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Mastering Fiduciary Accounting Income

for Estate Planners and Administrators

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, JUNE 1, 2017

Presenting a live 90-minute webinar with interactive Q&A

Gregory V. Gadarian, Partner, Gadarian & Cacy, Tucson. Ariz.

Scott M. Nelson, CPA, Hellmuth & Johnson, Minneapolis

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Mastering Fiduciary Accounting Income for Estate Planners and

Administrators

Strafford CLE June 1, 2017

Gregory V. Gadarian Gadarian and Cacy, PLLC

Tucson, AZ greg@gadarianlaw.com

Scott M. Nelson Hellmuth & Johnson, PLLC

Edina, MN snelson@hjlawfirm.com

Overview of issues

I. Specific challenges in allocating income and expenses to FAI

II. UPIA factors in calculating FAI

III. Impact of FAI on trust distributions

IV. Tax considerations such as distributable net income inclusion on distribution strategies

V. Planning considerations and traps to avoid

6

Fiduciary Accounting Income • Fiduciary accounting income (also referred to as trust accounting

income) is the amount the fiduciary has available for current distributions to the income beneficiaries of a trust or estate.

• Fiduciary accounting income is determined under the terms of the governing instrument and applicable local law (the trust or estate’s situs).

• Applicable local law means the state’s version of the Uniform Principal and Income Act.

• The Principal and Income Act determines whether a receipt or disbursement is to be categorized as allocable to principal or income.

7

Situs and State Law

• The situs of the trust or estate determines the applicable local law.

• The situs of the trust or estate is usually determined by the governing instrument.

• If the governing document is a will, and is silent regarding situs, the place of the testator’s domicile at the time of death will usually control.

8

Income Beneficiary and Remainder Beneficiary

• An income beneficiary is a beneficiary currently entitled to distributions of net income from the trust.

• A remainder beneficiary is a beneficiary entitled to distributions from the trust when an income interest ends.

9

Allocation of Income Earned During Administration

• How is income earned during administration of an estate to be distributed to trusts and to persons who receive outright bequests of specific property, pecuniary gifts, and the residue?

• When an income interest in a trust begins (i.e., when a person who creates the trust dies or when he transfers property to a trust during life), what property is principal that will eventually go to the remainder beneficiaries and what is income?

• When an income interest ends, who gets the income that has been received but not distributed, or that is due but not yet collected, or that has accrued but is not yet due?

• After an income interest begins and before it ends, how should its receipts and disbursements be allocated to or between principal and income?

10

I. SPECIFIC CHALLENGES IN ALLOCATING INCOME AND EXPENSES TO FAI

• When can capital gains be allocated to income?

• Whether capital gains received from passthrough entities retain their character when distributed to a trust?

• When are distributions from entities treated as income?

11

Treatment of Capital Gains

• Section 643(a)(3) Distributable net income. For purposes of this part, the term “distributable net income” means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications—

• (3) Capital gains and losses. Gains from the sale or

exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c).

12

Analysis – Step One

• Has a distribution been made (or is one required to be made)?

– Fiduciary duties apply.

• Are Capital Gains in fact allocated to Income or to Principal?

• “Income” refers to fiduciary/trust accounting income.

• “Income” is determined under the terms of the governing instrument and applicable local law.

• If Capital Gains are allocated to income, such gains are automatically part of DNI.

13

Analysis – Step Two

If Capital Gains are in fact allocated to principal, can such gains be included in DNI?

Such gains still may be included in DNI.

Treas. Reg. §1.643(a)-3 lists circumstances in which an allocation to DNI is allowed.

Authority under state law or the governing instrument is required.

14

§1.643(a)-3(b) and §1.643(b)-1

• An allocation of capital gains to income will generally be respected if:

– the allocation is made either pursuant to the terms of the governing instrument and applicable local law, or

– pursuant to a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law.

15

Sample Language – Discretion Granted under Terms of Governing Instrument

to Allocate Capital Gains to Income.

The Trustee (other than a Trustee who is also a qualified beneficiary, and other than the Grantor) may allocate realized short term capital gains and/or realized long term capital gains to either trust income or trust principal.

