POSSIBLY ONE OF THE MOST IMPORTANT REGULATIONS OF
B. Wolf, Esq.
Tener, Van Kirk, Wolf & Moore,
Courtesy Leimberg Information Services, Inc. (http://www.leimbergservices.com)
You may have breezed by it. It's understandable.
A regulation changing the federal income tax definition of trust
accounting income to comport with state law changes might seem,
at a very quick glance, to be another unimportant, ho hum, highly
technical fix of interest only to academics and legal scholars.
BUT, take it from me, TO ESTATE PLANNING PRACTITIONERS
AND OUR CLIENTS, REG-106513-00 MAY BE THE SINGLE MOST IMPORTANT
REGULATORY CHANGE OF THE DECADE!
REG-106513-00 may well signal nothing less
than a sea change in trust planning - and may have arrived at
the very time (the increase in unified credit exemptions, gradual
lowering of the top rates, and possible repeal of the estate
tax) when it is needed most by life insurance agents and advisors.
The long term implications of this proposed regulation must
be understood and should not be underestimated by any estate
planning attorney, CPA, trust officer, life insurance agent,
or financial planner!
So what is the story?
Somewhere, in a galaxy far, far away, some
years ago, the world of total return investing collided with
the age-old trust concept of "invest to maintain the principal
and produce income". The world of Total Return Investing survived
and thrived. The age-old concept of principal and income was
mortally wounded, and has been dying ever since.
The Proposed Regulations revising the definition
of income under 643(b) of the Internal Revenue Code provide
confirmation of the "death" of the old, and the birth of the
new. Like all of such events that we see in space, the "collision"
occurred many years ago. But due to the distance, the light
from the event is just now reaching our eyes. Perhaps we would
have seen it sooner, but for the glare of death taxes, which
kept us from seeing the obvious.
But with the future of federal estate taxes
currently much in doubt, it is interesting, encouraging, and
even exciting to observe that the Treasury is one of the first,
rather than one of the last, to recognize the event, and adapt
itself sensibly to new investment realities.
ALREADY IN A THEATER NEAR YOU!
A total of 13 states have adopted the new Uniform
Principal and Income Act with the Power to Adjust between Principal
and Income, with 8 introductions in 2001. A total of 5 states
(New York (Passed by Legislature-waiting for Governor to sign),
Missouri (Now Law), Pennsylvania (Bill Form), New Jersey (Passed
by the legislature--waiting for Governor to sign) and Delaware
(Now Law) have enacted or are close to enacting legislation
to allow a unitrust definition of income as an additional alternative
to the power to adjust. Clearly, REG-
106513-00 will provide significant impetus
to accelerate the adoption of such laws.
REGS VERY POSITIVE!
The Treasury department has placed its blessing
on both the power to adjust and the unitrust with the Proposed
Regulations, and in doing so, is providing guidance precisely
when it is needed, rather than after it has been needed for
a long time.
"The proposed changes to the regulations
will permit trustees to implement a total return investment
strategy and to follow the applicable state statutes designed
to treat the income and remainder beneficiaries impartially."
(Explanation of Provisions, Federal Register at 10397)
SPECIFIC IMPACT OF PROPOSED REGS:
What DO these proposed regulations do in connection
with these state law changes?
They bless a state law unitrust interest and a principal
and income act with the power to adjust as qualifying for the
marital gift and estate tax deduction. A conforming change is
made in the QDOT regulations.
They allow the use of an ordering rule by the governing
instrument or by state law, which includes short and long term
capital gains in DNI.
They allow the administration of a trust that was GST
grandfathered to retain its exempt status where such trust is
converted to a unitrust pursuant to a state statute which defines
income as a unitrust amount or which permits the power to adjust.
DON'T the regulations do in connection with these state law
They do not allow the charitable deduction in a pooled
income fund for capital gains if the income beneficiary's rights
to income may be satisfied by a unitrust amount.
They do not allow for purposes of a net income charitable
remainder unitrust for the income to be defined as a unitrust
amount. The trust must have its own definition of income.
are the implications of these proposed regulations on the drafting
of trusts and on state legislatures considering the passage
of laws affecting the definition of income under the proposed
new Uniform Principal and Income Act?
The promulgation of these Proposed Regulations indicates that
Treasury views the sea change in the definitions of income and
the way distributions are described in trusts as inevitable
and sensible. They are facilitating, if not actually encouraging,
these changes, which are, in the final analysis, tax neutral
The marital deduction can only be ensured in the context of
a unitrust payout or the power to adjust where there is a conforming
state law change, so that it meets the definition of income
under the new regulations 1.643(b). Without the state law change,
the unitrust would have to be an "income or unitrust interest,
whichever is the greater." Please note: The power to adjust
could never be placed in the governing document without a conforming
Changes in GST grandfathered trusts are only safe in the context
of a state law change. A court modification to a unitrust payout
without the state law change would require an income or unitrust,
whichever is greater approach.
