $80,000 in income from
the estate. The income tax basis
of the stocks in the hands of the
widower would be $230,000, their FMV on distribution.
As previously noted, Examples 16 and 17 were prepared based on a
true worth pecuniary funding
approach. If either the fairly
representative or minimum worth pecuniary approach had been used,
the
distribution would not have triggered a gain although use of the minimum
worth approach
could result in a loss. However, these possible income
tax benefits must be weighed against the
possibility that use of a
fairly representative pecuniary gift or bequest tends to overfund
or
underfund the marital deduction, while a minimum worth approach can,
under certain
circumstances, endanger the qualification of the residue for the estate tax marital deduction and
even the deductibility of a
charitable bequest for estate tax purposes.
When an executor transfers depreciated property in satisfaction of
a true worth pecuniary formula
bequest, the estate realizes a capital
loss. The legatee receives a "step-down" in the income
tax
basis of the property received.
A net capital loss realized by an estate in any tax year (other
than the year of termination) cannot be
"distributed" or
passed through to the beneficiaries in that year.(52) A loss realized on
a
distribution by a trustee of depreciated property to a trust
beneficiary is disallowed under Sec.
267(b)(6). it may not be completely
lost, however. If the beneficiary later sells the property at a
gain,
such gain will not be recognized to the extent of the prior
nondeductible loss.(53)
* Funding residuary bequests
A distribution in satisfaction of a fractional or percentage share
formula gift or bequest is a
distribution of a portion of the residue
and, as such, does not qualify as a gift or bequest of specific
property
or a specific sum of money.(54) Therefore, such a distribution will
always carry out income
to the beneficiary (limited to DNI).
The Code essentially provides that when an estate or trust
distributes property in kind, a gain or
loss is not normally recognized
unless the distribution is in satisfaction of a pecuniary (fixeddollar)
gift or bequest. When no gain or loss is recognized, the
beneficiary's income tax basis of the
property is the estate's
or trust's adjusted basis.(55)
The executor or trustee can, however, make an irrevocable
affirmative election (under Sec.
643(e)(3)) to have the gain or loss
recognized on the distribution to the beneficiary of a fractional
or
residuary gift or bequest, as if the property had been sold to the
beneficiary at its FMV on the
distribution date.
When property is distributed in kind, the amount to be taken into
account in computing the "other
amount paid or credited" when
the Sec. 643(e)(3) election is not made is the lesser of the basis
of
the property in the beneficiary's hands or its FMV when
distributed. When the election is made,
the amount of OAPC is the
property's FMV on distribution.(56)
Example 18: Assume the same facts as in Example 15, except
that the stock distributed was in
partial satisfaction of a residuary
(or fractional) marital bequest, rather than of a specific
bequest.
The determination of the estate's taxable income for
19XX, the income reportable by the widower
and the income
tax basis of the property distributed in his hands would depend
on whether the
executor chooses to make a Sec. 643(e)
election:
Sec. 643(e)(3) election
No Yes
Dividend income
$ 80,000 $ 80,000
Capital gain realized on
distribution of stock 0 55,000
Total income 80,000
135,000
Less deduction for
distributions, lower of:
DNI 80,000 80,000
Distribution 175,000
230,000
Lower 80,000 80,000
0 55,000
Less personal exemption 600 600
Taxable income (600)
54,400
Income taxed to the
surviving spouse 80,000 80,000
Widower's income tax
basis for
stock $175,000 $230,000
The Sec. 643(e)(3) election is an annual election and once made, is
revocable only with IRS consent.
The election applies to all
distributions made during the estate or trust's tax year; it cannot
be
made on a separate distribution basis.(57)
If the trustee or executor does not make the Sec. 643(e)(3)
election, the holding period of the
property in the hands of the trust
or estate is "tacked on" to that of the beneficiary.
If a trustee (not an executor) distributes depreciated property, he
should not make the election
since the loss on the "deemed
sale" will be disallowed.(58) Further, when a trust
distributes
depreciable property, Sec. 1239 denies capital gain treatment to the
trust on any gain
when the trustee makes a Sec. 643(e)(3) election.
When there are multiple beneficiaries of the residue of an estate,
the property of the estate may
need to be distributed in fractional (or
percentage) shares. Unless the will authorizes the executor
to divide or
partition the estate's assets in a non-pro rata manner (e.g., all
of A Corp. stock to one
beneficiary, all of B Corp. stock to another),
the IRS has ruled(59) that distributions other than in
fractional shares will be treated as taxable exchanges among the beneficiaries.
The Sec. 643(e)(3) election is a very flexible tax planning device.
See Part 18 in March for
illustrations.
See the chart on page 127 for a summary of the income tax
consequences of funding the various
types of gifts and bequests with
appreciated/depreciated property in kind valued at the date
of
distribution.
[TABULAR DATA OMITTED]
(1) Subpart B of subchapter J (Secs. 651 and 652) refers to trusts
that distribute income currently.
Subpart C (Secs. 661 through 664)
refers to estates and trusts that may accumulate income or
that
distribute principal. The regulations refer to these as "simple
trusts" (Regs. Sec. 1.651(a)-1)
and "complex trusts"
(Regs. Sec. 1.661(a)-1), respectively. (2) Regs. Sec. 1.643(b)-1 defines
the
term "income," "when not preceded by the words
'taxable', 'distributable net', 'undistributed
net',
or 'gross', ... [as] the amount of income of ...