16

Methods of including Capital Gains in DNI when Capital Gains are allocated to

Principal.

• Capital Gains are allocated to principal, but treated consistently by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary.

• Capital Gains are allocated to principal but actually distributed to the beneficiary.

• Capital Gains are allocated to principal but utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.

17

Example 1

Under the terms of Trust's governing instrument, all income is to be paid to A for life. Trustee is given discretionary powers to invade principal for A's benefit and to deem discretionary distributions to be made from capital gains realized during the year.

During Trust's first taxable year, Trust has $5,000 of dividend income and $10,000 of capital gain from the sale of securities. Pursuant to the terms of the governing instrument and applicable local law, Trustee allocates the $10,000 capital gain to principal. During the year, Trustee distributes to A $5,000, representing A's right to trust income. In addition, Trustee distributes to A $12,000, pursuant to the discretionary power to distribute principal.

Trustee does not exercise the discretionary power to deem the discretionary distributions of principal as being paid from capital gains realized during the year. Therefore, the capital gains realized during the year are not included in distributable net income and the $10,000 of capital gain is taxed to the trust. In future years, Trustee must treat all discretionary distributions as not being made from any realized capital gains. The Example is equating the term deem with the distribution being "treated by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary."

18

Example 2

Under the terms of Trust's governing instrument, all income is to be paid to A for life. Trustee is given discretionary powers to invade principal for A's benefit and to deem discretionary distributions to be made from capital gains realized during the year.

The Trust has $5,000 of dividend income and $10,000 of capital gain. Pursuant to the terms of the governing instrument and applicable local law, Trustee allocates the $10,000 capital gain to principal. During the year, Trustee distributes to A $5,000, representing A's right to trust income. In addition, Trustee distributes to A $12,000, pursuant to the discretionary power to distribute principal.

The Trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains realized by Trust during the year. Trustee evidences this treatment by including the $10,000 capital gain in distributable net income on Trust's federal income tax return so that it is taxed to A. This treatment of the capital gains is a reasonable exercise of Trustee's discretion. In future years Trustee must treat all discretionary distributions as being made first from any realized capital gains.

19

Example 4

Under the terms of Trust's governing instrument, all income is to be paid to A for life. Trustee is given discretionary powers to invade principal for A's benefit and to deem discretionary distributions to be made from capital gains realized during the year.

During Trust's first taxable year, Trust has $5,000 of dividend income and $10,000 of capital gain from the sale of securities. Pursuant to the terms of the governing instrument and applicable local law, Trustee allocates the $10,000 capital gain to principal. During the year, Trustee distributes to A $5,000, representing A's right to trust income. In addition, Trustee distributes to A $12,000, pursuant to the discretionary power to distribute principal. Pursuant to the terms of the governing instrument (in a provision not prohibited by applicable local law), capital gains realized by Trust are allocated to income. Because the capital gains are allocated to income pursuant to the terms of the governing instrument, the $10,000 capital gain is included in Trust's distributable net income for the taxable year. Capital gains are allocated to income under the trust agreement. Thus there is no discretion and no consistency requirement.

20

II. UPIA FACTORS IN CALCULATING FAI

21

Uniform Principal and Income Act

• www.uniformlaws.org (The National Conference of Commissioners on Uniform State Laws)

• Description – This act’s purpose is to provide procedures for trustees administering trusts and personal representatives administering estates in allocating assets to principal and income, and to govern their proper distribution to beneficiaries, heirs and devisees.

• Original Act – 1931 • Restatement – 1962, 1997, 2000 • Amended - 2008

22

• Revocable Trusts

• New Financial Instruments

• Uniform Prudent Investor Act • Total Return vs. Income

• 1997 Updates

• 2000 Updates

• 2008 Updates

23

1997 Act

1) How is income earned during the probate of an estate to be distributed to trusts and to persons who receive outright bequests of specific property, pecuniary gifts, and the residue?

2) When an income interest in a trust begins (i.e., when a person who creates the trust dies or when she transfers property to a trust during life), what property is principal that will eventually go to the remainder beneficiaries and what is income?

