Income Taxation of Trusts by Gibson & Perkins, PC

THE FEDERAL INCOME TAXATION OF TRUSTS Prepared by EDWARD L. PERKINS, JD, LLM (Tax), CPA of GIBSON & PERKINS, PC Suite 204 100 W. Sixth Street, Media, PA 19063 610-565-1708 www.gibperk.com

INTRODUCTION This Course is designed to provide the tax practitioner with a basic understanding of the federal income tax taxation of trusts. INSTRUCTIONAL DELIVERY METHOD: Self-study. PROGRAM KNOWLEDGE LEVEL: The course is basic. PREREQUISITE EDUCATION AND EXPERIENCE: This course is aimed primarily towards professionals with a basic understanding of the federal income tax taxation of trusts. RECOMMENDED CPE CREDIT AND FIELD OF STUDY: 2.0 CPE credit hour—Tax ADVANCE PREPARATION: None required. COURSE REGISTRATION REQUIREMENTS: To receive credit for this course, please complete all Review Questions and the Final Examination located at the end of these materials. Instructions on requesting course credit are provided with the Final Examination. REFUND POLICY /CANCELLATION POLICY: It is the policy of YourOnlineProfessor.net to satisfy participants and purchasers in a reasonable manner. Refunds to dissatisfied participants will be given in order to maintain good will. However, the reason for a participant's dissatisfaction and any resulting refund must be clearly indicated. A refund is always given if a course does not qualify for CPE credit in the state in which the purchaser seeks to apply it for credit. YourOnlineProfessor.net will refund any customer who cancels a Group Live or Live Webinar program prior to the start of the program. Notice of Cancellation must be sent to yop@youronlineprofessor.net. Refunds are not offered to customers who do not provide notice of cancellation prior to the start of the program. Full refunds will be provided if a program is cancelled by YourOnlineProfessor.net.

COMPLAINT RESOLUTION AND PROGRAM EVALUATION POLICY: All evaluations will be reviewed by Edward Perkins. Grievance complaints should be directed to Mr. Perkins at (610) 565-1708 ext.102 or via email to yop@youronlineprofessor.net. It is the policy of YourOnlineProfessor.net to respond to every grievance complaint. Such response shall include when 3

appropriate: reviewing the grievance complaint in conjunction with other participant evaluations and discussion of the grievance complaint with the course instructor or other employees.

CONTRIBUTORS: Contributing Editor: Edward Perkins JD, LLM (Tax) Preparation Date: These materials were originally prepared March 10, 2018, and updated again February 3, 2020. Technical Reviewer: Stephen Loester JD, LLM (Tax) Review Date: These materials were technically reviewed February 10, 2020.

OFFICIAL NASBA SPONSOR STATEMENT: YourOnlineProfessor.net is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.learningmarket.org

COURSE OBJECTIVES Upon completion of this Course you will be able to:  Understand basically how trusts are taxed like individuals, but also identify some of the differences in how they are taxed  Understand the accounting period s and accounting methods required of trusts  Understand when a trust is required to make estimated tax payments  Understand why trusts are considered “semi conduits” for income tax purposes.  Identify the items of gross income of a trust  Understand when distributions of appreciated property will result in come to a trust  Identify the deductions and credits allowed to individuals that are also allowed to trust  Identify certain expenses incurred by a trust which are not deductible  Understand how the Knight Case and Regulations impact the deductibility of administration expenses  Identify the significance of the “income distribution deduction” to the taxation of simple and complex trusts  Understand how “distributable net income” is computed  Be able to distinguish between a “simple” and “complex” trust  Identify the differences in how a simple trust is taxed as compared to a complex trust  Gain an overview of how a trust beneficiary is taxed  Distinguish the taxation of the beneficiary of a simple trust as compared to a complex trust  Identify how the character and allocation of amounts included in income taxed to a trust beneficiary is determined  Identify how items of deduction of a trust that enter into the computation of distributable net income are allocated among the items of income  Understand how income of a grantor trust is taxed  Identify what powers and interest will result in a trust being treated as a grantor trust  Identify when someone other than the grantor is treated as the owner?  Distinguish the powers the grantor may retain without being treated as an owner

Table of Contents UNIT ONE The Income Taxation of Trusts – An Overview...........................................................13 § 1.1

Introduction...................................................................................................................13

§ 1.1.1 Taxed Like Individuals..............................................................................................13 § 1.1.2 Differences from Individuals.....................................................................................14 § 1.1.3 Grantor Trusts............................................................................................................14 § 1.1.4 Election to Treat Revocable Trust as Part of the Estate.............................................15 § 1.1.5 Form to File...............................................................................................................15 § 1.1.6 Tax Identification Number...........................................................................................15 § 1.1.7 Tax Rates......................................................................................................................15 § 1.2. Accounting Periods and Methods......................................................................................17 § 1.2.1. Accounting Periods....................................................................................................17 § 1.2.2. Accounting Methods...................................................................................................17 § 1.3.

Estimated Tax................................................................................................................17

§ 1.3.1. In General..................................................................................................................17 § 1.3.2 Exceptions..................................................................................................................18 § 1.3.3 Section 643(g) Election.............................................................................................18 UNIT TWO The Taxation of Trust Income.....................................................................................21 § 2.1

Overview.......................................................................................................................21

§ 2.2

The Gross Income of Trusts..........................................................................................21

§ 2.2.1 In General....................................................................................................................21 § 2.2.2 Interest.........................................................................................................................21 § 2.2.3 Ordinary and Qualified Dividends..............................................................................22 § 2.2.4 Business Income and Loss..........................................................................................22 § 2.2.5 Capital Gain and Loss.................................................................................................22 § 2.2.6 Rents, Royalties, and the Trust’s share of Income from Partnerships, S Corporations, other Trusts, and REMICs.......................................................................................................23 § 2.2.7 Farm Income...............................................................................................................23 7

§ 2.2.8 Income in Respect of a Decedent...............................................................................23 § 2.2.9 Other Income..............................................................................................................23 § 2.2.10 Treatment of Property Distributed in Kind...............................................................24 UNIT THREE Ordinary Deductions and Credits............................................................................27 § 3.1

Overview.......................................................................................................................27

§ 3.2

Trade or Business Expense...........................................................................................27

§ 3.3

Expenses Incurred in Income Producing Activities......................................................27

§ 3.4

Interest...........................................................................................................................28

§ 3.4.1 Interest Deduction in General......................................................................................28 § 3.4.2 Investment Interest......................................................................................................28 § 3.5

Taxes.............................................................................................................................29

§ 3.5.1 Deductible Taxes.........................................................................................................29 § 3.5.2 Non-deductible Taxes..................................................................................................30 § 3.6

Losses and Bad Debts...................................................................................................30

§ 3.6.1 In General...................................................................................................................30 § 3.6.2 Property Losses...........................................................................................................30 § 3.6.3 Activity Losses............................................................................................................31 § 3.7 The Net Operating Loss Deduction.................................................................................31 § 3.8

At Risk Limitations.......................................................................................................32

§ 3.9

Passive Activity Loss Rules..........................................................................................32

§ 3.10 Transactions between Related Party Rules......................................................................32 § 3.11 Depreciation, Amortization, and Depletion.....................................................................33 § 3.11.1 Overview...................................................................................................................33 § 3.11.2 Depreciation..............................................................................................................33 § 3.11.3 Depletion...................................................................................................................34 § 3.11.4 Amortization.............................................................................................................34 § 3.11.5 Section 179................................................................................................................34 § 3.12 Deduction for Estate Taxes Paid – § 691(c)....................................................................34 § 3.13 Domestic Production Activities by Trusts.......................................................................35 § 3.13.1 Deduction for Income Attributable to QPAI..............................................................35 8

§ 3.13.2 Allocation of Expenses..............................................................................................36 § 3.13.3 Apportionment...........................................................................................................36 § 3.13.4 Grantor Trusts............................................................................................................36 § 3.14 Qualified Business Income Deduction............................................................................36 § 3.14.1 Overview....................................................................................................................36 § 3.14.2 Special Rules for Trusts and Estates..........................................................................37 § 3.15 Charitable Contribution Deductions................................................................................38 § 3.15.1 Overview....................................................................................................................38 § 3.15.2 Amounts Paid.............................................................................................................38 § 3.15.3 Adjustments and Other Special Rules for Determining Unlimited Charitable Contributions Deduction..........................................................................................................39 § 3.16 Allowable Itemized Deductions Subject to the 2% Floor.................................................40 § 3.16.1 Limitation on Deduction of “Miscellaneous Itemized Deductions.".........................40 § 3.16.2 The Knight Case and Regulations.............................................................................41 § 3.16.3 Calculating Adjusted Gross Income..........................................................................44 § 3.17 Deduction in Lieu of Exemption.....................................................................................45 § 3.17.1 Simple Trusts............................................................................................................45 § 3.17.2 Complex Trusts.........................................................................................................45 § 3.18 Tax Credits.......................................................................................................................45 UNIT FOUR The Income Distribution Deduction.........................................................................47 § 4.1

In General......................................................................................................................47

§ 4.2

Distributable Net Income..............................................................................................47

§ 4.3

Distinguishing Simple Trusts from Complex Trusts.....................................................48

§ 4.4

Section 651(a) - Deduction for Distributions to Beneficiaries of a Simple Trust.........48

§ 4.4.1 In General...................................................................................................................48 § 4.4.2 Income Required to be Distributed Currently.............................................................48 § 4.5

Accumulation of Income in One Year...........................................................................49

§ 4.5.1 Overview.....................................................................................................................49 § 4.5.2 Distributions in Kind..................................................................................................49 § 4.5.3 Distribution of Amounts Other Than Income.............................................................49 9

§ 4.5.4 Charitable Purposes....................................................................................................50 § 4.6

Section 661(a) - Deduction for Distributions of Complex Trusts.................................50

§ 4.6.1 Deduction Allowed.....................................................................................................50 § 4.6.2 Definition “Income required to be Distributed Currently."........................................50 § 4.6.3 Definition “Any Other Amounts Properly Paid, Credited, or Required to be Distributed.".............................................................................................................................51 UNIT FIVE How the Trust Beneficiary is Taxed............................................................................53 § 5.1

Overview.......................................................................................................................53

§ 5.1

The Taxation of a Simple Trust Beneficiary.................................................................53

§ 5.1.1 Overview.....................................................................................................................53 § 5.1.2 Character and Allocation of Amounts Included in Gross Income..............................54 § 5.1.3 Allocation of Deductions............................................................................................54 § 5.2

The Taxation of Complex Trust Beneficiaries..............................................................54

§ 5.2.1 In General...................................................................................................................54 § 5.2.2 Additional Rules.........................................................................................................55 § 5.2.3 Special Rules Applicable to §§ 661 and 662..............................................................56 UNIT SIX The Tax Treatment of Grantor Trusts............................................................................61 §6.1

Overview - Grantors Treated as Owners..........................................................................61

§6.2

Who is a Considered a “Grantor”?...................................................................................61

§6.3

When is a Grantor Treated as an Owner?.........................................................................61

§6.3.1 Grantor Treated as Owner.............................................................................................61 §6.3.2 Other Persons Treated as the Owner.............................................................................62 §6.3.3 Powers or Interests Held by the Grantor’s Spouse......................................................62 §6.4.

Attribution of Income, Deductions, and Credits...........................................................62

§6.4.1 Overview.......................................................................................................................62 §6.4.2 Grantor Treated Owner of the Entire Trust...................................................................62 §6.4.3 Grantor Treated as Owning an Undivided Fractional Share.........................................63 §6.4.4 Grantor Treated as Owning a Specific Trust Property..................................................63 §6.5 Definitions.........................................................................................................................63 §6.6

Rule Where Power is Subject to Condition Precedent.....................................................64 10

§6.7

Rules for Determining When the Grantor or Another Person is Treated as the Owner....64

§6.7.1

Overview....................................................................................................................64

§6.7.2 Reversionary Interests.................................................................................................64 §6.7.3 Power to Control Beneficial Enjoyment.....................................................................65 §6.7.4 Person Other Than Grantor Treated as Substantial Owner.........................................70 GLOSSARY....................................................................................................................................73

UNIT ONE The Income Taxation of Trusts – An Overview Learning Objectives: Upon completion of this Unit, you will be able to:  

Understand basically how trusts are taxed like individuals, but also identify some of the differences in how they are taxed Understand the accounting period s and accounting methods required of trusts 

Understand when a trust is required to make estimated tax payments

§ 1.1 Introduction § 1.1.1 Taxed Like Individuals

A trust is treated as separate taxpayer for federal income tax purposes. It calculates its gross income in much the same manner as individual taxpayers.1 In addition, most of the deductions and credits allowed to individuals are also allowed to trusts.2 Here is the income tax equation for trusts Gross Income: − Dividends − Business income or loss − Capital gain or loss − Rents, Royalties, partnerships, other trusts − Farm income or loss − Ordinary income or loss − Income in respect of a decedent − Other Income Less Allowable Deductions: − Interest − Taxes Charitable Deduction − Attorney, accountant and return preparer fees 1 Treas. Reg. § 1.641(a)-2. 2 Treas. Reg. § 1.641(b)-1.

