DEFINITION OF INCOME

How Prop. Regs. on the Definition of Income Affect Total Return Trusts

Before using total return trusts, practitioners should carefully analyze the tax consequences, and should consider the impact of new Proposed Regulations that revise the definition of trust income.

LAURA HOWELL-SMITH, J.D., LL.M. TAX

LAURA HOWELL-SMITH is a Senior Manager in the National Tax Office of Deloitte & Touche, LLP, in Washington, D.C.  The author would like to thank Larry Rabun, Partner, and Laura Peebles, Director, of Deloitte & Touche, LLP, for reviewing this article.

The modern portfolio theory of investing, the 1997 Revised Uniform Principal and Income Act (UPIA), [1] and the Prudent Investor Act [2] have together revolutionized trust practice and caused practitioners to examine the use of the estate planning tool of total return trusts. [3]   This new manner of investing trust assets for total return (i.e., income plus gain) replaces the traditional income and principal trust that was typically invested to produce income.  While the concept of total return trusts may have a dramatic impact on future trust drafting and investing, practitioners should be alert to certain tax consequences of total return trusts before adding this technique to their estate planning toolkit.

There are many variations [4] but, basically, a total return trust is a trust in which the current beneficiary is annually entitled to a percentage of the net fair market value (FMV) of the trust assets (this value is calculated on the same date each calendar year).  A total return trust generally allows the trustee to distribute significantly more than the trust accounting income and to invest a greater amount of the trust fund in growth-generating assets. [5]   Many states either have amended or are considering amending their state law definition of "trust income" to be a unitrust amount.

Overview of the Prop. Regs.

On 2/14/01, the IRS issued Proposed Regulations [6] that revise the definition of income under Section 643(b) to take into account changes in the definition of trust accounting income under state laws.  A Treasury Department official has publicly said that this Regulation project considers how total return trusts and the equitable adjustment provision of the UPIA [7] will affect federal tax provisions.  The Proposed Regulations also clarify the situations in which capital gains are included in distributable net income (DNI) under Section 643(a)(3).  Moreover, the Proposed Regulations make conforming amendments affecting ordinary trusts, pooled income funds, charitable remainder trusts (CRTs), marital deduction trusts, and trusts that are exempt from generation-skipping transfer (GST) taxes.

Definition of income.  Reg. 1.643(b)-1 provides that, for purposes of subparts A through D, part I, Subchapter J, Chapter 1 of the Code, the term "income," when not preceded by the words "taxable," "distributable net," "undistributed net," or "gross," means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law.  Trust provisions that depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for this purpose.

To take into account certain state statutory changes to the concepts of income and principal, Prop. Reg. 1.643(b)-1 provides that "income," when not preceded by the words "taxable," "distributable net," "undistributed net," or "gross," means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law.  Trust provisions that depart fundamentally from traditional principles of income and principal (that is, allocating ordinary income to income and capital gains to principal) will generally not be recognized.

Nevertheless, amounts allocated between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary income, capital gains, and appreciation.  For example, a state law that provides for the income beneficiary to receive each year a unitrust amount of between 3% and 5% of the annual FMV of the trust assets is a reasonable apportionment of the total return of the trust.

Prop. Reg. 1.643(b)-1 makes clear that a state law that permits the trustee to make equitable adjustments between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust.  These equitable adjustments are permitted when the trustee invests and manages the trust assets under the state's prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust's income, and the trustee after applying the state statutory rules regarding allocation of income and principal is unable to administer the trust impartially.  In addition, an allocation of capital gains to income will be respected if the allocation is made either pursuant to the terms of the governing instrument and local law, or pursuant to a reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or the governing instrument.

Capital gains.  A total return trust allows the trustee to invest in growth-producing assets as opposed to income-producing assets.  To pay the unitrust obligation, a trustee may have to either sell a portion of the trust assets or distribute a portion of the trust assets in satisfaction of the unitrust amount. [8]   Such action will have capital gain consequences.

The Proposed Regs. acknowledge that capital gains earned by a trust may be distributed to a current beneficiary pursuant to the terms of a trust or applicable local law that provides either for a unitrust amount to be paid to the current beneficiary or for the trustee to equitably adjust between income and principal to achieve a total return on trust investing.  As a result, the Proposed Regulations provide that under certain circumstances capital gains will be included in DNI.