3) When an income interest ends, who gets the income that has been received but not distributed, or that is due but not yet collected, or that has accrued but is not yet due?

4) After an income interest begins and before it ends, how should its receipts and disbursements be allocated to or between principal and income?

24

2000 Act – New Rules

1) The application of the probate administration rules to revocable living trusts after the settlor’s death and to other terminating trusts. Articles 2 and 3.

2) The payment of interest or some other amount on the delayed payment of an outright pecuniary gift that is made pursuant to a trust agreement instead of a will when the agreement or state law does not provide for such a payment. Section 201(3).

3) The allocation of net income from partnership interests acquired by the trustee other than from a decedent (the old Acts deal only with partnership interests acquired from a decedent). Section 401.

4) An “unincorporated entity” concept has been introduced to deal with businesses operated by a trustee, including farming and livestock operations, and investment activities in rental real estate, natural resources, timber, and derivatives. Section 403.

25

2000 Act – New Rules cont.

5) The allocation of receipts from discount obligations such as zero-coupon bonds. Section 406(b).

6) The allocation of net income from harvesting and selling timber between principal and income. Section 412.

7) The allocation between principal and income of receipts from derivatives, options, and asset-backed securities. Sections 414 and 415.

8) Disbursements made because of environmental laws. Section 502(a)(7).

9) Income tax obligations resulting from the ownership of S corporation stock and interests in partnerships. Section 505.

10) The power to make adjustments between principal and income to correct inequities caused by tax elections or peculiarities in the way the fiduciary income tax rules apply. Section 506.

26

2000 Act - Clarifications and changes

A number of matters provided for in the prior Acts have been changed or clarified in this revision, including the following:

1) An income beneficiary’s estate will be entitled to receive only net

income actually received by a trust before the beneficiary’s death and not items of accrued income. Section 303.

2) Income from a partnership is based on actual distributions from the partnership, in the same manner as corporate distributions. Section 401.

3) Distributions from corporations and partnerships that exceed 20% of the entity’s gross assets will be principal whether or not intended by the entity to be a partial liquidation. Section 401(d)(2).

4) Deferred compensation is dealt with in greater detail in a separate section. Section 409.

27

2000 Act cont.

5) The 1962 Act rule for ?property subject to depletion,” (patents, copyrights, royalties, and the like), which provides that a trustee may allocate up to 5% of the asset’s inventory value to income and the balance to principal, has been replaced by a rule that allocates 90% of the amounts received to principal and the balance to income. Section 410.

6) The percentage used to allocate amounts received from oil and gas has been changed – 90% of those receipts are allocated to principal and the balance to income. Section 411.

7) The unproductive property rule has been eliminated for trusts other than marital deduction trusts. Section 413.

8) Charging depreciation against income is no longer mandatory, and is left to the discretion of the trustee. Section 503.

28

Coordination with the Uniform Prudent Investor Act

• The law of trust investment has been modernized. See Uniform Prudent Investor Act (1994); Restatement (Third) of Trusts: Prudent Investor Rule (1992) (hereinafter Restatement of Trusts 3d: Prudent Investor Rule). Now it is time to update the principal and income allocation rules so the two bodies of doctrine can work well together. This revision deals conservatively with the tension between modern investment theory and traditional income allocation. The starting point is to use the traditional system. If prudent investing of all the assets in a trust viewed as a portfolio and traditional allocation effectuate the intent of the settlor, then nothing need be done. The Act, however, helps the trustee who has made a prudent, modern portfolio-based investment decision that has the initial effect of skewing return from all the assets under management, viewed as a portfolio, as between income and principal beneficiaries. The Act gives that trustee a power to reallocate the portfolio return suitably. To leave a trustee constrained by the traditional system would inhibit the trustee’s ability to fully implement modern portfolio theory.