− Other deductions − Income distribution deduction − Estate tax deduction − Exemption Amount = Taxable Income § 1.1.2 Differences from Individuals

For the most part, trusts are taxed in much the same manner as individuals; however, there are some significant differences. One major difference is that trusts are allowed a deduction against taxable income for distributions of income made to beneficiaries.3 Simplistically, trusts are taxed on the income retained by the trust and the beneficiaries are taxed on the income distributed to them. For this reason, trusts are sometimes referred to for tax purposes as “semiconduits.” Another difference between trusts and individual taxpayers is that “complex” trusts are allowed an unlimited deduction for amounts paid or permanently set aside for charitable purposes. In addition, note the following differences: − Trusts are not allowed a standard deduction. − Simple trusts are allowed a deduction of $300, complex trusts $100, instead of a personal exemption. − Trusts are not allowed a Section 179 deduction available for making certain capital expenditures. − The ordinary income tax rates apply at significantly lower levels of taxable income than they apply to individual taxpayers. § 1.1.3 Grantor Trusts

The rules of taxation that normally apply to trusts do not apply if the trust is a “grantor trust." If the trust instrument contains certain provisions which reserve for the person creating the trust (i.e., the "grantor") certain rights to either control or benefit from the trust, the trust may be treated as a "grantor trust" for income tax purposes. In that case, all or part of the income and deductions realized by the trust are taxable to the grantor and reported on the grantor’s income tax return and not to the trust.4

3 IRC §§ 651(a), and 661(a). 4 A discussion of the taxation of grantor trusts is provided in Unit Six.

§ 1.1.4 Election to Treat Revocable Trust as Part of the Estate

The trustee of a decedent's “qualified revocable trust” and the executor of the decedent's estate may make an irrevocable election to treat the trust as part of the decedent's estate (and not as a separate trust) for federal income tax purposes.5 The term “qualified revocable trust” means any trust which was treated as a grantor trust, because the decedent held a power or interest in the trust.6 The Code provides comparable treatment for a trust treated as part of the estate for generation-skipping transfer tax purposes.7 § 1.1.5 Form to File

For federal income tax purposes, trusts file Form 1041 – U.S. Income Tax Return for Trusts.

§ 1.1.6 Tax Identification Number

Trusts including “grantor trusts,” as discussed in Unit Six, are required to obtain an employer tax identification number for the trust.9 § 1.1.7 Tax Rates

Ordinary Tax Rates

The income tax rates which apply to trusts in 2019 are as follows

If taxable income is:

The tax is:

Not over $2,600

15% of taxable income

Over $2,600 but not over $9,300

$260, plus 24% of the excess over $2,600

Over $9,300 but not over $12,750

$1,868 plus 35% of excess over $9,300

Over $12,750

$3,075.50 plus 37% of the excess over $12,750

Capital Gain Rates

5 IRC § 645(a). 6 IRC § 645(b)(1). 7 IRC § 2654(b). 8 Instructions for Form 1041, p4. 9 Grantor trusts treated as owned by one grantor or by one other person, and for which the trustee gives all payers of income during the tax year the name and TIN of the grantor or other person treated as the owner of the trust, as well as the address of the trust, may choose to Optional Method One, as the trusts reporting method. Such trusts are not required to obtain a tax identification number. However, the trust must obtain a tax identification number for the first year the trust is no longer treated as a grantor trust, or the first year it no longer reports under Optional Method One. See Instructions for Form 1041, p13.

Net capital gains are taxed at preferential rates of 0%, 15%, or 20%, depending on the taxpayer's ordinary income tax rate.10 For tax years 2018 through 2025, special modifications are made to the taxation of net capital gains.11 These modifications are made to account for the different rates applicable during those years. 3.

Surtax on Unearned Income 3.8%

Surtax

A 3.8% surtax referred to as the “unearned income Medicare contribution” tax is imposed on “net investment income.”12 For trusts, the tax is 3.8% of the lesser of (i) the trusts undistributed net investment income, or (ii) the excess of the trust’s modified adjusted gross income over the dollar amount at which the highest income tax bracket begins.13 This 3.8 percent tax is in addition to the normal tax on such income. b.

Definition

The definition of “net investment income” is the excess of the sum of the following items less any otherwise allowable deductions properly allocable to such income or gain: (i) gross income from interest, dividends, annuities, royalties and rents unless such income is derived in the ordinary course of any trade or business (excluding a passive activity or financial instruments/commodities trading); (ii) other gross income from any passive trade or business; and (iii) net gain included in computing taxable income that is attributable to the disposition of property other than property held in any trade or business that is not a passive trade or business. 4.

Trusts that are Exempt

Trusts totally devoted to one or more of the charitable purposes described in IRC § 170(c) (2)(B), and tax-exempt trusts under IRC § 501 or charitable remainder trusts exempt from tax under IRC § 664, are not subject to the unearned income Medicare contribution. 5.

The Alternative Minimum Tax

Trusts are subject to the alternative minimum tax (“AMT”). The AMT equals the excess (if any) of (i) the “tentative minimum tax” for the tax year over (ii) the regular tax for the tax year. To compute a trust’s tentative minimum tax, the taxpayer’s “alternative minimum taxable income” (“AMTI”) must be determined. AMTI is computed by taking the taxpayer’s regular taxable income, after being adjusted for certain deductions, increased by AMT tax preferences, such as tax-exempt interest and 10 IRC§1(h). 11 IRC§1(j)(5). 12 IRC § 1411. 13 IRC § 1411(a)(2) - for this purpose the “modified adjusted gross income” of a trust is computed in the same manner as in the case of an individual, except that (a) the deductions for costs which are paid or incurred in connection with the administration of the trust and which would not have been incurred if the property had not been held in trust, and (b) the deductions allowable for charitable contributions, and distributions of income to beneficiaries; See IRC § 67(e).

accelerated depreciation on real property, and decreased by the AMT exemption amount. The result is the “taxable excess.” A trust’s tentative minimum tax for the tax year equals (i) the sum of 26 percent of the taxable excess that doesn’t exceed a statutory amount, as adjusted for inflation, that is, for 2019, $194,800, plus (ii) 28 percent of the taxable excess over the statutory amount, as adjusted for inflation, minus the taxpayer’s AMT foreign tax credit, if any. For trusts, the exemption amount for 2019 is $25,000. 14 This amount is adjusted for inflation. The exemption amount is phased out for trusts in the amount of 25 percent for each dollar of AMT over $83,500. The exemption is totally phased out when AMT reaches $183,500.

§ 1.2. Accounting Periods and Methods § 1.2.1. Accounting Periods

Generally, a trust must adopt a calendar year.15 The following trusts are exempt from this requirement: − A trust that is exempt from tax under IRC § 501(a); − A charitable trust described in IRC § 4947(a)(1); and − A trust that is treated as wholly owned by a grantor under the rules of IRC §§ 671 through 679.16 § 1.2.2. Accounting Methods

A trust must calculate its taxable income using the same method of accounting it regularly uses in keeping its books and records.17 Generally, permissible methods include the cash method, the accrual method, or any other method authorized by the Internal Revenue Code. In all cases, the method used must clearly reflect income.18 A trust wishing to change its accounting method may only do so by filing Form 3115, Application for Change in Accounting Method, and obtaining the consent of the IRS.19

§ 1.3. Estimated Tax § 1.3.1. In General

With certain exceptions, a trust must pay estimated income tax if it expects to owe, after subtracting any withholding and credits, at least $1,000 in tax, and it expects the withholding and credits to be less than the smaller of: (i) 90% of the tax shown on the current year’s tax return, or (ii) 100% of the tax shown on the prior year’s tax return (110% of that amount if the trust’s adjusted gross income on that return is more than $150,000, and less than 2/3 of gross income for 14 IRC § 55(d) 15 IRC § 644(a). 16 IRC § 644(b). 17 IRC § 446(a). 18 IRC § 446(b). 19 IRC § 446(e), and Instructions for Form 1041 (2012), p. 9.

the prior tax year or the current tax year is from farming or fishing).20 However, if a return was not filed for the prior year or that return did not cover a full 12 months, and (ii), above, does not apply.21 § 1.3.2 Exceptions

Estimated tax payments are not required from: (i) a domestic trust that had no tax liability for the full 12-month in the prior tax year; or (ii) a trust that was treated as owned by the decedent if the trust will receive the residue of the decedent's estate under the will (or if no will is admitted to probate, the trust primarily responsible for paying debts, taxes, and expenses of administration) for any tax year ending before the date that is 2 years after the decedent's death. § 1.3.3 Section 643(g) Election

Fiduciaries of trusts that pay estimated tax may elect under IRC § 643(g) to treat any portion of a payment of estimated tax made by such trust as a payment made by a beneficiary of the trust.22 The election under IRC § 643(g) must be made by filing Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries on or before the 65th day after the close of the taxable year of the trust.23 Any amount so treated is treated as a distribution to the beneficiary on the last day of the taxable year.24

20 Form 1041-ES, p. 1. 21 See Instructions for Form 1041 (2012), p. 9. - For this purpose, include household employment taxes in the tax shown on the tax return, but only if either of the following is true: the trust will have federal income tax withheld for the current tax year, or the trust would be required to make estimated tax payments for 2012 even if it did not include household employment taxes when figuring estimated tax. 22 IRC § 643(g)(1). 23 IRC § 643(g)(2), see also Instructions for Form 1041 (2012), p.9. 24 IRC § 643(g)(1)(B).

Review Exercise One For the most part, trusts are taxed in much the same manner as individuals; however, there are some significant differences. Which of the following is not one of those differences? A. Trusts are allowed a deduction against taxable income for distributions of income made to beneficiaries. B.

Trusts are not allowed a standard deduction.

C. Simple trusts are allowed a deduction of $300, complex trusts $100, instead of a personal exemption. D. The ordinary income tax rates which apply to trusts are significantly higher than the rates which apply to individual taxpayers.

A. Incorrect -Trusts are allowed a deduction against taxable income for distributions of income made to beneficiaries. B.

Incorrect Trusts are not allowed a standard deduction.

C. Incorrect Simple trusts are allowed a deduction of $300, complex trusts $100, instead of a personal exemption. D. Correct The ordinary income tax rates which apply to trusts are significantly lower than the rates which apply to individual taxpayers. Review Exercise Two

Generally, a trust must adopt a calendar year tax year. Which of the following trusts are exempt from this requirement? A.

A trust that is exempt from tax under IRC § 501(a);

A simple trust

A complex trust

A foreign trust

A. Correct -A trust that is exempt from tax under IRC § 501(a). Also exempt are charitable trusts described in IRC § 4947(a)(1); and grantor trusts. B.

Incorrect -A simple trust must adopt a calendar year.

Incorrect -A complex trust must adopt a calendar year.

Incorrect -A foreign trust must adopt a calendar year unless it is a grantor trusts.

UNIT TWO The Taxation of Trust Income Learning Objectives: Upon completion of this Unit, you will be able to: 

Understand why trusts are considered “semi conduits” for income tax purposes. 



Identify the items of gross income of a trust

Understand when distributions of appreciated property will result in come to a trust

§ 2.1 Overview The taxable income of a trust is generally determined in the same manner as that of an individual taxpayer with one major difference. 25 Trusts are not taxed on the income distributed to trust beneficiaries. Rather they are allowed a deduction against taxable income for distributions of income made to those beneficiaries.26 For this reason, trusts are sometimes referred to for tax purposes as “semi-conduits,” i.e., they are taxed on the income retained by the trust and the beneficiaries are taxed on the income distributed to them.

§ 2.2 The Gross Income of Trusts. § 2.2.1 In General

The gross income of a trust consists of all items of gross income received during the taxable year, including the following items: − Interest; − Ordinary and qualified dividends; − Business income and loss; − Capital gain and loss; − Rent and royalties; − Farm Income; − Distributions from retirement plans. 27

25 IRC § 643(b)(1). 26 IRC §§ 651(a), and 661(a). 27 Treas. Reg. § 1.641(a)(2).

§ 2.2.2 Interest

A trust must report its share of the taxable interest income that was realized during its tax year. Examples of taxable interest include interest from: − Accounts (including certificates of deposit and money market accounts) with banks, credit unions, and thrift institutions; − Notes, loans, and mortgages; − U.S. Treasury bills, notes, and bonds; − U.S. savings bonds; − Original issue discount; and − Income received as a regular interest holder of a real estate mortgage investment conduit (“REMIC”).28 § 2.2.3 Ordinary and Qualified Dividends

A trust reports its share of the ordinary and qualified dividends realized during the tax year.

§ 2.2.4 Business Income and Loss

If the trust operates a business, the income or loss generated by that business must be reported.30 If the trust operates the business at a loss, the trust is permitted the benefit of the net operating losses.31 § 2.2.5 Capital Gain and Loss

Capital gains and losses realized by a trust, including capital gain distributions, are reportable on the trust tax return.32 In the case of property transferred by gift to a non-grantor trust, the basis of property in the hands of the trust for purposes of calculating that gain is the same as it would be in the hands of the donor. The same rule applies to determine loss unless the basis is greater than the fair market value of the property at the time of the gift. In that case, the basis for determining loss is the fair market value at the time of the gift.33 The holding period of such property begins for the trust on the date of the transfer.34 In the case of property acquired by a trust as a result of a testamentary transfer, the basis of the property is its fair market value on the date of the decedent’s death. However, if the alternate valuation date is elected by the executor, the basis is the fair market value on the date 28 IRC § 61(a)(4), see also Instructions for Form 1041 (2012), p. 19. 29 IRC § 61(a)(7). 30 IRC § 61(a)(2). 31 IRC § 642(d). 32 IRC § 61(a)(3). 33 See Treas. Reg. § 1.1015-1(a)(1). 34 See Treas. Reg. § 1.1015-1(c).

six months after death.35 The holding period of such property is considered to be more than one year.36 § 2.2.6 Rents, Royalties, and the Trust’s share of Income from Partnerships, S Corporations, other Trusts, and REMICs

A trust must report its share of income or losses from rents,37 royalties,38 partnerships,39 S corporations, and other trusts.40 § 2.2.7 Farm Income

A trust reports profit and loss from the operation of a farm.41 § 2.2.8 Income in Respect of a Decedent

“Income in respect of a decedent” (“IRD”) is income which is earned on the date of death but not reportable by the decedent on his or her final tax return under his or her method of accounting; e.g., wages accrued on the date of death but not paid to a cash basis taxpayer.42 IRD is includible in the gross income of the trust if it actually receives the payment. The income retains the same character in the hands of the trust recipient as it would have had in the hands of the decedent.43 § 2.2.9 Other Income

The ordinary gain realized from the sale or exchange of other than capital assets, and of business property,44 and other income distributions realized by a trust from pensions, annuities, retirement or profit-sharing plans, IRAs,45 insurance contracts, etc., is also taxable to a trust.46

35 Treas. Reg. §1014- 1(a). In general, §2032 provides for the valuation of a decedent's gross estate at a date other than the date of the decedent's death. More specifically, if an executor elects the alternate valuation method under section 2032, the property included in the decedent's gross estate on the date of his death is valued at a date 6 months after death, unless sold or distributed prior to that date, see Treas. Reg. §20.2032-1(a). 36 IRC § 1223(9). 37 IRC § 61(a)(5). 38 IRC § 61(a)(6). 39 IRC § 61(a)(13). 40 IRC § 61(a)(15). 41 IRC § 61(a)(2). 42 Treas. Reg. § 1.691(a) -1(b). 43 Treas. Reg. § 1.691(a) -3. 44 IRC § 61(a)(3). 45 IRC § 61(a)(11). 46 IRC § 61(a)(10) - Also included in the gross income of a trust is the following : (1) income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests; (2) income accumulated or held for future distribution under the terms of trust; (3) income which is to be distributed currently by the fiduciary to the beneficiaries, and income collected by a guardian of an infant which is to be held or distributed as the court may direct; (4) income which, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated. The several classes of income enumerated in this Section do not exclude others which also may come within the general purposes of § 641- see § 641(a); see Treas. Reg. §1.641(a)-2).