Prop. Reg. 1.643(a)-3(b) states that capital gains are included in DNI to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and consistent exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law):

1.                  Allocated to income;

2.                  Allocated to corpus but treated by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary; or

3.                  Allocated to corpus but used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.

The examples illustrating Prop. Reg. 1.643(a)-3 make clear that if a fiduciary intends to follow a regular practice of (1) treating discretionary distributions as being paid first from any net capital gains realized, or (2) treating principal as distributed to the beneficiary to the extent of any unitrust amount that exceeds trust ordinary income, or (3) treating net capital gains as distributed to the extent any unitrust amount exceeds the trust's ordinary income, the trustee must consistently treat the item in such manner in the future.

To explain Prop. Reg. 1.643(a)-3, the Preamble to the Proposed Regulations indicates that capital gains are included in DNI in the following four possible circumstances:

1.                  Any capital gain that is included in the Section 643(b) definition of income is included in DNI.

2.                  Any capital gain that is used to determine the amount or timing of a distribution to a beneficiary is included in DNI.

3.                  Capital gains are included in DNI if the fiduciary, pursuant to a discretionary power granted by local law or by the governing instrument (if not inconsistent with local law), treats capital gains as distributed to a beneficiary, provided the power is exercised in a reasonable and consistent manner.

4.                  If, under the terms of the governing instrument or applicable local law, realized capital gains are treated as income to the extent the unitrust amount or the equitable adjustment amount exceeds ordinary income, capital gains so treated are included in DNI.

Impact of the Proposed Regs.

Ordinary trusts.  Amending Reg. 1.643(b)-1 (regarding the definition of income) may change the character of simple trusts under Section 651 and the accompanying Regulations.  Reg. 1.651(a)-1 defines a simple trust as a trust the governing instrument of which (1) requires that the trust distribute all its income currently for the taxable year, and (2) does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for the charitable and other purposes specified in Section 642(c).

With respect to the definition of income, Reg. 1.651(a)-2(a) refers taxpayers to Section 643(b) and Reg. 1.643(b)-1.  It follows that a change in the definition of income under Section 643(b) to a unitrust amount that allows a trustee to distribute an amount that may exceed trust accounting income would cause a trust not to be a simple trust; and therefore to be ineligible for the $300 exemption under Section 642(b).

Prop. Reg. 1.651(a)-2 states that if a trust distributes property in kind as part of its requirement to distribute currently all the income as defined under Section 643(b) and the applicable Regulations, the trust will be treated as having sold the property for its FMV on the date of distribution.  This Proposed Regulation further states that if no amount in excess of the amount of income as defined under Section 643(b) and the applicable Regulations is distributed by the trust during the year, the trust will qualify for treatment under Section 651, even though property in kind was distributed as part of a distribution of all the income.  The preceding sentence appears to indicate that a trust will be a simple trust if it does not distribute an amount in excess of trust accounting income.

Prop. Reg. 1.661(a)-2(f) provides that gain or loss is realized by a trust or estate (or the other beneficiaries) by reason of a distribution of property in kind if the distribution is in satisfaction of a right to receive a distribution (1) of a specific dollar amount, (2) of specific property other than that distributed, or (3) of income as defined under Section 643(b) and the accompanying Regulations, if income is required to be distributed currently.  In addition, gain or loss is realized if the trustee or executor makes an election to recognize gain or loss under Section 643(e).

Pooled income funds.  A pooled income fund is a split-interest trust.  A donor of a pooled income fund transfers money or other property to a separate fund that a charitable organization invests with other contributed funds.  The donor or some other person designated by the donor receives an income interest for life or for a term of years from the donor's separate fund, and the charitable organization receives the remainder interest.  Reg. 1.642(c)-5(a)(5)(i) specifies that the income that a pooled income fund pays to a noncharitable beneficiary is income as defined under Section 643(b) and the Regulations thereto.

Generally, a total return pooled income fund will provide benefits that an income interest pooled income fund could not.  A total return pooled income fund would allow charities to attract more contributors by being able to offer an annual payment in excess of trust accounting income.  Moreover, the charity's total return investing will maximize the value of the charitable remainder.

The Preamble to the Proposed Regulations notes that a pooled income fund is subject to taxation under Section 641, relating to the income taxation of estates and trusts.  A pooled income fund is entitled to a distribution deduction under Section 661 for income distributed to the noncharitable beneficiaries.  In addition, the fund receives a charitable deduction under Section 642(c) for any net long-term capital gain that is permanently set aside for charitable purposes under the terms of the governing instrument.  A pooled income fund is taxed on any net short-term capital gain that is not required to be distributed to the income beneficiaries pursuant to the governing instrument and local law.