29

Common Allocations

Allocable to Income Allocable to Corpus

*Ordinary and operating net *Depreciation on business assets income from trust assets *Casualty gain/loss on *Interest, dividend, rent, and income-producing assets royalty income *Insurance recoveries on *Stock dividends income-producing assets *One-half of fiduciary fees/ *Capital gain/loss on investment commissions assets *Stock splits *One-half of fiduciary fees/ commissions

30

III. IMPACT OF FAI ON TRUST DISTRIBUTIONS

32

• Distribution of “Income” vs. “Principal”

• Local Law

• Governing Instrument

• Unitrust Distribution – Percent of annually revalued fair market value.

• Treasury Regulation (2004) – Subchapter J – Disregard departure from traditional concepts of

income and corpus.

33

1. Capital Gains—usually principal

2. Partnerships—Dealing with differences between a trust/partner’s K-1 income from a partnership, and partnership distributions to the trust.

3. S Corporations—QSSTs

4. IRD—usually principal

5. State Law Considerations/Variations

34

Capital Gains

Shifting Capital Gain by Distributions in Kind

• Assume the trustee of a trust wants to make a $10,000 discretionary distribution to a

beneficiary, assume the trust has no net capital gains, and assume the trust owns stock with a

value of $10,000 and basis of $7,500. Consider the following two choices.

1. The trustee could sell the stock to raise the $10,000 to make the distribution, and recognize $2,500 of capital gain. If the trustee then distributes the $10,000, the $2,500 of capital gain is also included in Net Investment Income ("NII") that is taxed to trust under Section 1411, unless that capital gain is included in DNI. Assume that capital gain is not includible in DNI and is taxed to the trust.

2. Alternatively, the trustee could distribute the stock in kind. Under Section 643, no capital gain is recognized on the distribution and the appreciation is not part of NII. The recipient beneficiary has a carryover basis of $7,500 in the stock. If the beneficiary subsequently sells the stock, the $2,500 of capital gain is recognized by and taxed to the beneficiary. This is the same result which arises if the trust had been able to include the $2,500 of capital gain in DNI.

35

Partnerships

• Example (1) – Trust T receives a Schedule K-1 from Partnership P reflecting taxable income of $1 million. Partnership P distributes $100,000 to T, which allocates the receipts to income. Both Trust T and income Beneficiary B are in the 35 percent tax bracket. Trust T’s tax on $1 million of taxable income is $350,000.

• Under UPAIA § 505(c), T’s tax must be paid from income receipts because receipts from the entity are allocated only to income. Therefore, T must apply the entire $100,000 of income receipts to pay its tax. In this case, Beneficiary B receives nothing.

36

• Example (2) - Trust T receives a Schedule K-1 from Partnership P reflecting taxable income of $1 million. Partnership P distributes $500,000 to T, which allocates the receipts to income. Both Trust T and income Beneficiary B are in the 35 percent tax bracket. Trust T’s tax on $1 million of taxable income is $350,000.

• Under UPAIA § 505(c), T’s tax must be paid from income receipts because receipts from P are allocated only to income. Therefore, T uses $350,000 of the $500,000 to pay its taxes and distributes the remaining $150,000 to B. The $150,000 payment to B reduces T’s taxes by $52,500, which it must pay to B. But the $52,500 further reduces T’s taxes by $18,375, which it also must pay to B. In fact, each time T makes a distribution to B, its taxes are further reduced, causing another payment to be due B.

• Alternatively, T can apply an algebraic formula to determine the amount payable to B.

37

S Corporations

• An electing small business trust (“ESBT”) does not receive an income distribution deduction with respect to its Schedule K-1 income that is distributed to its beneficiaries. The trust pays the income tax on the K-1 income.

• A qualified subchapter S trust (“QSST”) is treated as

wholly owned by one beneficiary and does not pay taxes on any of its Schedule K-1 income from an S corporation. Instead, the individual beneficiary is treated for income tax purposes as receiving Schedule K-1 income and pays all the income taxes attributable to the Schedule K-1 income.

38

QSSTs

• UPAIA § 506(a)(3) applies to a QSST whose income beneficiary is required to include a pro rata share of the S corporation’s taxable income in his return.

• If the QSST does not receive a cash distribution from the corporation that is large enough to cover the income beneficiary’s tax liability, the trustee may distribute additional cash from principal to the income beneficiary. In this case the retention of cash by the corporation benefits the trust principal.