§ 2.2.10 Treatment of Property Distributed in Kind

General Rule

As a general rule, a trust does not recognize gain or loss on the distribution of appreciated property to the trust beneficiaries, unless the distribution is in satisfaction of a right to receive: (i) a distribution of a specific dollar amount, (ii) a specific property other than that distributed, or (iii) income, if income is required to be distributed currently.47 2.

Exception for Distributions Described in § 663(a)

Even the exception has its exceptions, however, under that Code § 663, no gain or loss is recognized upon distribution of appreciated property in regard to: − Any distribution which, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of a specific sum of money or of specific property and which is paid or credited all at once, or in not more than 3 installments;48 − Any amount paid or permanently set aside or otherwise qualifying for the charitable deduction,49 or − Any amount paid, credited, or distributed in the taxable year if distribution deduction applied to such amount for a preceding taxable year of a trust because credited or required to be distributed in such preceding taxable year.50 3.

Section 643(e)(3) Election

The foregoing notwithstanding, under IRC § 643(e)(3), the fiduciary of a trust may elect to recognize gain on the distribution of appreciated property in kind to a beneficiary. The gain recognized by the trust is recognized in the same manner as if the property had been sold to the distribute at its fair market value.51

47 Treas. Reg. § 1.661(a)-(2)(f). 48 IRC § 663(a)(1). 49 IRC § 663(a)(2). 50 IRC § 663(a)(3). 51 IRC § 643(e)(3)(A)(ii).

Review Exercise Three As a general rule, a trust does not recognize gain or loss on the distribution of appreciated property to the trust beneficiaries, unless the distribution is in satisfaction of a right to receive which of the following: A.

A distribution of a specific dollar amount,

A specific property other than that distributed,

Income, if income is required to be distributed currently.

All of the above

A. Incorrect - A trust will generally recognize gain or loss on the distribution of appreciated property to the trust beneficiaries if the distribution is in satisfaction of a right to receive: (i) a distribution of a specific dollar amount, (ii) a specific property other than that distributed, or (iii) income, if income is required to be distributed currently. B. Incorrect - A trust will recognize gain or loss on the distribution of appreciated property to the trust beneficiaries if the distribution is in satisfaction of a right to receive a specific property other than that distributed. C. Incorrect - The distribution of appreciated property to the trust beneficiaries made in satisfaction of a right to receive income, if income is required to be distributed currently will result in the recognition of income to a trust. D. Correct - All of the above. As a general rule, a trust will recognize gain or loss on the distribution of appreciated property to the trust beneficiaries if the distribution is in satisfaction of a right to receive: (i) a distribution of a specific dollar amount, (ii) a specific property other than that distributed, or (iii) income, if income is required to be distributed currently.

UNIT THREE

Ordinary Deductions and Credits Learning Objectives: Upon completion of this Unit, you will be able to: 

Identify the deductions and credits allowed to individuals that are also allowed to trust  

Identify certain expenses incurred by a trust which are not deductible

Understand how the Knight Case and Regulations impact the deductibility of administration expenses

§ 3.1 Overview Generally, the deductions and credits allowed to individuals are also allowed to trusts.52 These deductions include: − Trade or business expenses; − Expenses Incurred in Income Producing Activities; − Interest; − Taxes; − Losses and bad debts; − Depreciation, amortization, and depletion; − Deduction for Estate Taxes Paid – IRC § 691(c); and − Domestic production activities income deduction This Unit will review the ordinary deductions and credits which are available to trusts.

§ 3.2 Trade or Business Expense If a trust operates a business, the ordinary and necessary expenditures directly connected with or pertaining to that trade or business are tax deductible.53

§ 3.3 Expenses Incurred in Income Producing Activities IRC § 212 provides that a deduction is allowed for the ordinary and necessary expenses paid or incurred: (i) for the production or collection of income, (ii) for the management, conservation, or maintenance of property held for the production of income, or (iii) in connection 52 Treas. Reg. § 1.641(b)-1. 53 IRC § 162.

with the determination collection, or refund of any tax.54 Essentially, trusts are in the business of managing, conserving, and maintaining property. As a result, the Regulations under IRC § 212 provide that the ordinary and necessary administration expenses of a trust are deductible provided they are reasonable.55 A trust may deduct certain expenses under IRC § 212 that an individual would not be able to deduct. Some of these expenses, such as trustees' fees, are deductible in full in determining adjusted gross income deductible under IRC § 67(e). Other IRC § 212 expenses are subject to the limitations on miscellaneous itemized deductions pursuant to IRC § 67(c)(3)(B). Under the Tax Cuts and Jobs Act of 2017, all miscellaneous itemized deductions that are subject to the 2% floor (including expenses for the production of income) are suspended for tax years beginning after December 31, 2017, but before January 1, 2026.56 Deductions that meet the conditions of IRC § 67 (e)(1) remain deductible, however.

§ 3.4 Interest § 3.4.1 Interest Deduction in General

Interest, subject to certain limitations, paid or incurred by a trust on amounts borrowed by the trust, or a debt acquired by the trust is deductible.57 Types of interest which may be deductible by a trust include: (i) investment interest within limitations, discussed below; (ii) any qualified residence interest if the residence would be a “qualified residence” if owned by the trust beneficiary, and (iii) interest payable under IRC § 6601.58 Interest incurred in a trade or business is deducted, not as interest, but as a business expense. Interest that is paid or accrued to purchase or carry obligations, which is wholly tax exempt is not deductible.59 Also, no deduction is allowed for “personal interest.”60 Examples of personal interest include interest paid on revolving charge accounts used to purchase personal use property, and personal notes for money borrowed from a bank, credit union, or another person; installment loans on personal use property; and underpayments of federal, state, or local income taxes.61 § 3.4.2 Investment Interest

Investment interest is interest that is paid or incurred on indebtedness that is allocable to 54 IRC § 212. 55 Treas. Reg. § 1.212-1(i); note that such expenses are not deductible if allocable to the production or collection of tax-exempt income. 56 IRC § 67(g). 57 IRC § 163 - If the proceeds of the loan were used for more than one purpose, for example, to purchase an investment and to acquire an interest in a passive activity, the trustee must make an interest allocation according to the rules in Temporary Regulations Section 1.163-8T. 58 Instructions for Form 1041(2012), p. 22. Interest payable under IRC § 6601, relates to interest payable on any unpaid portion of the estate tax attributable to the value of a reversionary or remainder interest in property for the period during which an extension of time for payment of such tax is in effect. 59 Treas. Reg. § 1.265 – 2(a). 60 Treas. Reg. § 1.163-9T(b). 61 Instructions for Form 1041 (2012), p. 21.

property held for investment.62 Investment interest is deductible only to the extent that it does not exceed “net investment income.”63 “Investment income” is defined generally as gross income from property held for investment.64 Section 163(d)(4)(A) defines “net investment income” as the excess of investment income over “investment expenses.” The term “investment expenses” means the allowable deductions (other than for interest) which are directly connected with the production of investment income.65

§ 3.5 Taxes § 3.5.1 Deductible Taxes

Like an individual taxpayer, a trust may deduct certain taxes paid or incurred by the trust. Deductible taxes include the following: 66

− State and local income taxes – A trust can deduct state and local income taxes unless an election is made to deduct state and local general sales taxes;67 − State and local general sales taxes – A trust may elect to deduct state and local general sales taxes instead of state and local income taxes;68 − Foreign or U.S. possession income taxes – A trust can take a deduction, or elect to take a credit for the tax instead of a deduction;69 − Generation Skipping Tax - The generation-skipping transfer (GST) tax imposed on income distributions is deductible by a trust.70 Also, deductible: − State, local, and foreign real property taxes; and71 − State and local personal property taxes.72 The Tax Cuts and Jobs Act of 2017 provides that individual taxpayers and trusts may elect to deduct state and local sales, income, or property taxes up to $10,000 ($5,000 for a married taxpayer filing a separate return) for tax years beginning after Dec. 31, 2017, and beginning before Jan. 1, 2026. The Act also provides that individuals may deduct state, local, and

62 IRC § 163(d)(3) (A)- “Investment interest” does not include any qualified residence interest, or interest that is taken into account under Section 469 in calculating income or loss from a passive activity. 63 IRC § 163(d)(1). 64 IRC § 163(d)(4)(B). 65 IRC § 163(d)(4)(C). 66 IRC § 164. 67 IRC § 164(a)(3). 68 IRC §164(b)(5)(A). 69 IRC § 164(a)(3), and IRC § 901. 70 IRC § 164(a)(4). 71 IRC § 164(a)(1). 72 IRC § 164(a)(2).

foreign property taxes and state and local sales taxes when paid or accrued in carrying on a trade or business. § 3.5.2 Non-deductible Taxes

A trust cannot deduct: − Federal income taxes;73 − Estate, inheritance, legacy, succession, and gift taxes;74 or − Federal duties and excise taxes.75

§ 3.6 Losses and Bad Debts § 3.6.1 In General

Trusts are allowed the same deductions for losses as individual taxpayers. There are basically two types of losses: (i) those related to the sale, exchange or disposition of property at a loss, and (ii) those related to the conduct of a particular activity at a loss. § 3.6.2 Property Losses

Property losses related to the sale, exchange or disposition of property include: − Ordinary losses;76 − Worthless securities;77 − Capital losses;78 − Personal casualty and theft losses,79 and − Bad debts.80 In regard to such losses, the same rules apply to trusts as apply to individuals.81 Therefore, the loss must be incurred either in a trade or business,82 in a transaction entered into for a profit83 or as an allowable casualty loss under IRC § 165(h).84 The loss is generally limited 73 IRC § 275(a)(1) and Reg. § 1.164-2(a). 74 IRC § 275(a)(3) and Treas. Reg. §1.164-2(c). 75 Treas. Reg. § 1.164-2(f). 76 Treas. Reg. §1.165-1. 77 Treas. Reg. §1.165-5. 78 IRC § 165(f). 79 IRC §165(e)(h). 80 Treas. Reg.§1.166-1(a). 81 Treas. Reg.§1.641(b)-1. 82 IRC § 165(c)(1). 83 IRC § 165(c)(2). 84 IRC § 165(c)(3) - A trust is entitled to deduct casualty and theft losses incurred in connection with trust property in computing its taxable income under the rules applicable to casualty loss deductions by individuals. As a result, the deductible loss for nonbusiness property is allowed only to the extent that: (a) each separate casualty or theft loss is more than $100 ($500 for 2009), and (b) the total of all losses for the year is more than 10% of adjusted gross income, see Treas. Reg. § 1.165(c).

to the difference between the adjusted basis of the asset in the hands of the trust and the amount realized in the sale, exchange, or disposition of the property.85 Like individual taxpayers, a trust is entitled to deduct losses from sales or exchange of capital assets up to the amount of capital gain plus $3,000.86 To the extent that such losses are not currently deductible, they can be carried over until the losses are used.87 Upon termination of the trust, the unused losses will carry over to the individuals or entities which succeed to the property of the trust.88 For tax years beginning after 2017 and before 2026, any personal casualty loss is permitted only if it is attributable to a federally declared disaster under IRC § 165(i)(5).340.1. Taxpayers, however, may offset personal casualty losses not attributable to Federally declared disasters with personal casualty gains.89 § 3.6.3 Activity Losses

Like property losses, activity losses must be sustained in the conduct of a trade or business or in a transaction entered into for a profit. Losses related to an activity may be limited by: (i) the limitations placed on net operating losses; (ii) the application of the “at risk” rules, (iii) the application of the “passive loss” rules, or (iv) the related party rules.