Under traditional principles of income and principal, ordinary income would be paid to the income beneficiaries.  Any long-term capital gain would be allocated to principal and held for the ultimate benefit of the charitable remainder beneficiaries, and therefore would qualify for the charitable deduction under Section 642(c)(3).

The Preamble to the Proposed Regulations provides that if state law or the governing instrument defines the income of a pooled income fund as a unitrust amount, or allows the trustee to make adjustments between principal and income, the charitable deduction under Section 642(c)(3) permitted to pooled income funds for net long-term capital gain will be jeopardized if long-term capital gain is not permanently set aside for charitable purposes.

To address the problem arising from a pooled income fund that pays an income beneficiary a unitrust amount in satisfaction of the right to income that may include net long-term capital gain, the Proposed Regulations amend Reg. 1.642(c)-2(c) to provide that no amount of net long-term capital gain will be considered permanently set aside for charitable purposes if it is possible, under the terms of the fund's governing instrument or local law, that the income beneficiaries' right to income may--at any time--be satisfied by the payment of either an amount equal to a fixed percentage of the annual FMV of the trust property or any amount based on unrealized appreciation in the value of the trust property.

Charitable remainder trusts.  There are several types of charitable remainder unitrusts (CRUTs), two of which are income type of trusts: the net income unitrust (NICRUT) and the net income with make-up charitable remainder unitrust (NIMCRUT).  A NICRUT limits the unitrust amount to the lesser of a fixed percentage amount or the trust's net income for the year.  The NIMCRUT similarly limits the unitrust amount to the lesser of the fixed percentage amount or the trust's net income for the year, but any shortfall in the amount of income compared with the fixed percentage amount in any year can be paid in a future year when the trust income exceeds the fixed percentage amount.

Practitioners may believe that applying the total return trust concept to NICRUTs and NIMCRUTs would allow the noncharitable beneficiary to receive a substantial amount without investing the trust assets in such a way as to deplete the corpus. [9]   However, Reg. 1.664-3(a)(1)(i)(b)(4) prohibits the allocation of precontribution capital gain to income of NICRUTs and NIMCRUTs.  Thus, the benefit that a total return trust NICRUT or NIMCRUT could provide by permitting the trust to distribute gain to the current beneficiary would be limited because the trustee could distribute only post-contribution gain to the current beneficiary.

Moreover, none of the benefits associated with using a total return NICRUT are possible if Prop. Reg. 1.664-3(a)(1)(i)(b)(3) is finalized as proposed because the Proposed Regulation prohibits CRTs from defining income as a unitrust amount.  The Proposed Regulations provide that trust income for purposes of the CRUT rules means income as defined under Section 643(b) and the applicable Regulations.  However, trust income may not be determined by reference to a fixed percentage of the annual FMV of the trust property.

If applicable state law provides that income is a unitrust amount, the trust's governing instrument must contain its own definition of trust income.  In addition, capital gains attributable to appreciation in the value of a trust asset after the date it was contributed to the trust or purchased by the trust may be allocated to income pursuant to local law and the governing instrument but not pursuant to a discretionary power granted to the trustee.

Effect on other trusts

Marital deduction trusts.  Sections 2056(b)(5) and 2523(e) respectively set forth the estate and gift tax marital deduction rules for a life estate with a general power of appointment trust.  Sections 2056(b)(7) and 2523(f) respectively provide estate and gift tax marital deduction rules for QTIP trusts.  In order for these trusts to qualify for the marital deduction, the trust must require that the surviving spouse be paid all the trust income at least annually.

Regs. 20.2056(b)-5(f) and 25.2523(e)-1(f) contain rules for determining whether the spouse is entitled to all the income from either a life estate with a general power of appointment trust or a QTIP trust.  These rules provide that, if an interest is transferred in trust, the surviving spouse is entitled for life to all the income from the entire interest or a specific portion of the entire interest if the effect of the trust is to give the surviving spouse substantially that degree of beneficial enjoyment of the trust property during the surviving spouse's life which the principles of trust law accord a person who is unqualifiedly designated as the life beneficiary of a trust.

To take into account state law changes to the definition of income with respect to marital deduction trusts, the Proposed Regulations provide that a spouse's interest satisfies the income standard of Regs. 20.2056(b)-5(f) and 25.2523(e)-1(f) if the spouse is entitled to income as defined under a state statute that provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust and that meets the requirements of Reg. 1.643(b)-1.