39

IRD

40

IV. TAX CONSIDERATIONS

41

Income Taxation of Non-Grantor Trusts and Estates

• General Rule – § 641(a) imposes an income tax on the income of estates and trusts.

• § 641(b) – income computed in the same manner as that of an individual with certain exceptions, and tax is paid by the fiduciary.

• Tax rates are found in §1(e).

42

Simple Trusts and Complex Trusts and Estates

• Simple trusts – §651 and §652

– Income (fiduciary accounting income) is required to be distributed currently.

• Complex trusts and estates – §661 and §662

– All fiduciary entities that do not qualify as simple trusts.

43

Role of DNI

• Limits Beneficiaries’ Taxable Income

– Separate share rule

• Character Rule

– Character flows through

• Limits Trust/Estate’s Distribution Deduction

44

Distribution Deduction

• Distribution deduction is limited to the lesser of trust accounting income (§651) or DNI for simple trusts, and the lesser of distributions or DNI for complex trusts (§661)

• DNI is the maximum amount of taxable income of the trust that is taxed to a beneficiary as the result of a distribution to the beneficiary (§652 and §662)

45

Distributable Net Income

Computation of Distributable Net Income • Taxable income before

– Personal exemption – Distribution deduction – Special deductions • Add back

– Capital losses – Net tax exempt income • Subtract capital gains?

46

IRD

• Items of income or gain “earned” by the decedent but not properly reportable for income tax purposes before the decedent's death.

• Peterson Test: – Decedent entered into legally significant

transaction

– Decedent performed substantive tasks required

– No economically significant contingencies

– Decedent would have received property but for death

47

Common Sources of IRD

• Salary

• IRAs and pensions

• Share of S corp and partnership earnings earned prior to death

• Accrued interest, dividends, rents and royalties

• Payments on installment notes

48

Tax Consequences of IRD

No Basis Adjustment

Taxable as Income

§ 691(c) Deduction

49

V. Planning Considerations and Traps to Avoid

50

Planning Considerations and Traps to Avoid

• Election of fiscal year tax year for estate and

section 706. • 65 day rule for discretionary trusts and estates. • IRD • Effect of fiduciary decisions on income taxation

consequences. • Distributions in kind • Charitable deduction • Trust Termination • Trapping distributions • Section 67(e)

51 51

Election of fiscal year tax year for estate

and section 706. §706 (b)TAXABLE YEAR

(1)PARTNERSHIP’S TAXABLE YEAR (B)Taxable year determined by reference to partners. Except as provided in subparagraph (C), a partnership shall not have a taxable year other than— (i)the majority interest taxable year (as defined in paragraph (4))… (4)MAJORITY INTEREST TAXABLE YEAR; LIMITATION ON REQUIRED CHANGES (A)Majority interest taxable year defined. For purposes of paragraph (1)(B)(i)— (i)In general. The term “majority interest taxable year” means the taxable year (if any) which, on each testing day, constituted the taxable year of 1 or more partners having (on such day) an aggregate interest in partnership profits and capital of more than 50 percent.

52

65 day rule

• §663(b)DISTRIBUTIONS IN FIRST SIXTY-FIVE DAYS OF TAXABLE YEAR

(1)GENERAL RULE. If within the first 65 days of any taxable year of an estate or a trust, an amount is properly paid or credited, such amount shall be considered paid or credited on the last day of the preceding taxable year.

53

Planning for IRD

Bequest to charity

Bequest to spouse

Allocating IRD income to charitable share or marital share

Allocating IRD income away from certain bequests

Avoid funding pecuniary bequest with IRD

54

Effect of fiduciary decisions on income taxation consequences

56

Compensatory (Equitable) Adjustments

• Trustee Duty of Impartiality.

• Example. An estate that is subject to payment of FET may make a §642(g) election to use estate expenses as an FET deduction under §§2053 and 2054, or to use those expenses (to the extent possible) to reduce estate income taxes. The unavoidable choice is between reducing taxable income that will reduce DNI that should reduce the income tax that income beneficiaries would incur, or reducing FET that would leave more corpus for the remainder beneficiaries.