§ 3.7 The Net Operating Loss Deduction The net operating loss deduction allowed by IRC § 172 is available to trusts generally, with certain exceptions and limitations. When computing gross income and deductions for the purposes of determining the net operating loss, a trust excludes any income and deductions attributable to a grantor or another person under sections 671 through 678 relating to grantors and others treated as substantial owners.90 In addition, in calculating the net operating loss, a trust disregards the charitable contributions deduction and the deduction for distributions to beneficiaries.91 For NOLs arising in tax years ending after December 31, 2017, subject to two exceptions, taxpayers may not carry back NOLs but may carry unused NOLs forward indefinitely.92 For NOLs that arise in tax years beginning after December 31, 2017, the NOL deduction is limited to the lesser of the aggregate NOL carryovers to such year or 80% of the current taxable income computed without regard to the allowable NOL deduction.93

85 Treas. Reg.§ 1.165-1(a). 86 IRC § 1211(b). 87 IRC § 1212(b)(1). 88 Treas. Reg. § 1.642(h)-1. 89 IRC §165(h)(5)(B)(i), added by Pub. L. No. 115-97, § 11044, effective for losses incurred in tax years beginning after December 31, 2017. 90 Treas. Reg. § 1.642(d)-1(a). 91 Treas. Reg. § 1.642(d)-1(b). 92 IRC §172(b)(1). 93 IRC §172(a).

§ 3.8 At Risk Limitations The “at risk” rules generally limit a taxpayer’s deductible losses from an activity to the amount the taxpayer is financially “at risk” with respect to that particular activity.94 The at risk rules apply to trusts other than trusts treated as “grantor trusts” described in IRC § 671 through IRC § 678.95 If a grantor is treated as the owner of an entire trust, he is treated as being engaged in any “at risk” activity of the trust for purposes of determining the limitation on allowable losses under the at-risk rules.96

§ 3.9 Passive Activity Loss Rules The “passive activity” rules under IRC § 469 generally limits the amount of deductible losses generated by "passive activities" in a particular tax year to the amount of passive activity income realized by the taxpayer in the same year.97 A “passive activity” is defined as an activity in which the taxpayer does not “materially participate.”98 The passive activity rules apply to trusts.99 A trust is treated as materially participating in an activity if the trustee in his or her fiduciary capacity materially participates in the activity.100 For grantor trusts, the trust is disregarded, and material participation is established at the grantor level.101 If a trust distributes an interest in a passive activity, the basis of the interest immediately before the distribution is increased by the passive activity losses allocable to the interest. Those losses cannot be deducted thereafter.102

§ 3.10 Transactions between Related Party Rules Under IRC § 267, no deduction is allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between “related taxpayers.”103 In addition, a taxpayer using the accrual method may only deduct expenses and interest owed to a related party in the year the income is included in the income of the related party.104 These rules apply to trusts. For purposes of IRC § 267, the following parties are considered related parties to trusts:  A grantor and a fiduciary of any trust;

94 Prop. Reg. § 1.465 -1(a). 95 Treas. Reg. § 1.465-1(d)(2). 96 Rev. Rul. 78-175, 1978-1 CB 144. 97 IRC § 469(b). 98 IRC § 469(c)(1). 99 IRC § 469(a)(2)(A). 100 See Senate Report at p. 75, note that the Temporary Regulations under IRC § 465, have reserved comment on what is considered material participation by a trust; see Treas. Reg. § 1.469-5T(g). 101 Temp. Reg. §1.469-1T(b)(2). 102 IRC § 469(j)(12). 103 IRC § 267(a)(1). 104 IRC § 267(a)(2).

 A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;  A fiduciary of a trust and a beneficiary of such trust;  A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; and  A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust.105  An executor of an estate and a beneficiary of that estate, except in the case of a sale or exchange a pecuniary bequest.106

§ 3.11 Depreciation, Amortization, and Depletion § 3.11.1 Overview

Trusts, like individual taxpayers, may deduct a reasonable amount for the exhaustion, wear, and tear of property used in a trade or business, or held for the production of income.107 A trust which owns a mine, oil and gas well, other natural deposits, or timber, is also permitted a reasonable allowance for depletion (and depreciation of improvements).108 A trust may also be entitled to an amortization deduction if it owns a certified pollution control facility or if it owns goodwill or other intangibles.109 § 3.11.2 Depreciation

For property held in a trust, the allowable deduction is apportioned between the income beneficiaries and the trustee on the basis of the trust income allocable to each, unless the governing instrument (or local law) requires or permits the trustee to maintain a reserve for depreciation in any amount.110 Under the Uniform Principal and Income Act, a trustee may transfer to principal a reasonable amount of the net cash receipts, i.e., income, from a principal asset that is subject to depreciation. In that case, the deduction is first allocated to the trustee to the extent that income is set aside for a depreciation reserve. Any part of the deduction in excess of the income set aside for the reserve is apportioned between the income beneficiaries and the trustee on the basis of the trust income (in excess of the income set aside for the reserve) allocable to each. Irrespective of any provisions in the trust instrument, no effect is given to an allocation of the depreciation deduction which gives any beneficiary or the trustee a share of the deduction 105 IRC § 267(b) (4) – (8). 106 Instructions for Form 1041(2012), p. 21. 107 Treas. Reg. § 1.167(a) -1(a). 108 Treas. Reg. § 1.642(e) -1. 109 IRC § 169, also IRC §197. 110 IRC § 167(h)-1(b); IRC § 611(b)(3).

greater than their pro rata share of the trust income. However, such a disproportionate allocation may be made to the trust up to the level of the reserve when the trust instrument or local law requires or permits the trustee to maintain a reserve for depreciation.111 § 3.11.3 Depletion

For mineral or timber property held in a trust, the depletion deduction is apportioned between the income beneficiaries and the trust based on the trust income from such property allocable to each. However, in the case of a trust, if the governing instrument or local law requires or permits the trustee to maintain a reserve for depletion, the deduction is first allocated to the trust, up to the amount of the reserve. Any excess is allocated among the beneficiaries and the trust in the same manner as the trust's accounting income.112 § 3.11.4 Amortization

The deduction for amortization is apportioned between a trust and its beneficiaries under the same principles used to apportion the deductions for depreciation and depletion. § 3.11.5 Section 179

A trust is not permitted to expense depreciable business assets under IRC § 179.113 Likewise, a Section 179 expense received from a pass-through entity on a Schedule K-1 is not deductible by the trust.114

§ 3.12 Deduction for Estate Taxes Paid – § 691(c) As a receivable owned at the time of death, income in respect of a decedent may be an asset of the decedent subject to federal estate tax. If a trust is required to include in its gross income, income in respect of a decedent the trust is permitted to deduct the portion of the estate tax imposed upon the decedent's estate which is attributable to the IRD.115 The deduction is determined as follows: − Determine the net value of the IRD in excess of deductions in respect of a decedent; − Determine the estate tax attributable to the inclusion of the IRD in the gross estate, by computing the estate tax without including the net value of the IRD as determined in step one.116

111 Id. 112 Treas. Reg. § 1.611-1(c)(4). 113 IRC § 174(d)(4). 114 Instructions for Form 1041 (2012), p. 19. 115 IRC § 691(c)(1)(A). 116 Treas. Reg. § 1.691(c) -1(a)(1)(2).

For purposes of IRC § 691(c), the term “estate tax” means the federal estate tax.117 In the case of trust, if any amount properly paid, credited, or required to be distributed by a trust to a beneficiary consists of income in respect of a decedent received by the trust during the taxable year, then that amount is excluded in determining the income in respect of the decedent with respect to which the trust is entitled to a deduction under IRC § 691(c). Further, that amount is considered income in respect of a decedent of the beneficiary for purposes of determining the deduction under IRC § 691(c) to such beneficiary.118

§ 3.13 Domestic Production Activities by Trusts § 3.13.1 Deduction for Income Attributable to QPAI

The Tax Cuts and Jobs Act of 2017 repealed the former IRC § 199 domestic production activities deduction for tax years beginning after 2017.119 For tax years beginning before January 1, 2018, former IRC § 199 allowed a trust a deduction against income, not for a particular expenditure, but for a percentage of the qualifying income that was taken into account. Pursuant to IRC § 199, taxpayers, including trusts, were permitted to deduct up to 9% of their share of “qualified production activities income” (“QPAI”)120 from the following activities: − Construction performed in the United States.121 − Engineering or architectural services performed in the United States for construction projects in the United States.122 − Any lease, rental, license, sale, exchange, or other disposition of: (i) tangible personal property, computer software, and sound recordings that the trust manufactured, produced, grew, or extracted in whole or in significant part within the United States; (ii) any qualified film the trust produced; or (iii) electricity, natural gas, or potable water the trust produced in the United States.123 The deduction was the lesser of 9% of (i) qualified production activities income, or (ii) taxable income computed without the IRC § 199 deduction.124 In addition, the deduction could not exceed 50% of certain “W-2 wages.”125 § 3.13.2 Allocation of Expenses

A non-grantor trust calculates each beneficiary's share (as well as the trust’s share, if any) of qualified production activities income from the trust at the trust level. The beneficiary of a 117 IRC § 691(c)(2(A). 118 Treas. Reg. § 1.691(c) – 2(a). 119 Former IRC § 199, repealed by Pub. L. No. 115-97, § 13305, effective for tax years beginning after December 31, 2017. 120 IRC § 199(a); IRC § 199(d)(1)(B). 121 IRC § 199(c)(4)(A)(ii). 122 IRC § 199(c)(4)(A)(iii). 123 IRC § 199(c)(4)(A)(i). 124 IRC § 199(a)(1)(A) and (B). 125 IRC § 199(b).

trust may not recompute its share of qualified production activities income from the trust by using another method to reallocate the trust’s qualified production costs, or otherwise.126 A non-grantor trust must compute its qualified production activities income by allocating expenses items attributable to the actual conduct of a trade or business, as follows: (i) expenses that are “directly attributable” within the meaning of Treas. Reg. § 1.652(b)-3 (governing the allocation of deductions entering into the computation of distributable net income), must be allocated as provided in that Regulation, and (ii) expenses not directly attributable within the meaning of Treas. Reg. § 1.652(b)-3 (“other expenses”) must be allocated under the “simplified deduction method” as provided in Treas. Reg. § 1.199-4(e)(1).127 § 3.13.3 Apportionment

The QPAI of non-grantor trust and the W-2 wages of a non-grantor trust are apportioned among each beneficiary and to the trust based on the relative proportion of the trust’s distributable net income for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust.128 If the trust has no DNI for the tax year, QPAI and W-2 wages are allocated entirely to the trust. For this purpose, the trust’s DNI is determined with regard to the “separate share rule” of IRC § 663(c),129 but without regard to IRC § 199.130 § 3.13.4 Grantor Trusts

To the extent that the trust is treated as “grantor trust,” the grantor computes its QPAI with respect to the portion of the trust considered owned by the grantor, or as if that QPAI had been generated by activities performed directly by the grantor.131

§ 3.14 Qualified Business Income Deduction § 3.14.1 Overview

For tax years beginning after 2017, individual taxpayers and certain trusts and estates are eligible to take a 20% deduction for their qualified business income (QBI) from a sole proprietorship, partnership, or S corporation, as well as a 20% deduction for their qualified REIT dividends and qualified publicly traded partnership income. However, the deduction is subject to several limitations and exclusions. Proposed regulations have been issued to provide guidance on the application of the deduction and may be relied upon until final regulations are issued. Note: 126 Treas. Reg. § 1.199-5(e)(1). 127 Under the “simplified deduction method,” a taxpayer's deductions are apportioned between Domestic Production Gross Receipts and other receipts based on relative gross receipts. To be eligible to use the simplified method, the trust must have average annual gross receipts of $100,000,000 or less; or (ii) A taxpayer that has total assets of $10,000,000 or less. If the trust does not qualify to use the simplified deduction method, it must use the Section 861 method of IRC § 1.199-4(d), with respect to such other expenses. 128 Unit 6 – for a discussion of “distributable net income.” 129 Unit 8 – for a discussion of the “separate share rule.” 130 Treas. Reg. § 1.199-5(e)(2)(i). 131 Treas. Reg. § 1.199-5(d).

Although qualified business income is just one component of the deduction, the deduction is commonly referred to as the qualified business income (QBI) deduction. The QBI deduction reduces taxable income but is not allowed in computing adjusted gross income. Taxpayers may take the QBI deduction whether they itemize or claim the standard deduction. Thus, the deduction is reported separately from the standard deduction and itemized deductions. Individual taxpayers report the QBI deduction on line 9 of Form 1040, U.S. Individual Income Tax Return. The Form 1040 instructions provide the worksheet below for calculating the QBI deduction. The QBI deduction is equal to the lesser of: (i) the taxpayer's “combined qualified business income amount,” or (ii) the taxpayer's taxable income limitation (20% of the taxpayer's taxable income less net capital gain).132 The taxpayer's “combined qualified business income amount” is generally equal to the sum of two components:133 −

20% of the total amount of the taxpayer's QBI from each qualified trade or business (subject to a wage-basis limitation), plus

−

20% of the total amount of the taxpayer's qualified REIT dividends and qualified publicly traded partnership (PTP) income.

§ 3.14.2 Special Rules for Trusts and Estates.

Trusts and estates are generally eligible for the QBI deduction. A trust or estate is treated as a pass-through (e.g., a partnership or S corporation) to the extent that it allocates qualified items, W-2 wages, etc., to its beneficiaries, and is treated as an individual to the extent it retains such items. For grantor trusts, a person treated as owning all or part of the trust computes the QBI deduction as though that person directly conducted the activities conducted by the trust. For non-grantor trusts and estates, the QBI deduction is computed at the entity level and the qualified items, W-2 wages, etc., are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust's or estate's distributable net income (DNI) that is distributed (or required to be distributed) to the beneficiary or is retained by the trust or estate.134

§ 3.15 Charitable Contribution Deductions § 3.15.1 Overview

Complex trusts are allowed an unlimited charitable deduction for amounts which are paid pursuant to the governing instrument or, in certain cases, permanently set aside for a charitable purpose.135 This deduction is in lieu of the limited deduction otherwise allowed by IRC § 170.136 132 IRC. §199A(a). 133 IRC§199A(b)(1) 134 Prop. Reg. §1.199A-6(d). 135 IRC § 642(c). 136 Treas. Reg. § 1.642(c)-1 note that "simple" trusts, by definition, do not make charitable contributions, see Unit 6.