[a] trust ... determined under the terms of its governing
instrument and
applicable local law." (3) Sec. 651. (4) Sec. 652. (5) Sec. 652(b);
Regs. Sec.
1.652(b)-2; Rev. Rul. 81-244, 1981-2 CB 151. (6) Regs. Sec.
1.652(b)-3. (7) Secs. 167(d) and
611(b)(3). See also Regs. Secs.
1.167(h)-1(b) and 1.611-1(c)(4). (8) Sec. 652(c); Regs. Sec. 1.652(c)1.
The fiduciary must inform the beneficiary of the amount and character of
income he should
report, using Schedule K-1 of Form 1041, U.S. Fiduciary
Income Tax Return. (9) Regs. Sec.
1.652(c)-2. (10) Sec. 661(a). (11)
Sec. 662(a). (12) Sec. 662(b). (13) Regs. Sec. 1.662(b)-2. (14)
Sec.
662(b). (15) Sec. 662(c). (16) Regs. Sec. 1.662(c)-2. (17) The decision
in Rebekah Harkness,
469 F2d 310 (Ct. Cl. 1972)(30 AFTR2d 72-5754, 72-2
USTC [para]9740), specifically upheld the
constitutionality of the
pertinent regulations under Secs. 661 and 662. (18) Sec. 663(a)(2). (19)
Sec.
642(c)(1). The deduction is normally allowed for charitable
contributions paid during the trust's or
estate's tax year.
However, if the charitable contribution is paid on or before the last
day of the
trust's or estate's next tax year, the fiduciary
can elect to treat the contribution as having been
made during the year
preceding the year of payment. (20) Sec. 642(c)(1). (21) Sec. 642(c)(2).
(22)
Regs. Sec. 1.663(a)-1(c)(1)(iii). (23) Regs. Sec. 1.663(a)-1(b).
(24) Regs. Sec. 1.643(a)-3(a). (25) But
the IRS has ruled that this
exception will not apply in the initial year of a trust or estate. IRS
Letter
Ruling (TAM) 8324002 (2/16/83). (26) The trust remainderman will
succeed to the trust's unused
net capital loss carryover in the
year of termination of the trust. Sec. 642(h). See Part 19 in
March.
(27) Sec. 663(b). (28) See Regs. Sec. 1.663(b)-2. (29) Sec. 663(c). (30)
Regs. Sec. 1.663(c)1(d). (31) Regs. Sec. 1.663(c)-l(c). (32) Barnett,
"No Haruspex Needed to Demystify the Fiduciary,"
24th Annual
U. Miami Institute on Estate Planning, Ch. 5 (1990), for an in-depth discussion of the
AMT as it affects estates, trusts and beneficiaries,
including planning possibilities. (33) The term
"distributable net
alternative minimum taxable income" is not in the Code but is used
by the IRS on
tax forms (e.g., Schedule H of Form 1041, and the
Instructions thereto). For AMT purposes,
DNAMTI corresponds to the term
"distributable net income" (DNI) used in computing the Sec.
651
and 661 deductions allowed the fiduciary for distributions to
beneficiaries for regular income tax
purposes. (34) Sec.
56(b)(1)(A)(ii). (35) Sec. 56(b)(1)(a)(i). (36) Sec. 56(b)(1)(c). (37)
Sec. 58(b). (38)
Sec. 651. (39) Sec. 661. (40) Secs. 652 and 662. (41)
Although the amounts of IRDC and OAPC as
fiduciary accounting concepts
will always be identical for both regular income tax and AMT
purposes,
each of these items must be reduced by adjusted tax-exempt income when
the respective
actual income distributions deductions are determined.
And since there is one type of municipal
bond interest that is exempt
from regular income tax, but taxable for AMT purposes (i.e., interest
on
private activity municipal bonds issued after Aug. 7, 1986), the amount
of distributions made to
beneficiaries (IRDC and OAPC) will differ for
regular tax and AMT purposes. DNI and DNAMTI will
also differ by the
amount of such interest income since it constitutes an AMT adjustment
item
under Sec. 57(a)(5). (42) Under Sec. 1014, the uniformity of basis
rule. (43) Regs. Sec. 1.663(a)-1(a)
and b)(2)(iv). (44) Regs. Sec.
1.663(a)-1(c). (45) Regs. Sec. 1.1014-4(a)(3). (46) Id. (47) See
the
discussion in Part 15 in March. (48) See Casner, Estate Planning,
[Subsections]13.10.1 (5th ed.
1988). (49) Rev. Proc. 64-19, 1964-1 (Part
1) CB 682. (50) Regs. Sec. 1.1014-4(a)(3). (51) Regs.
Sec.
1.663(a)-1(b), because the amount is not ascertainable as of the date of
death. (52) Sec.
642(h). See the discussion in Part 9, supra. (53) Sec.
267(d). (54) Regs. Sec. 1.663(a)-1(b)(2)(iii).
(55) Sec. 643(e)(1). (56)
Sec. 643(e)(2). (57) Sec. 643(e)(3). (58) Under Sec. 267(b)(6). (59)
Rev.
Rul. 69-486, 1969-2 CB 159.