With respect to the QTIP provisions, the Proposed Regulations [10] make clear that a power under state law that permits the trustee to adjust between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries that meets the requirements of Reg. 1.643(b)-1 will not be considered a power to appoint trust property to a person other than the surviving spouse.

The marital deduction provisions of the Proposed Regulations are applicable with respect to trusts for taxable years that begin on or after the date that final Regulations are published in the Federal Register.

Qualified domestic trusts.  Generally, the estate tax marital deduction is disallowed for property passing to a non-U.S. citizen spouse unless the property is in a qualified domestic trust (QDOT).  Moreover, Section 2056A(b) imposes an estate tax on any distributions from the QDOT in excess of trust income during the life of the surviving non-U.S. citizen spouse.  Reg. 20.2056A-5(c)(2) defines income as Section 643(b) income, but income specifically does not include capital gains.  Hence, under Reg. 20.2056A-5(c)(2), if income is defined as a unitrust amount, an estate tax will be imposed on all amounts distributed in satisfaction of the unitrust payment in excess of trust accounting income.

The Proposed Regulations address problems that may arise if a QDOT defines income as a unitrust amount or allows a trustee to adjust between income and principal.  Prop. Reg. 20.2056A-5(c)(2) provides that distributions made to the surviving spouse as the income beneficiary of the QDOT in conformance with state law that defines income as a unitrust amount, or permits the trustee to adjust between principal and income to fulfill the trustee's duty of impartiality between income and principal beneficiaries, will be considered distributions of trust income, if the state statute provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust and meets the requirements of Reg. 1.643(b)-1.

GST tax trusts.  Generally, the GST tax provisions impose a tax on the transfer of property to a donee who is at least two generations below the generation of the donor.  Congress enacted the GST tax provisions as part of TRA '86, and imposed the tax on all generation-skipping transfers made after 10/22/86. [11]   Section 1433(b)(2) of TRA '86 exempts from GST tax transfers from certain trusts.  The GST tax does not apply to any transfer from a trust that was irrevocable on 9/25/85, but only to the extent the transfer is not made out of corpus added to the trust after 9/25/85.  The GST tax also does not apply to any generation-skipping transfer under a will or revocable trust executed before 10/22/86, if the decedent died before 1/1/87.

The benefits associated with total return trusts are attractive and may be used in newly created GST trusts.  However, practitioners may want to use a total return concept with a grandfathered GST-tax-exempt trust by converting an income interest GST-tax-exempt trust to a total return GST trust.  An issue exists as to whether the conversion would cause an exempt trust to be subject to GST tax and otherwise lose its grandfathered status.

Practitioners who commented on the Proposed Regulations governing grandfathered GST-tax-exempt trusts [12] raised this issue.  The IRS indirectly responded to this comment by adding an example to the final Regulations on grandfathered GST-tax-exempt trusts. [13]   Example 9 of Reg. 26.2601-1(b)(4)(i)(E) illustrates the consequences of a judicial modification of a grandfathered GST-tax-exempt trust to allow the trustee to allocate capital gain to income.  The example concludes that the modification does not subject the trust to the GST tax provisions.

The Proposed Regulations on the definition of trust income set forth a definitive rule as to whether a GST-tax-exempt trust will lose its grandfathered status if the trust is modified to define income as a unitrust amount, or to permit the trustee to adjust between income and principal.  Prop. Reg. 26.2601-1(b)(4)(i)(D)(2) provides that administration of a trust in conformance with applicable state law that defines income as a unitrust amount, or permits the trustee to adjust between principal and income to fulfill the trustee's duty of impartiality between income and principal beneficiaries, will not be considered to shift a beneficial interest in the trust, if the state statute provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust and meets the requirements of Reg. 1.643(b)-1.

Accordingly, the Proposed Regulations allow a GST-tax-exempt trust to maintain its grandfathered status upon a modification of the definition of income only if state law defines income as a unitrust amount, or permits the trustee to adjust between principal and income to fulfill the trustee's duty of impartiality between income and principal beneficiaries.

Other tax provisions not addressed by the Prop. Regs.

The Proposed Regulations do not address a number of other tax provisions that are affected by the definition of income under Section 643(b) and the accompanying Regulations.  Practitioners should nonetheless be aware of the impact of these other tax provisions when using a total return trust.  These other provisions pertain to limitations on the charitable deduction, private foundations, information reporting rules, Subchapter S trusts, and foreign trusts.