§ 3.15.2 Amounts Paid

General Rule

As a general rule to be deductible, the amounts paid must be paid from gross income, “pursuant to the terms of the governing instrument,” i.e., the trust agreement, in the case of a trust. 2.

No Restriction for Domestic Charities

In determining whether an amount is paid for a charitable purpose, IRC 170(c) (2) provides that in order for a charitable contribution deduction to be allowed, the charity must be created or organized in the United States or in any possession thereof, or under the law of the United States, any State, the District of Columbia, or any possession of the United States. This is not a requirement for contributions made by trusts. Thus, an amount paid by a trust to a charity is permitted even though the corporation, trust, or community chest, fund, or foundation is not created or organized in the United States, any State, the District of Columbia, or any possession of the United States.137 3.

Election to Treat Contributions as Paid in the Preceding Taxable Year

If a charitable contribution is paid after the close of a tax year, but on or before the last day of the next succeeding tax year, the trustee is permitted to treat that contribution as paid that taxable year. The election is made at such time and in such manner as the Secretary prescribes by regulations.138 In order to make the election, the fiduciary must file a statement with the Form 1041 for the tax year in which the contribution was paid. 139 This statement must include: − The name and address of the fiduciary; − The name of the trust; − An indication that the fiduciary is making the election under IRC § 642(c)(1) for contributions treated as paid during the tax year; − The name and address of each organization to which any such contribution is paid: − The amount of each contribution and date of actual payment or, if applicable, the total amount of contributions paid to each organization during the next tax year, to be treated as paid in the prior tax year.

137 Treas. Reg. § 1.642(c)-2(a)(2), (b)(2). 138 Treas. Reg. § 1.642(c) -1(b). 139 Instructions for Form 1041 (2012) p 27.

The election must be filed by the due date (including extensions) for Form 1041. If the original was filed on time, the fiduciary may make the election on an amended return filed no later than 6 months after the original due date (excluding extensions).140 4.

Amounts Permanently Set Aside

Certain trusts may also be allowed, as a charitable deduction, to deduct any part of gross income of the trust that was “permanently set aside” for a charitable purpose, under the terms of the governing instrument. For a trust to qualify for the “set aside” deduction, the trust must be an inter vivos trust created on or before October 9, 1969141 or a testamentary trust under a will executed on or before such date.142 No amount is considered to be permanently set aside for a charitable purpose unless, under the terms of the governing instrument and the circumstances of the particular case, there is a negligible possibility that the amount set aside will not be devoted to such purpose or use.143 § 3.15.3 Adjustments and Other Special Rules for Determining Unlimited Charitable Contributions Deduction

Income in Respect of a Decedent

For purposes of determining the allowable charitable deduction amount, income in respect of a decedent is included in the gross income of the trust.144 2.

Tax Exempt Income

The charitable contributions deduction is reduced by amounts not included in gross income. If a pooled income fund or other trust pays, permanently sets aside, or uses any amount of its income for a charitable purpose and that amount includes any tax-exempt income, the charitable deduction allowable under IRC § 642(c) is limited to the gross income so paid, permanently set aside, or used.145 In determining whether the amounts of income so paid, permanently set aside, or used for charitable purpose, include particular items of income of a trust, whether or not included in gross income, a provision in the governing instrument or in local law that specifically provides the source out of which amounts are to be paid, permanently set aside, or used for such a purpose, controls for Federal tax purposes to the extent such provision has economic effect independent of income tax consequences.146

140 Id. 141, See Treas. Reg. § 1.642(c)-2(b)(3). 142 Treas. Reg. § 1.642(c)-2(b)(4). 143 Treas. Reg. § 1.642(c)-2(d). 144 Treas. Reg. § 1.642(c)-3(a). 145 Treas. Reg. § 1.642(c)-3(b)(1); in the case of a pooled income fund for which a deduction is allowable under IRC § 642(c) for amounts permanently set aside, only the gross income of the fund which is attributable to net longterm capital gain is taken into account. 146 Treas. Reg. § 1.642(c)-3(b)(2).

Where there are no specific provisions in the governing instrument or in local law, the amount to which IRC § 642(c) applies consists of the “same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.”147 In all other cases, the tax-exempt income allocable to charitable contributions is determined by multiplying the amounts paid or permanently set aside by a fraction, the numerator of which is the total tax-exempt income of the trust, and the denominator is the gross income of the trust.148 3.

Disallowance if Allocable to Unrelated Business Income

The charitable deduction otherwise allowable under IRC § 642(c) is disallowed to the extent of amounts allocable to the trust's unrelated business income.149 4.

Certain Private Foundations and Trusts

The charitable deduction is also denied for any private foundation, nonexempt charitable trust, or split-interest trust, as defined in IRC § 4947, that fails to meet the governing instrument requirements for private foundations.150 Also, the charitable deduction is disallowed for bequests and gifts to the foreign foundation after the IRS notifies it that it has engaged in a prohibited transaction or a year in which such organization loses its exempt status for engaging in such a transaction.151

§ 3.16 Allowable Itemized Deductions Subject to the 2% Floor § 3.16.1 Limitation on Deduction of “Miscellaneous Itemized Deductions."

In the same manner as individual taxpayers, "miscellaneous itemized deductions" incurred by trusts for any taxable year are allowed only to the extent that the aggregate of such deductions exceeds two percent of “adjusted gross income.” Under the Tax Cuts and Jobs Act of 2017, all miscellaneous itemized deductions that are subject to the 2% floor (including expenses for the production of income) are suspended for tax years beginning after December 31, 2017, but before January 1, 2026. Deductions that meet the conditions of IRC § 67(e) will still be deductible, however. For this purpose, the term “miscellaneous itemized deductions” means deductions other than : −

The deduction under IRC § 163 (relating to interest),

− The deduction under IRC § 164 (relating to taxes), − The deduction under IRC § 165(a) for casualty or theft losses described in paragraph (2) or (3) of IRC § 165(c) or for losses described in IRC § 165(d),

147 Treas. Reg. § 1.643(a)-5(b). 148 Id. 149 Treas. Reg. § 1.642(c)-3(d), and § 681(a), and the regulations thereunder. 150 IRC § 508(d)(2). 151 IRC § 4948(c)(4).

− The deductions under IRC § 170 (relating to charitable, etc., contributions and gifts) and § 642(c) (relating to deduction for amounts paid or permanently set aside for a charitable purpose), − The deduction under IRC § 213 (relating to medical, dental, etc., expenses), − Any deduction allowable for impairment-related work expenses, − The deduction under IRC § 691(c) (relating to deduction for estate tax in case of income in respect of the decedent), − Any deduction allowable in connection with personal property used in a short sale, − The deduction under IRC § 1341 (relating to computation of tax where taxpayer restores substantial amount held under claim of right), − The deduction under IRC § 72(b)(3) (relating to deduction where annuity payments cease before investment recovered), − The deduction under IRC § 171 (relating to deduction for amortizable bond premium), and − The deduction under IRC § 216 (relating to deductions in connection with cooperative housing corporations).152 A trust may deduct certain expenses under IRC § 212 that an individual would not be able to deduct. Some of these expenses, such as trustees’ fees, are deductible in full in determining adjusted gross income deductible under IRC § 67(e). Other IRC § 212 expenses are subject to the limitations on miscellaneous itemized deductions pursuant to IRC § 67(c)(3)(B). § 3.16.2 The Knight Case and Regulations

The Knight Decision

Section 67(e) provides an exception to the 2-percent floor in regard to miscellaneous itemized deductions for costs that are paid or incurred in connection with the administration of a non-grantor trust. The exception is made for costs which “would not have been incurred if the property were not held in such trust.” A cost is subject to the 2-percent floor to the extent that it is included in the definition of miscellaneous itemized deductions under IRC § 67(b), and commonly or customarily would be incurred by a hypothetical individual holding the same property. In Knight v. Comm, 101 AFTR 2d 2008-544, 128 S. CT. 782, the Supreme Court resolved a conflict among various Circuits Courts of Appeals and held that only trust expenses that “would not have been incurred” within the meaning of the IRC § 67(e) exception if property were not held by a trust, were expenses that would be uncommon, unusual, or unlikely for a 152 IRC § 67(a) and (b).

hypothetical individual to incur. The IRS issued regulations under IRC § 67(e) on May 9, 2014,153 intending to provide a uniform standard for identifying the types of costs that are not subject to the 2% floor. The regulations are intended to be consistent with the Supreme Court's unanimous decision in Knight v. Commissioner. 2.

Regulations Under Section 67(e)

Overview – For tax years beginning after December 31, 2017, and before January 1, 2026, taxpayers are not entitled to a deduction for miscellaneous itemized deductions.154 IRC Section 67(e) provides an exception to the 2-percent floor on miscellaneous itemized deductions for costs that are paid or incurred in connection with the administration of an estate or a nongrantor trust, and that would not have been incurred if the property were not held in such estate or trust. Thus, costs of administration that are incurred only because the property is held in an estate or trust, and that would not have been incurred otherwise, are above-the-line deductions not subject to the suspension for miscellaneous itemized deductions. Deductions that meet the conditions of §67(e)(1) will still be deductible because they are not itemized deductions as defined under §63(d)(1) and, thus, they cannot be miscellaneous itemized deductions. A cost is subject to the 2-percent floor to the extent that it is included in the definition of miscellaneous itemized deductions under IRC § 67(b), is incurred by an estate or non-grantor trust, and commonly or customarily would be incurred by a hypothetical individual holding the same property.155 The Regulations provide guidance as to whether a particular cost would be commonly or customarily incurred by a hypothetical individual owning the same property. Under the Regulations, it is the type of product or service rendered to the non-grantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative. Costs that are incurred commonly or customarily by individuals also include expenses that do not depend upon the identity of the payor (in particular, whether the payor is an individual or instead is a trust). Such commonly or customarily incurred costs include, but are not limited to, costs incurred in defense of a claim against the non-grantor trust that are unrelated to the existence, validity, or administration of the trust.156 The following costs are considered miscellaneous itemized deductions and are not deductible for tax years beginning after December 31, 2017, and before January 1, 2026: Ownership Costs - Ownership costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. Thus, for purposes of IRC § 67(e), ownership costs are commonly or customarily incurred by a hypothetical individual owner of such property.

153 T.D. 9664, 79 Fed. Reg. 26,616 (May 9, 2014). The final regulations apply to tax years beginning after December 31, 2014. Reg. §1.67-4(d). 154 IRC §67(g). 155 Treas. Reg. § 1.67–4(a). 156 Treas. Reg § 1.67-4(b)(1).

Tax Preparation Fees - Costs relating to all estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent's final individual income tax returns are not subject to the 2-percent floor. The costs of preparing all other tax returns (for example, gift tax returns) are costs commonly and customarily incurred by individuals and thus are subject to the 2-percent floor. Investment Advisory Fees — Fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are incurred commonly or customarily by a hypothetical individual investor and therefore are subject to the 2-percent floor. However, certain incremental costs of investment advice beyond the amount the normally would be charged to an individual investor are not subject to the 2-percent floor. For this purpose, such an incremental cost is a special, additional charge that is added solely because the investment advice is rendered to a trust or estate rather than to an individual or attributable to an unusual investment objective or the need for a specialized balancing of the interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen) such that a reasonable comparison with individual investors would be improper. The portion of the investment advisory fees not subject to the 2-percent floor by reason of the preceding sentence is limited to the amount of those fees, if any, that exceeds the fees normally charged to an individual investor.157 Appraisal Fees — Appraisal fees incurred by an estate or a non-grantor trust to determine the fair market value of assets as of the decedent's date of death (or the alternate valuation date), to determine value for purposes of making distributions, or as otherwise required to properly prepare the estate's or trust's tax returns, or a generation-skipping transfer tax return, are not incurred commonly or customarily by an individual and thus are not subject to the 2-percent floor. The cost of appraisals for other purposes (for example, insurance) is commonly or customarily incurred by individuals and is subject to the 2-percent floor.158 Certain Fiduciary Expenses — Certain other fiduciary expenses are not commonly or customarily incurred by individuals, and thus are not subject to the 2-percent floor. Such expenses include, with limitation, the following: probate court fees and costs; fiduciary bond premiums; legal publication costs of notices to creditors or heirs; the cost of certified copies of the decedent's death certificate; and costs related to fiduciary accounts.159 Examples of fiduciary expenses that are not considered to be miscellaneous itemized deductions include:  Probate court fees and costs; 

Fiduciary bond premiums;



Legal publication costs of notices to creditors or heirs;

157 Treas. Reg. § 1.67–4(b)(4). 158 Treas. Reg. § 1.67–4(b)(5). 159 Treas. Reg. § 1.67–4(b)(6).



The cost of certified copies of the decedent's death certificate; and



Costs related to fiduciary accounts.160

Bundled Fees - “Bundled fees” are a single fee, commission, or other expense (such as a fiduciary's commission, attorney's fee, or accountant's fee) which include both costs that are subject to the 2-percent floor and costs (in more than a de minimus amount) which are not. Under the Regulations the single fee, commission, or other expense (i.e., the “bundled fee”) must be allocated, for purposes of computing the adjusted gross income of the trust in compliance with IRC § 67(e), between the costs subject to the 2-percent floor and those that are not. Out-ofpocket expenses billed to a trust are treated as separate from the bundled fee.161 According to the Regulations, if a bundled fee is not computed on an hourly basis, only the portion of that fee that is attributable to investment advice is subject to the 2-percent floor; the remaining portion is not subject to that floor.162 In addition, payments made from the bundled fee to third parties that would have been subject to the 2-percent floor if they had been paid directly by the non-grantor trust are subject to the 2-percent floor, as are any fees or expenses separately assessed by the fiduciary or other payee of the bundled fee (in addition to the usual or basic bundled fee) for services rendered to the trust that are commonly or customarily incurred by an individual.163 Any reasonable method may be used to allocate a bundled fee between those costs that are subject to the 2-percent floor and those costs that are not, including without limitation the allocation of a portion of a fiduciary commission that is a bundled fee to investment advice.164 § 3.16.3 Calculating Adjusted Gross Income

The “adjusted gross income” of the trust is computed in the same manner as an individual taxpayer except, that the following items are subtracted from the total income of the trust: − The deductions for costs which are paid or incurred in connection with the administration of the trust and which would not have been incurred if the property were not held in such trust; − The income distribution deduction; − The exemption amount; and − The net operating loss deduction.165

160 Id. 161 Treas. Reg. § 1.67-4(c)(1). 162 Treas. Reg. § 1.67-4(c)(2). 163 Treas. Reg. § 1.67-4(c)(3). 164 Treas. Reg § 1.67-4(c)(4). 165 IRC § 67(e).