57

Compensatory (Equitable) Adjustments-continued

• Trustee Duty of Impartiality.

• Example. Trustee makes a distribution of cash to the income beneficiary. Trustee raised the cash by the sale of stock. Trustee has discretion to treat the capital gain as part of DNI. The unavoidable choice is between increasing DNI that will increase the income tax that the income beneficiary would incur, or excluding the capital gain from DNI that would cause the income tax burden to be borne by the remainder beneficiaries.

58

Illustration involving distributions

The following distributions occur in a year in which DNI is $200x A and B each receive property/cash with a Fair Market Value of $150x How much DNI will A and B receive? What if the fiduciary makes the §643(e)(3) election?

59

Illustration –No Separate Shares and DNI of $200 and Total FMV $150 each

Asset FMV Basis Recipient DNI Carryout

Built-in Gain

Blackacre $75 $50 A $50 $25

A corp stock

$60

$10

A $10 $50

Cash $15 A $15

$150 [$75] [$75]

Greenacre $50 $50 B $50 $0

B corp stock

$45

$30

B $30 $15

C corp stock

$15

$5

B $5 $10

Cash $40 B $40

$150 [$125] [$25]

60

Illustration –Separate Shares and DNI of $200 and Total FMV $150 each

Asset FMV Basis Recipient DNI Carryout

Built-in Gain

Blackacre $75 $50 A $50 $25

A corp stock

$60

$10

A $10 $50

Cash $15 A $15

$150 [$75] [$75]

Greenacre $50 $50 B $50 $0

B corp stock

$45

$30

B $30 $15

C corp stock

$15

$5

B $5 $10

Cash $40 B $40

$150 [$100] [$25]

61

Distributions in Kind

• Income carried out by a distribution of property in kind is limited by §643(e)(2) to lesser of property's FMV or basis.

• Recipient’s basis-carryover basis.

• § 643(e) election-basis equal to FMV

62

Charitable Deduction

• Intermediate Tier-reduces DNI

• § 642(c) requires tracing of amounts distributed and limits the deduction to amounts actually paid from gross income of the estate or trust.

• Governing instrument requirement.

63

Charitable Deduction–Sample Language

• The Trustee is authorized to distribute current gross income to fund bequests or distributions to charitable organizations.

64

Set Aside Deduction

• § 642(c)(2) permits a deduction for amounts of gross income permanently set aside for a qualified charitable purpose pursuant to the terms of a governing instrument for any estate.

• Deduction does not apply to trusts unless a § 645 election is in effect.

65

Trust Termination–Deductions and Carryovers

• Deductions reduce taxable income and, correspondingly, DNI.

• Deductions that exceed taxable income, do not pass out to the beneficiaries and are wasted unless they constitute a net operating loss or capital loss and carryover to the entity's next tax year.

66

• § 642(h) provides that excess deductions in the year of termination of a trust or estate pass through to the beneficiaries.

67

Trust Termination–Deductions and Carryovers

Trapping Distributions

• A “trapping distribution” is a distribution from an estate to a trust or trusts that carries out DNI of the estate to the trust. The trust can then distribute some or all of the DNI to the trust beneficiaries. Trapping distributions allow the estate to split its income among several taxpayers (the estate, trusts, and trust beneficiaries).

• Although a distribution is considered a distribution of income for federal tax purposes, it may represent principal for trust accounting purposes (e.g., a distribution of a right to income in respect of a decedent). A trapping distribution will be made to a simple trust only if the distribution is treated as principal for trust accounting purposes. Otherwise, the estate’s DNI will pass through the trust and be taxable to the beneficiary to whom the trust income must be distributed.

• DNI is not carried out to the beneficiaries of a complex trust in the year the

trapping distribution is made, except to the extent the trust makes a distribution. It does not matter whether the trapping distribution is treated as principal or income for trust accounting purposes.

68

Section 67 (e)

• Expenses subject to the 2% AGI floor for individuals are also subject to the 2% AGI floor for trusts and estates, except for-

– Expenses incurred during administration; and

– Which would not have been incurred if the property were not held in the trust.

• Fiduciary fees – must be separately stated

69