Charitable deduction limitations.  The limitation rules relating to the charitable contribution deduction of trusts will be affected by an amendment to Reg. 1.643(b)-1.  Reg. 1.681(a)-1 limits the otherwise unlimited charitable contribution deduction allowable to a trust under Section 642(c) under the following circumstances:

1.                  To the extent that the deduction is allocable to unrelated business income;

2.                  For taxable years beginning before 1970, if the trust has engaged in a prohibited transaction; or

3.                  For taxable years beginning before 1970, if income is accumulated for a charitable purpose, and the accumulation is (a) unreasonable, (b) substantially diverted for a noncharitable purpose, or (c) invested against the interests of the charitable beneficiaries.

If (1) or (3) above is applicable, the deduction is limited to income actually paid out for charitable purposes, and is not allowed for income only set aside or to be used for those purposes.  Income for this purpose is defined as income under Section 643(b) and Reg. 1.643(b)-1.

Private foundations.  An amendment of Reg. 1.643(b)-1 may affect the private foundation rules with respect to the computation of undistributed income.  The private foundation rules impose an excise tax on the undistributed income of a private foundation. Reg. 53.4942(a)-2(a) defines undistributed income by taking into account the "distributable amount," which must be increased by the "income portion" of amounts placed in trusts after a certain date.  The computation of this "income portion" must take into account Section 643(b) income. [14]

Information reporting.  Practitioners must also be aware of any impact that an amendment of Reg. 1.643(b)-1 would have on the information reporting rules under Reg. 1.6034-1(b)(1).  Reg. 1.6034-1(b)(1) excepts certain charitable split-interest trusts claiming a Section 642 charitable deduction from filing a Form 1041-A.  The types of trusts that are excepted include trusts whose terms require the trustee to distribute currently all the Section 643(b) income.

Subchapter S.  One type of trust that is eligible to hold S corporation stock is the qualified subchapter S trust (QSST).  A QSST is defined, in part, as a trust the terms of which require that all the income (within the meaning of Section 643(b)) of the trust is distributed (or required to be distributed) currently to one individual who is a U.S. citizen or resident. [15]   To qualify as a QSST, either the terms of the trust must require that all income be distributed annually, or the trustee must annually distribute all the trust accounting income.

A total return trust distributes a percentage of the total value of the trust assets; this payout may not include all the trust accounting income.  A total return trust may not be usable as a QSST because it may be difficult to determine whether all the income would be annually distributed.  Further, practitioners may not want to use the total return trust concept for a QSST because of the nontax reason that the hard-to-value S stock must be valued annually.

Foreign trusts.  Although a discussion of foreign trusts is beyond the scope of this article, practitioners who want to use the total return concept with foreign trusts should consider the various tax ramifications, including the fact that the throw back rules apply to foreign trusts.

Collateral consequences of using total return trusts.  If a trust agreement or local law provides that the definition of trust accounting income is a unitrust amount, advisors should be aware of the collateral effect that such a definition will have for valuation purposes.  For instance, a total return trust will influence the valuation of partially complete gifts under Section 2512, the valuation of interests in trust under Section 7520, the valuation of 5% reversionary interests of grantor trusts under Section 673, and the valuation of beneficial interests in trust with respect to the attribution rules under Sections 267, 318, and 4946.

Conclusion

While a total return trust is a dynamic, revolutionizing estate planning tool, total return trusts have certain tax consequences that practitioners should analyze carefully.  Before using total return trusts, practitioners should consider the Proposed Regulations that revise the definition of income to take into account governing instruments or state laws that define trust accounting income as a unitrust amount or permit the trustee to make adjustments between income and principal.  Practitioners should also consider the tax consequences of a total return trust under other existing federal tax provisions not addressed by the Proposed Regulations.

Blurbs

The Preamble to the Prop. Regs. on the definition of trust income explains that capital gains are included in DNI in certain circumstances.

The Prop. Regs. take into account state law changes in the definition of income with respect to trusts qualifying for the marital deduction.

Under the Prop. Regs., a GST-tax-exempt trust may maintain its grandfathered status after modification to a total return GST trust.

PRACTICE NOTES

If a trust agreement or local law provides that the definition of trust accounting income is a unitrust amount, practitioners should be aware of the collateral effect that such a definition will have for valuation purposes.