§ 3.17 Deduction in Lieu of Exemption § 3.17.1 Simple Trusts

In lieu of the personal exemption, a trust which, under its governing instrument, is required to distribute all of its income for the taxable year (a "simple trust") currently is allowed a deduction of $300.166 This is true, even though the trust also distributes amounts other than income in the taxable year and even though it may be required to make distributions which would qualify for the charitable contributions deduction under IRC § 642(c) (and therefore does not qualify as a “simple trust”).167 § 3.17.2 Complex Trusts

All other trusts - “complex” trusts - are allowed a deduction of $100.168

§ 3.18 Tax Credits The credits allowed to individuals are also allowed to trusts.169 Credits are typically apportioned between the trust and their beneficiaries on the basis of income allocable to each. These credits include a credit from regulated investment companies, a general business credit, and a low-income housing credit. In regard to foreign taxes, the Regulations provide that a trust is allowed the credit against tax for taxes imposed by foreign countries and possessions of the United States to the extent allowed by IRC § 901 only for so much of those taxes as are not properly allocable under that section to the beneficiaries.170

166 IRC § 642(b)(2)(B). 167 Treas. Reg. § 1.642(b) -1(c). 168 IRC § 642(b)(2)(A). 169 Treas. Reg. § 1.641(b) – 1. 170 Treas. Reg. § 1.642(a)(2) -1.

UNIT FOUR

The Income Distribution Deduction Learning Objectives: Upon completion of this Unit, you will be able to: 



Identify the significance of the “income distribution deduction” to the taxation of simple and complex trusts  Understand how “distributable net income” is computed  Be able to distinguish between a “simple” and “complex” trust Identify the differences in how a simple trust is taxed as compared to a complex trust

§ 4.1 In General One significant difference between the way individuals are taxed under the Code and the way trusts are taxed is that trusts are allowed a deduction – the "income distribution deduction." This deduction is applied against taxable income for distributions of income made to beneficiaries. In turn, the trust beneficiaries are required to report the distributed income which they receive on their individual tax returns. Both the amount of the deduction and the amount of income taxable to the beneficiaries are limited by the determination of what the Code terms “distributable net income.”

§ 4.2 Distributable Net Income “Distributable net income” is defined in IRC § 643(a) as the taxable income of the trust, computed with the following modifications: −

No deduction is allowed for distributions to beneficiaries.171

−

No deduction is allowed for personal exemptions. 172

−

Gain from the sale or exchange of capital assets is excluded to the extent that such gains are allocated to corpus and are not (i) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (ii) paid, permanently set aside, or to be used for charitable purposes.173

− Losses from the sale or exchange of capital assets are excluded, except to the extent such losses are taken into account in determining the amount of gains from the sale or exchange of capital assets which are paid, credited, or required to be distributed to any beneficiary during the taxable year.174 171 IRC § 643(a)(1). 172 IRC § 643(a)(2). 173 IRC § 643(a)(3). 174 Id.

− For purposes of “simple trusts” extraordinary dividends or taxable stock dividends which are allocable to corpus are excluded.175 − Any tax-exempt interest is included but reduced by expenses allocable to such interest.176

§ 4.3 Distinguishing Simple Trusts from Complex Trusts The Code makes a distinction between "simple trusts" and "complex trusts.” This distinction is important for purposes of understanding and applying the concept of “distributable net income.” A “simple trust” is a trust which is required under the terms of the trust to distribute currently all of its income for the taxable year and does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for the charitable purposes specified in IRC § 642(c).177 A “complex trust” is any trust other than a simple trust.178

§ 4.4 Section 651(a) - Deduction for Distributions to Beneficiaries of a Simple Trust § 4.4.1 In General

In the case of a “simple trust,” IRC § 651(a) allows a deduction for the “amount of the income” for the taxable year which is “required to be distributed currently.”179 In any year the trust also distributes corpus, IRC § 651 will not apply to the trust - rather the rules which apply to “complex trusts” under IRC § 661, discussed in the following section, will apply. § 4.4.2 Income Required to be Distributed Currently

Determination

The determination of whether trust income is “required to be distributed currently” depends upon the terms of the trust instrument and the applicable local law. Remember, for this purpose, the “income” of the trust is the income as determined under the principals of fiduciary accounting. Receipts such as capital gain, extraordinary dividends, and taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument or applicable local law, are not considered income for this purpose.180 2.

Reserve for Depreciation

If the trust instrument provides that the trustee, in determining the distributable income, first retains a reserve for depreciation or otherwise make due allowance for keeping the trust corpus intact by retaining a reasonable amount of the current income for that purpose, the retention of current income, for that purpose, will not disqualify the trust from being a "simple" 175 IRC § 643(a)(4). 176 IRC § 643(a)(5). 177 Treas. Reg. §§ 1.651(a)-1(a), (b). 178 Treas. Reg. § 1.651(a) -1. 179 IRC § 651(a). 180 See IRC § 643(a)(3).

trust.181 Note that under § 8164(a) of the PUPIA, a trustee may transfer to principal a reasonable amount of the net cash receipts from a principal asset that is subject to depreciation.182 3.

Distributions After the Close of the Tax Year

The fiduciary must be under a duty to distribute the income currently even if, as a matter of practical necessity, the income is not distributed until after the close of the trust's taxable year. 4.

Sprinkle Powers

It is immaterial, for purposes of determining whether all the income is required to be distributed currently, that the amount of income allocated to a particular beneficiary is not specified in the instrument.183 Therefore, if the fiduciary is required to distribute all the income currently, but has discretion to distribute or "sprinkle" the income among a class of beneficiaries or among named beneficiaries, in such amount as the fiduciary sees fit, then “all the income is required to be distributed currently,” even though the amount distributable to a particular beneficiary is unknown until the fiduciary has exercised his discretion.184

§ 4.5 Accumulation of Income in One Year § 4.5.1 Overview

A trust could provide that in one tax year income is permitted to be accumulated, and in another taxable year income is required to be distributed currently. Such a trust will be considered a simple trust for the latter year, but not the earlier year.185 § 4.5.2 Distributions in Kind

If a trust distributes property in kind in satisfying its requirement to distribute currently all the income, the trust is treated as having sold the property for its fair market value on the date of distribution. If no amount in excess of the amount of income is distributed by the trust during the year, the trust will still qualify as a simple trust even though property in kind was distributed as part of a distribution of all such income.186 § 4.5.3 Distribution of Amounts Other Than Income

In General

A trust does not qualify for treatment as a simple trust for any taxable year in which it actually distributes corpus.187 2.

Corpus Distributions Made Upon Specified Events

181 Treas. Reg. § 1.651(a) -2(a). 182 Uniform Principal and Income Act (1997), § 503. 183 Treas. Reg. § 1.651(a)-(2)(b). 184 Id. 185 Treas. Reg. § 1.651(a)-2(c). 186 Treas. Reg. § 1.651(a)-(2)(d). 187 Treas. Reg. § 1.651(a)-3(a).

A trust, otherwise qualifying as a simple trust, which may make a distribution of corpus in the discretion of the trustee, or which is required under the terms of trust to make a distribution of corpus upon the happening of a specified event, will only be disqualified from being treated as a simple trust for the taxable year in which an actual distribution of corpus is made.188 § 4.5.4 Charitable Purposes

A trust is not considered to be a simple trust if it may pay, permanently set aside, or use any amount for charitable purposes for any taxable year for which it is not allowed a charitable deduction as provided under IRC § 642(c).189 Therefore, a trust with remainder interest which is to be distributed to a charitable organization is not disqualified for treatment as a simple trust if either: (i) the remainder is subject to a contingency, so that no deduction would be allowed for capital gains or other amounts added to corpus as amounts permanently set aside for a charitable purpose, or (ii) the trust receives no capital gains or other income which is added to corpus for the taxable year for which such a deduction would be allowed.190

§ 4.6 Section 661(a) - Deduction for Distributions of Complex Trusts § 4.6.1 Deduction Allowed

Complex trusts are allowed a deduction under IRC § 661(a) equal to the sum of: − Any amount of income required to be distributed currently (including any amount required to be distributed which may be paid out of income or corpus to the extent such amount is paid out of income for such taxable year); and − Any other amounts properly paid or credited or required to be distributed to the extent it does not exceed the distributable net income of the trust.191 § 4.6.2 Definition “Income required to be Distributed Currently."

The term “income required to be distributed currently” includes any amount required to be distributed which may be paid out of income or corpus (such as an annuity), to the extent it is paid out of income for the taxable year.192 § 4.6.3 Definition “Any Other Amounts Properly Paid, Credited, or Required to be Distributed."

The term “any other amounts properly paid, credited or required to be distributed" includes all amounts properly paid, credited, or required to be distributed by a trust other than income required to be distributed currently.193 188 Treas. Reg. § 1.651(a)-3(b). 189 Treas. Reg. § 1.651(a)-4. 190 Id. 191 IRC § 661(a). 192 Treas. Reg. § 1.661(a)-2(b). 193 Treas. Reg. § 1.661(a)-2(c).

Review Exercise Four The Code makes a distinction between "simple trusts" and "complex trusts.” Which of the following defines a simple trust? A. A trust which is required under the terms of the trust to distribute currently all of its income for the taxable year. B. A trust that is essentially ignored as a taxpayer, and all of the income, deductions, etc., are treated as belonging directly to the grantor C. A trust which under the terms of the trust distribute income at the discretion of the trustee. D.

A trust which only has one beneficiary

UNIT FIVE

How the Trust Beneficiary is Taxed Learning Objectives: Upon completion of this Unit, you will be able to:  

Distinguish the taxation of the beneficiary of a simple trust as compared to a complex trust 



Gain an overview of how a trust beneficiary is taxed

Identify how the character and allocation of amounts included in income taxed to a trust beneficiary is determined

Identify how items of deduction of a trust that enter into the computation of distributable net income are allocated among the items of income

§ 5.1 Overview As we have discussed previously, the beneficiaries of a trust are generally taxed on the trust income which is distributed to them. How this premise is applied in practice is the subject of this Unit.

§ 5.1 The Taxation of a Simple Trust Beneficiary § 5.1.1 Overview

The amount of income required to be distributed currently by a simple trust for the taxable year to the trust beneficiaries is included in their gross income, whether the income is actually distributed or not.194 If that amount exceeds the distributable net income of the trust, each beneficiary of the trust includes an amount which bears the same ratio to the distributable net income as the amount of income required to be distributed to that particular beneficiary bears to the amount of income required to be distributed to all beneficiaries.195 The amounts included in the gross income of the beneficiaries have the same character in the hands of the beneficiary as in the hands of the trust. Items of deduction of a trust that enter into the computation of distributable net income are allocated among the items of income according to the following principles:196

194 Treas. Reg. § 1.652(a)-1. 195 Treas. Reg. § 1.652(a)-2. 196 Treas. Reg. § 1.652(b)-1.

§ 5.1.2 Character and Allocation of Amounts Included in Gross Income

The amounts included in the gross income of the beneficiaries have the same character in the hands of the beneficiary as in the hands of the trust.197 The amounts which are required to be included in income under IRC § 652(a) are treated as consisting of the same proportion of each class of items entering into the computation of distributable net income of the trust as the total of each class bears to the total distributable net income of the trust. That is, unless the terms of the trust specifically allocate different classes of income to different beneficiaries, or unless local law requires such an allocation.198 § 5.1.3 Allocation of Deductions

Items of deduction of a trust that enter into the computation of distributable net income are allocated among the items of income according to the following principles. All deductible items directly attributable to one class of income are allocated to that class of income. To the extent that any items of deduction which are directly attributable to a class of income exceed that class of income, they may be allocated to any other class of income, (including capital gains), included in distributable net income in the same manner provided for deductions which are not directly attributable to specific class of income.199 The deductions which are not directly attributable to a specific class of income may be allocated to any item of income, including capital gains, included in computing distributable net income, but a portion must be allocated to tax-exempt income.200

§ 5.2 The Taxation of Complex Trust Beneficiaries § 5.2.1 In General

Included in the gross income of a beneficiary of a complex trust is the sum of (i) amounts of income required to be distributed currently to him or her, and (ii) all other amounts properly paid, credited, or required to be distributed to him or her.201 The amount of income for the taxable year of the trust “required to be distributed currently” to him or her is first included in the gross income of each beneficiary. In some cases, the amount of income required to be distributed currently to all beneficiaries will exceed distributable net income. In those cases, each beneficiary must include in gross income an amount which bears the same ratio to distributable net income as (i) the amount of income required to be distributed currently to that beneficiary bears to (ii) the amount required to be distributed currently to all beneficiaries.202

197 Id. 198 Treas. Reg. § 1.652(b)-2(a). 199 Treas. Reg. § 1.652(b)-3(d). 200 Treas. Reg. § 1.652(b)-3(b). 201 Treas. Reg. § 1.662(a) -1. 202 Treas. Reg. § 1.662(a)- 2(b).