The regulations specifically mention a unitrust amount of between
3 and 5%
being a reasonable allocation of return between the current
Legislatures are likely to be encouraged to enact laws within
these limits, to be sure that they are coloring inside the critical
DISTINCTIONS IN TAX TREATMENT BETWEEN "DO" and DON'T STATES!
obvious that states which have the new principal and income
act and which also have an elective unitrust option will benefit
trustees and beneficiaries of existing trusts which may otherwise
be locked into the dysfunctional income and principal distinctions.
As importantly, new trusts in those states can be drafted more
effectively with more certain and beneficial tax effect than
in those states which hang back from enacting legislative relief.
is this distinction so important? States which do promptly
enact such statutes now have a significant competitive edge
in the attraction and preservation of trust business within
I'D LIKE TO SEE ADDED TO THE REGULATIONS:
is missing from these regulations? Well, first, let me say that
there is always something missing. But these regulations reflect
an extraordinary effort on the part of the Treasury and IRS
to facilitate beneficial change that does not conflict with
valid tax policy.
there is always something missing. That is why they call them
is my WISH LIST:
Virtually everyone who has considered these matters, and all
of the state legislatures of which I am aware considering a
unitrust definition of income, is providing for or allowing
a "smoothing rule", whereby the unitrust amount is multiplied
times an average of the last three years' ending market values
or the like. The smoothing rule is a strictly economic and beneficiary-oriented
feature to avoid excessive volatility in the distribution. It
would be helpful to add a smoothing rule to Example 9.
With respect to the ordering of ordinary income, short and long
term capital gain Example 9 refers to state law providing the
ordering rule. Example 10, reflects the situation in which "neither
State law nor Trust's governing instrument has an ordering rule
for the character of the unitrust amount, but leaves the decision
to the discretion of the trustee." There is no example in which
state law is silent but the governing instrument has a consistent
ordering rule. I would assume that this is O.K., since the Explanation
of Provisions states that capital gains are includible in
DNI to the extent they are "pursuant to the terms of the governing
instrument OR local law" allocated to income.
This is somewhat important simply because it will be awhile
before all of the states have addressed these issues, and in
the meantime, drafters in the slower states will still want
to be able to draft for tomorrow today.
On a similar but broader note, what about other types of total
return trusts, like index payout trusts, as Bill Hoisington
has suggested, or TRUCAP index trusts (indexed for inflation
but with a unitrust cap), as I have suggested, or graduated
unitrusts (3% at 30, 4% at 40 and 5% at 50) as David Diamond
has suggested, or the Planned Income Trust (an index payout
trust with a 3% minimum increase each year as Frank Croak has
suggested)? If the governing document has a consistent ordering
provision, such as the one quoted in the proposed regulations,
there seems little reason for Treasury to be concerned with
The use of an ordering rule simply allows the drafter to be
sure of the tax assumptions that may impact the proper choice
of payout. Otherwise, the ordering rule or a consistently applied
trustee's discretionary power will give predictability to the
situation while remaining essentially tax neutral.
In the exceptions prescribed for the NIMCRUT and Pooled Income
Trust, we are reminded that the original rules concerning charitable
split interest trusts evolved at a
when interest rates were high and the concern initially was
that payouts from charitable trusts to the charities would be
unfairly low or even inconsequential, and that therefore the
charitable goals could not be achieved. Enigmatically, perhaps
simply to provide parity in the rules, the same rules requiring
a 5% minimum payout to the charities were also applied to the
in an ordinary CRUT, now that we are required to have at least
10% of the actuarial value passing to the charity, it is difficult
to draft a CRUT for a young person, because the 5% mandatory
payout typically makes their interest too big and the charity's
interest too small. If we were allowed to use a lower percentage
for the CRUT (down to 3% for example) these important charitable
vehicles would not be arbitrarily limited to those 26 years
of age and older.
the long run charities would profit by this expansion, because
the 5% limitation impedes the use of these valuable charitable
vehicles for a parent and child or grandchild. The 10% minimum
on the charitable interest will protect the policy concerns
adequately without arbitrarily limiting the use of these valuable
trusts. This would be an ideal time for Treasury to reconsider
their position on minimum payouts generally and perhaps Section
4942 also, now that they have wrestled with the major changes
in the concept of income.
WHERE CAN I LEARN MORE?
For articles and outlines on TRUs by David
Diamond, Michel Nelson, Mark Edwards, Bob Wolf, Patti Spencer,
Jim Dam, and from Forbes, go to http://www.leimberg.com and
look on the far right hand side under TRUs. (And be sure to
Information Services archives for more). Multi disciplinary practitioners
will find "Proposed Regs. On the Definition of Trust Income:
The Best Thing for Life Insurance Since Sliced Bread!, Estate
Planning Magazine (May 2001). Also, don't miss Estate Planning
Magazine (July 2001, Vol. 28, No. 7, Pg. 308) where you'll find
Laura Howell-Smith's comprehensive and well presented analysis,
"How Prop. Regs. On the Definition of Income Affect Total Return
Trusts which analyzes tax consequences of TRUs. The latest
article published in the popular press can be found in Bloomberg
News, Friday, July 13th entitled, "The TRU Takes