The phrase, “the amount of income for the taxable year required to be distributed currently,” includes any amount required to be paid out of income or corpus, to the extent the amount is satisfied out of income. Also included in the gross income of a beneficiary are other amounts properly paid, credited, or required to be distributed to the beneficiary for the taxable year.203 Other payments included in gross income of the beneficiaries include: − A distribution made to a beneficiary in the discretion of the fiduciary;204 − A distribution required by the terms of the governing instrument upon the happening of a specified event;205 If the sum of the amounts of income required to be distributed currently and other amounts properly paid, credited, or required to be distributed exceeds distributable net income, then such other amounts are included in gross income of the beneficiary but, only to the extent of the excess of distributable net income over the amounts of income required to be distributed currently.206 In determining the amount includible in the gross income of a beneficiary, the amounts which are determined to be included in the gross income of the beneficiary of a complex trust shall have the same character in the hands of the beneficiary as it had in the hands of the trust. § 5.2.2 Additional Rules

Unused Deductions

Without IRC § 642(h)(2), deductions exceeding gross income, net operating loss and capital loss carryovers in the year a trust terminates would be lost. Section 642(h)(2), however, mitigates this result by allowing beneficiaries who succeed to the property of a trust to take the following deductions which the fiduciary could not use: (i) a carryover of a net operating loss, (ii) a capital loss carryover, and (iii) any deductions for the last tax year of the trust (other than the personal exemption and charitable contributions) in excess of its gross income for that year.207 The right to use the carryovers and excess deductions is limited to those “beneficiaries succeeding to the property of the trust.”208 Those beneficiaries are the beneficiaries who, upon termination of the trust, bear the burden of any loss for which a carryover is allowed, or of any excess of deductions over gross income for which a deduction is allowed under IRC § 642(h).209 The excess estate or trust deductions are allowed as a deduction in computing the beneficiaries' taxable income, not their AGI.210 Thus, the IRC § 642(h) deduction for excess 203 Treas. Reg. § 1.662(a)-2(c). 204 Treas. Reg. § 1.662(a)-3(b). 205 Id. 206 Treas. Reg. § 1.662(a)-3(c). 207 IRC § 642(h). 208 Id. 209 Treas. Reg. § 1.642(h)-3(a). 210 Treas. Reg. §1.642(h)-2(a).

deductions will be a miscellaneous itemized deduction for the tax year of the beneficiary in which or with which the estate or trust ends and will be subject to the 2% floor provided in IRC § 67(a). Note: however, that miscellaneous itemized deductions have been suspended for tax years beginning after 2017 and before 2026.211 2.

The Throwback Rules

The “throwback” rules, as provided in IRC §§ 665 to 668, are designed to tax the beneficiary of a trust that accumulates, rather than distributes, all or part of its income (i.e., an “accumulation trust”), as if the income had been currently distributed to the beneficiary instead of accumulated by the trusts.212 If the tax rates which apply to trusts are lower than the rates that apply to individuals the rules serves a valid purpose. However, under the current law, the highest marginal tax rates apply to trusts at significantly lower levels of taxable income than when they apply to individual taxpayers. As a result, the throw-back rules generally only apply to trust distributions made in tax years beginning before August 6, 1997. The throwback rules are generally inapplicable to amounts paid, credited, or required to be distributed by a trust in a taxable year in which the trust qualifies as a simple trust.213 Although repealed for most trusts, the “throw-back rules” still apply to trusts created before March 1, 1984, and to foreign and to domestic trusts that were once treated as a foreign trust.214 § 5.2.3 Special Rules Applicable to §§ 661 and 662

The 65 Day Rule

The fiduciary of a complex trust may elect, under IRC § 663(b), to treat any amount or portion thereof that is properly paid or credited to a beneficiary within 65 days following the close of a taxable year as an amount that was properly paid or credited on the last day of that taxable year.215 2.

Separate Shares Treated as Separate Trusts

IRC § 663(c) provides that, if a single trust has more than one beneficiary, and if different beneficiaries have substantially separate and independent shares, their shares are treated as separate trusts for the sole purpose of determining the amount of distributable net income allocable to the respective beneficiaries under IRC §§ 661 and 662.216 Application of this rule will be significant in, for example, situations in which income is accumulated for beneficiary A, but a distribution is made to beneficiary B of both income and corpus in an amount exceeding the share of income that would be distributable to B had there been separate trusts. In the absence 211 IRC § 67(g), added by Pub. L. No. 115-97, §11045, effective for tax years beginning after December 31, 201.7 212 Treas. Reg. § 1.665(a)-0A(a)(1). 213 Id. 214 IRC §§ 665-668. 215 IRC § 663(b)(1). 216 IRC § 663(c).

of a separate share rule, beneficiary B would be taxed on income which is accumulated for A. The division of distributable net income into separate shares will limit the tax liability of B. Section 663(c) does not affect the principles of applicable law in situations in which a single trust instrument creates not one but several separate trusts, as opposed to separate shares in the same trust within the meaning of this section.

Review Exercise Five The fiduciary of a complex trust may elect, under IRC § 663(b), to treat any amount or portion thereof that is properly paid or credited to a beneficiary within how many days following the close of a taxable year as an amount that was properly paid or credited on the last day of that taxable year? A.

Incorrect – The correct number of days is 65.

B. Incorrect - The fiduciary of a complex trust may elect, under IRC § 663(b), to treat any amount or portion thereof that is properly paid or credited to a beneficiary within 65 days following the close of a taxable year as an amount that was properly paid or credited on the last day of that taxable year C.

Incorrect - The correct number of days is 65, not 55.

Correct – 65 days is the correct answer.

UNIT SIX

The Tax Treatment of Grantor Trusts Learning Objectives: Upon completion of this Unit, you will be able to:  

Understand how income of a grantor trust is taxed

Identify what powers and interest will result in a trust being treated as a grantor trust  

Identify when someone other than the grantor is treated as the owner?

Distinguish the powers the grantor may retain without being treated as an owner

§6.1 Overview - Grantors Treated as Owners If the "grantor trust rules" apply to a trust, the trust is essentially ignored as a taxpayer, and all of the income, deductions, etc., are treated as belonging directly to the grantor.217 As a result, the trust grantor must, in computing his or her taxable income, include the items of income, deduction, and credit which are attributable to that portion of a trust which he or she is treated as owning for tax purposes.218 The grantor trust rules are provided in IRC §§ 671 to 678. In this Unit, we examine those rules.

§6.2 Who is a Considered a “Grantor”? Under the Regulations, a "grantor" is defined as any person who creates a trust or makes a gift of property to a trust. If a person creates or funds a trust on behalf of another person, both the person creating the trust and the person for whom the trust is created are both treated as grantors of the trust. On the other hand, a person who creates a trust but makes no gratuitous transfers to the trust is not treated as a grantor under the grantor trust rules. Also, a person who funds a trust with an amount that is reimbursed to that person within a reasonable period of time and who makes no other gratuitous transfers to the trust is not treated as an owner of any portion of the trust under the grantor trust rules.219

§6.3 When is a Grantor Treated as an Owner? §6.3.1 Grantor Treated as Owner

IRC §§ 673 through 677 set forth the circumstances under which the grantor or other person is treated as the owner of the trust for tax purposes. These circumstances include the following:

217 Instructions for Form 1041 (2015). 218 IRC § 671. 219 Treas. Reg. § 1.671-2(e)(1).

–

If the grantor has retained a reversionary interest in the trust, within specified time limits (IRC § 673);

–

If the grantor or a non-adverse party has certain powers over the beneficial interests under the trust (IRC § 674);

–

If certain administrative powers over the trust exist under which the grantor can or does benefit (IRC § 675);

–

If the grantor or a non-adverse party has a power to revoke the trust or return the corpus to the grantor (IRC § 676);

–

If the grantor or a non-adverse party has the power to distribute income to or for the benefit of the grantor or the grantor's spouse (IRC § 677).

§6.3.2 Other Persons Treated as the Owner

There are situations when someone other than the actual trust grantor is taxed on the trust income. Under IRC § 678, the income of a trust is taxed to a person other than the grantor to the extent that that person has the sole power to vest corpus or income in himself or herself. §6.3.3 Powers or Interests Held by the Grantor’s Spouse

IRC § 672(e) provides that a grantor is treated as holding any power or interest held by the person who was the grantor's spouse either at the time of the creation of such power or interest or after the creation of such power or interest.220

§6.4. Attribution of Income, Deductions, and Credits §6.4.1 Overview

If the grantor trust rules apply, the grantor must include in computing his or her income tax those items of income, deduction, and credit attributable to that portion of the trust for which the grantor or other person is treated as the owner.221 The grantor may be treated as the owner of the entire trust or a fractional share of the trust. The grantor may also be simply found to be the owner of a specific property held by the trust. §6.4.2 Grantor Treated Owner of the Entire Trust

If a grantor or another person is treated as the owner of an entire trust, he or she must take into account all items of income, deduction, and credit realized by the trust.222

220 An individual legally separated from his or her spouse under a decree of divorce or of separate maintenance shall not be considered as married, see IRC § 672(e)(2). 221 IRC § 671. 222 Treas. Reg. § 1.671-3(a)(1).

§6.4.3 Grantor Treated as Owning an Undivided Fractional Share

If the portion of a trust treated as owned by a grantor or another person consists of an undivided fractional interest in the trust, or of an interest represented by a dollar amount, a pro rata share of each item of income, deduction, and credit is normally allocated to that portion. Thus, where the portion owned consists of an interest in, or a right to an amount of corpus only, a fraction of each item (including items allocated to corpus, such as capital gains) is attributed to the portion. The numerator of this fraction is the amount which is subject to the control of the grantor or other person and the denominator is normally the fair market value of the trust corpus at the beginning of the taxable year in question.223 §6.4.4 Grantor Treated as Owning a Specific Trust Property

If the portion treated as owned consists of specific trust property and its income, then the grantor must include, all items directly related to that property attributable to that specific property. The items directly related to trust property not included in the portion treated as owned by the grantor or other person are reported by the trust on its tax return.224

§6.5 Definitions In applying the grantor trust rules, IRC § 672 provides the following definitions: “Adverse party” – The term "adverse party" means any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which he or she possesses respecting the trust. A person having a general power of appointment over the trust property is deemed to have a beneficial interest in the trust.225A trustee is not an adverse party merely by the fact that he or she is the trustee of the trust.226 An interest is a “substantial interest” if its value in relation to the total value of the property subject to the power is not insignificant.227 “Non-adverse party” - The term "non-adverse party" means any person who is not an adverse party.228 “Related or subordinate party” - The term "related or subordinate party" means any nonadverse party who is: (i) the grantor's spouse if living with the grantor; (ii) the grantor's father, mother, issue, brother or sister; an employee of the grantor; (iii) a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or (iv) a subordinate employee of a corporation in which the grantor is an executive.229 223 Treas. Reg. § 1.671-3(a)(3). 224 Treas. Reg. § 1.671-3(a)(2). 225 IRC § 672(a). 226 Treas. Reg. § 1.672(a)-1(a). 227 Id. 228 IRC § 672(b). 229 IRC § 672(c).

For purposes of IRC § 674(c) (dealing with an exception to IRC § 674 for independent trustees who control beneficial enjoyment) and IRC § 675(3) (dealing with loans made by subordinate trustees subservient to the grantor), related and subordinate parties are presumed to be subservient to the grantor in respect of the exercise or non-exercise of the powers conferred on them unless shown not to be subservient by a preponderance of the evidence.230

§6.6 Rule Where Power is Subject to Condition Precedent Under the grantor trust rules, a person is considered to have a power even though the exercise of the power is subject to a precedent giving of notice. This is also true if it takes effect only on the expiration of a certain period after the exercise of the power. However, the grantor will not be treated as an owner by reason of the power if its exercise can only affect beneficial enjoyment of income received after the expiration of a period of time such that, if the power were a reversionary interest, he or she would not be treated as an owner under IRC § 673.231

§6.7 Rules for Determining When the Grantor or Another Person is Treated as the Owner §6.7.1 Overview

IRC §§ 673 through 678 set forth the rules for determining when the grantor or another person is treated as the owner of any portion of a trust. These rules are discussed in detail in the following sections. §6.7.2 Reversionary Interests

General Rule

A grantor is treated as the owner of any portion of a trust in which he or she has a “reversionary interest” in either the corpus or the income, if, as of the inception of that portion of the trust, the value of such interest exceeds 5 percent of the value of such portion.232 The value of the grantor's reversionary interest is determined by assuming the maximum exercise of discretion in favor of the grantor.233 2.

Beneficiary – Lineal Descendent Under 21

Under IRC § 673(b), if a beneficiary who is a lineal descendant of the grantor, holds all of the present interests in any portion of a trust, the grantor is not treated as the owner of such portion solely by reason of a reversionary interest portion which takes effect upon the death of such beneficiary before such beneficiary attains age 21.234 3.

Postponement of Reversionary Interest

230 Treas. Reg. § 1.672(c)-1. 231 Treas. Reg. § 1.672(d)-1; also see IRC §§ 674(b)(2), 676(b), and the last sentence of IRC § 677(a). 232 IRC § 673(a). 233 IRC § 673(c). 234 IRC § 673(b).

Any postponement of the date specified for the reacquisition of possession or enjoyment of the reversionary interest is treated as a new transfer in trust. That transfer will be considered to have been made on the date when the postponement is effective and will terminate on the date prescribed by the postponement. However, income for any period is not included in the income of the grantor but, for this rule, if such income would not have been includible in the absence of such postponement.235 §6.7.3 Power to Control Beneficial Enjoyment

General Rule

Under IRC § 674(a), the grantor is treated as the owner of trust assets to the extent the beneficial enjoyment of the corpus or the income is subject to a power of disposition, exercisable by the grantor (or the grantor’s spouse) or a non-adverse party, or both, without the approval or consent of any adverse party.236 The grantor is treated as holding all powers and interests of the grantor's spouse if the grantor's spouse is living with the grantor when such interests and powers are created. 237 The grantor is not, treated as the owner by virtue of certain powers exercisable by on-grantor trustees, not more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor.238 2.

Exceptions for Certain Powers

Regardless of the identity of the power holder, holding of the following powers over the beneficial enjoyment of a trust do not result in the grantor being treated as the trust owner under IRC § 674(a): −

Power to Apply Income to Support a Dependent - A power to apply or distribute income for the support or maintenance of a beneficiary (other than the grantor's spouse) whom the grantor is legally obligated to support or maintain, which can be exercised in the discretion of another person, the trustee, or the grantor acting as trustee or co-trustee, does not result in the grantor being treated as the owner except to the extent that such income is so applied or distributed.239

−

Power Affecting Beneficial Enjoyment Only After Occurrence of Event - A power, the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that a grantor would not be treated as the owner under IRC § 673 if the power were a reversionary interest.240

235 IRC § 673(d). 236 IRC § 674(a). 237 IRC § 672(e). 238 IRC § 674(c); Treas. Reg. § 1.674(c)-1. 239 IRC § 674(b)(1). 240 IRC § 674(b)(2).

−

Power Exercisable Only by Will - A power which may be exercisable only by will.241

−

Power to Allocate Among Charitable Beneficiaries - A power to determine the beneficial enjoyment of the corpus or the income of a trust if the corpus or income is irrevocably payable for a charitable purpose specified in IRC § 170(c).242

−

Power to Distribute Corpus - A power to distribute corpus to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries) provided that the power is limited by a reasonably definite standard set forth in the trust instrument. Also, if the trust holds a proportionate share of the corpus as a separate trust share and the income from that trust share is payable to a trust beneficiary, the power to distribute corpus to or for any current income beneficiary which is chargeable against that separate trust share.243

−

Power to Withhold Income Temporarily - A power to distribute to or apply income for any current income beneficiary, or to accumulate the income for him or her, provided that any accumulated income must ultimately be payable to the beneficiary from whom distribution or application is withheld, to his estate, or to his or her appointees.244

−

Power to Withhold Income During Disability of a Beneficiary - A power exercisable only during (i) the existence of a legal disability of any current income beneficiary, or (ii) the period during which any income beneficiary is under the age of 21 years, to distribute or apply income to or for such beneficiary or to accumulate and add the income to corpus.245

−

Power to Allocate between Corpus and Income - A power to allocate receipts and disbursements as between corpus and income, even though expressed in broad language.246

Exception for Certain Powers of Independent Trustees

General Rule

The general rule under IRC § 674(a) does not apply to a power solely exercisable (without the approval or consent of any other person) by an “independent trustee or trustees”: 241 IRC § 674(b)(3). 242 IRC § 674(b)(4). 243 IRC § 674(b)(5). A power does not fall within the powers described in this section if any person has the power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children. 244 IRC § 674(b)(6). 245 IRC § 674(b)(7). A power does not fall within the powers described in this paragraph if any person has the power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children. 246 IRC § 674(b)(8).

To distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries; or

To pay out corpus to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries).247

Power to Add Beneficiaries

A power does not fall within the powers described in IRC § 674(a) if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or afteradopted children.248 c.

Power to Allocate Income if Limited by a Standard

IRC § 674(a) also does not apply to a power solely exercisable (without the approval or consent of any other person) by a trustee or trustees, none of whom is the grantor or spouse living with the grantor, to distribute, apportion, or accumulate income to, or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries if such power is limited by a reasonably definite external standard which is set forth in the trust instrument.249 4.

Retention of Administrative Powers

In General

IRC § 675 provides that the grantor is treated as the owner of any portion of a trust if, under the terms of the trust instrument or circumstances attendant to its operation, administrative control is exercisable primarily for the benefit of the grantor rather than the beneficiaries of the trust. Likewise, if a grantor retains the right to amend the trust, and the power to amend is broad enough to permit amendments which would cause the grantor to be treated as the owner of a portion of the trust under IRC § 675, he or she will be treated as the owner of that trust portion from its inception.250 b.

The Circumstances

The circumstances under IRC § 675 which cause administrative controls to be considered exercisable primarily for the benefit of the grantor are the following: −

Power to Deal for Less than Adequate and Full Consideration - The power exercisable by the grantor or a non-adverse party, or both, without the approval or

247 IRC § 674(c); a power does not fall within the powers described in this Section if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children. For periods during which an individual is the spouse of the grantor (within the meaning of IRC § 672(e)(2)), any reference in this Section to the grantor is treated as including a reference to such individual. 248 IRC § 674(b)(5). For periods during which an individual is the spouse of the grantor (within the meaning of IRC § 672(e)(2), any reference in this section to the grantor is treated as including a reference to such individual. 249 IRC § 674(d). 250 Treas. Reg. § 1.675-1(a).

consent of any adverse party which allows the grantor or any person to purchase, exchange, or otherwise deal with or dispose of the corpus or the income therefrom for less than an adequate consideration in money or money's worth.251 −

Power to Borrow without Adequate Interest or Security - The power exercisable by the grantor or a non-adverse party, or both, which enables the grantor to borrow the corpus or income, directly or indirectly, without adequate interest or without adequate security except where a trustee (other than the grantor) is authorized under a general lending power to make loans to any person without regard to interest or security.252

−

Borrowing of the Trust Funds - The right held by the grantor or the grantor's spouse to directly or indirectly borrow corpus or income if the loan has not been completely repaid, including any interest, before the beginning of the taxable year. This does not apply to a loan which provides for adequate interest and adequate security if that loan is made by a trustee other than the grantor and other than a related or subordinate trustee subservient to the grantor.253

− General Powers of Administration - Anyone or more of the following powers exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity: −

The power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control;

−

The power to control the investment of the trust funds either by directing investments or reinvestments or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or

−

The power to reacquire the trust corpus by substituting other property of an equivalent value.254

Power to Revoke

General Rule

IRC § 676(a) provides that if a power exists to revest title to any portion of a trust in the grantor exercisable by the grantor or a non-adverse party, or both, without the approval or consent of an adverse party, then the grantor will be treated as the owner of that portion of the 251 IRC § 675(1). 252 IRC § 675(2). 253 IRC § 675(3). 254 IRC § 675(4).

trust. IRC § 676(b), provides an exception if the powers affect beneficial enjoyment of income only after the expiration of certain periods of time. This rule applies regardless of whether the power is a power to revoke, to terminate, to alter or amend, or to appoint.255 The rule also applies regardless of whether or not the grantor is treated as an owner under any other of the grantor trust rules, where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party, or both.256 b.

Exception for Power Affecting Beneficial Enjoyment Only After Occurrence of

Event The general rule provided in IRC § 676(a) does not apply to a power which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that, a grantor would not be treated as the owner under IRC § 673 if the power were a reversionary interest. But the grantor may be treated as the owner after the occurrence of such event unless the power is relinquished.257 6.

Income for Benefit of Grantor

General rule

Under IRC § 677, the grantor is treated as the owner of any portion of a trust, whether or not he is treated as such owner under IRC § 674, when the income of the trust without the approval or consent of any adverse party, or, in the discretion of the grantor or a non-adverse party, or both, may be:

−

Distributed to the grantor or the grantor's spouse;

−

Held or accumulated for future distribution to the grantor or the grantor's spouse; or

−

Applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse (except policies of insurance irrevocably payable for a purpose specified in IRC § 170(c) (relating to the definition of charitable contributions)).258 Exception - Obligations of Support

IRC § 677(b), provides an exception to the rule of IRC § 677(a), and also to the application of the other grantor trust rules. Under this exception a trust will not be treated as a grantor trust simply because the income of the trust may be applied or distributed in the 255 IRC § 671 and Treas. Reg. §§ 1.671-2 and 1.671-3 for rules concerning the treatment of items of income, deduction, and credit when a person is treated as the owner of all or only a portion of a trust. 256 Treas. Reg. § 1.676(a)-1. 257 The language of IRC § 676(b) is similar to the language of IRC § 674(b)(2). 258 IRC § 677(a). This Section does not apply to a power the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that the grantor would not be treated as the owner under IRC § 673 if the power were a reversionary interest; but the grantor may be treated as the owner after the occurrence of the event unless the power is relinquished.

discretion of another person, the trustee, or the grantor acting as trustee or co-trustee, for the support or maintenance of a beneficiary (other than the grantor's spouse) whom the grantor is legally obligated to support or maintain. However, to the extent that such income is actually applied or distributed to meet such obligations, the grantor trust rules will apply. In cases when the amounts under the terms of the trust instrument, can be paid out of corpus or out of a source other than income, the amounts actually paid or applied are considered to be an amount paid from income and are taxed to the grantor under IRC § 662.259 §6.7.4 Person Other Than Grantor Treated as Substantial Owner

General rule

Under IRC § 678(a) a person other than the grantor may be treated as the owner of all or a portion of a trust. That section applies if a person has a power exercisable solely by himself or herself to vest the corpus or the income therefrom in himself or herself.260 The section also applies if a person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of IRC §§ 671 to 677, inclusive, cause the trust to be treated as a grantor trust .261 2.

Exception where Grantor is Taxable

The general rule of IRC § 678(a) does not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust is treated as the owner under IRC §§ 671 to 677, inclusive.262 3.

Obligations of Support

Under IRC § 678(c), the general rule under IRC § 678(a) does not apply to a power which enables the holder, in the capacity of trustee or co-trustee, to apply the income of the trust to the support or maintenance of a person whom the holder is obligated to support, except to the extent the income is so applied.263 The general rule in IRC § 678(a) (and not the exception in IRC § 678(c)) is applicable in any case in which the holder of a power exercisable solely by himself or herself is able, in any capacity other than that of trustee or co-trustee, to apply the income in discharge of his obligation of support or maintenance.264 IRC § 678 is concerned with the taxability of income subject to a power described in IRC § 678(a). It has no application to the taxability of income which is either required to be applied pursuant to the terms of the trust instrument or is applied pursuant to a power which is not described in IRC § 678(a). The taxability of that income is governed by other provisions of the Code.265 259 IRC § 677(b). 260 IRC § 678(a)(1). 261 IRC § 678(a)(2). 262 IRC § 678(b). 263 Treas. Reg. § 1.678(c)-1(a). 264 Treas. Reg. § 1.678(c)-1(b). 265 Treas. Reg. § 1.678(c)-1(c), and Treas. Reg § 1.662(a)-4.

Effect of Renunciation or Disclaimer

The general rule of IRC § 678(a) does not apply with respect to a power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of its existence.266 5.

Foreign Trusts

The grantor trust rules generally apply under IRC § 679(a)(1) if a “U.S. transferor” “transfers” property to a “foreign trust” and there is a “U.S. beneficiary” of any portion of such trust.267

266 Treas. Reg. §1.678(d)-1. 267 IRC § 679(a)(1).

GLOSSARY “Adverse party” – The term "adverse party" means any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which he or she possesses respecting the trust. A person having a general power of appointment over the trust property is deemed to have a beneficial interest in the trust. A trustee is not an adverse party merely by the fact that he or she is the trustee of the trust. An interest is a “substantial interest” if its value in relation to the total value of the property subject to the power is not insignificant. “At Risk Rules” - The “at risk” rules generally limit a taxpayer’s deductible losses from an activity to the amount the taxpayer is financially “at risk” with respect to that particular ac “Bundled fees” are a single fee, commission, or other expense (such as a fiduciary's commission, attorney's fee, or accountant's fee) which include both costs that are subject to the 2-percent floor and costs (in more than a de minimus amount) which are not “Complex Trust”- A “complex trust” is any trust other than a simple trust. “Distributable net income” is defined in IRC § 643(a) as the taxable income of the trust, computed with certain modifications. “Grantor” - A "grantor" is defined as any person who creates a trust or makes a gift of property to a trust. “Grantor Trust” – A "grantor trust" is a trust, the trust is essentially ignored as a taxpayer, and all of the income, deductions, etc., are treated as belonging directly to the grantor. “Income in respect of a decedent” (“IRD”) is income which is earned on the date of death but not reportable by the decedent on his or her final tax return under his or her method of accounting; e.g., wages accrued on the date of death but not paid to a cash basis taxpayer “Income required to be distributed currently” - The term “income required to be distributed currently” includes any amount required to be distributed which may be paid out of income or corpus (such as an annuity), to the extent it is paid out of income for the taxable year. “Investment income” is generally as gross income from property held for investment. Section 163(d)(4)(A) defines “net investment income” as the excess of investment income over “investment expenses.” “Non-adverse party” - The term "non-adverse party" means any person who is not an adverse party. “Passive Activity Rules” - The “passive activity” rules under IRC § 469 generally limits the amount of deductible losses generated by "passive activities" in a particular tax year to the amount of passive activity income realized by the taxpayer in the same year

“Simple Trust” - A “simple trust” is a trust which is required under the terms of the trust to distribute currently all of its income for the taxable year and does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for the charitable purposes specified in IRC § 642(c). ”Throwback rules” - The “throwback” rules, as provided in IRC §§ 665 to 668, are designed to tax the beneficiary of a trust that accumulates, rather than distributes, all or part of its income (i.e., an “accumulation trust”), as if the income had been currently distributed to the beneficiary instead of accumulated by the trusts “Related or subordinate party” - The term "related or subordinate party" means any non-adverse party who is: (i) the grantor's spouse if living with the grantor; (ii) the grantor's father, mother, issue, brother or sister; an employee of the grantor; (iii) a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or (iv) a subordinate employee of a corporation in which the grantor is an executive.