THE TAX ASPECTS OF THE NEW UNIFORM PRINCIPAL AND INCOME ACT
by James L. Deeringer, Esq.*
[Editor’s Note: The author is a former member of the Trusts and Estates Section Executive Committee, and he wrote previously on this subject in the Fall 1999 issue of the Quarterly. This article was originally published in The University of Southern California 54th Institute on Federal Taxation – Major Tax Planning for 2002. The article was written approximately 15 months ago, but the author believes that it remains accurate, and the editors believe it to remain useful for practitioners.]
California enacted a new Uniform Principal and Income Act in July, 1999 (referred to hereinafter as "UPAIA" or "the Act").1 The Act became effective on January 1, 2000 as to all trusts and estates, regardless of the date of execution of the governing instrument or the date of death of the decedent. The Act is found in California Probate Code §§ 16320-16375.2 It completely replaces California’s previous Revised Uniform Principal and Income Act.3
The Act is based upon the Uniform Principal and Income Act (referred to hereinafter as "the Uniform Act") promulgated by the National Conference of Commissioners on Uniform State Laws (NCCUSL) in 1997.4 At last count, the Uniform Act has been passed in some form in 13 states. Legislation is currently pending in New York, Pennsylvania and Delaware, as well as other states. California is the first "major" state to adopt the Uniform Act. [Editor’s note: The Uniform Act has now been adopted in approximately 25 states, including New York, Delaware, and Florida, and at the time this issue went to print, a bill containing a version of the UPAIA was awaiting the governor’s signature in Pennsylvania.]
This article will first describe why and how the Act changed existing law; we will then focus on the tax issues raised by the Act. As the reader will discover, the Act offers trustees new powers and the flexibility to achieve better and more equitable economic results in trust administration, but uncertainties about the tax treatment of a trustee’s exercise of these new powers may greatly limit their use.
I. WHY DID WE NEED A NEW PRINCIPAL AN INCOME ACT?
A. Prior Law Had Become Inadequate
California’s previous principal and income act, which dated from 1962, had become inadequate in a number of respects. Many forms of investment now in common use, such as derivatives, were not part of the investment landscape in 1962, and prior law failed to deal with the profusion of new investment vehicles developed during the past 30 years. Qualified retirement plans and accounts are now a major fact of life in the financial world, and prior law failed to consider them at all. Also, living trusts have become much more popular during the past 30 years, and prior law failed to cover them in a comprehensive or consistent way.
B. Standards for Trustee Investment Performance Have Changed
The most compelling reason for revising the principal and income law was the need to respond to new standards for trustee investment performance that have developed during the past 30 years. These new standards de-emphasize the importance of accounting income (i.e., interest, dividends, rents, etc.) and instead measure a trustee’s performance in terms of the total return the trustee achieves (i.e., accounting income plus growth in the value of principal).
The Prudent Investor Act5 and its guiding principle of total return investing have codified this change in investment performance standards. The Prudent Investor Act makes several major changes to former law that are relevant to our topic:
1. The standard of prudence in evaluating trustee investments is applied to the portfolio as a whole rather than to individual investments.
2. Achieving an appropriate balance between risk and return is identified as the fiduciary’s primary consideration. The trustee’s investment strategy must have risk and return objectives reasonably suited to the trust. This key mandate is commonly referred to as the "Prudent Investor Rule."6
3. All categorical restrictions on types of investments have been eliminated. A trustee may invest in anything that plays an appropriate role in achieving the overall risk and return objectives and that meets the other requirements of prudent investing.7
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The Prudent Investor Act is a double-edged sword for trustees. On the one hand, it has liberated trustees from the former legal constraints that interfered with their ability to achieve optimal total return (that is, traditional accounting income, such as dividends and interest, plus capital appreciation). On the other hand, it has established a standard that obligates trustees to adopt an investment strategy reasonably designed to achieve optimal total return – consistent with the objectives and risk tolerance of the trust in question.
C. "Income Rule" Trusts Created a Dilemma for Trustees
The Prudent Investor Rule creates a problem particularly for trustees who are administering so-called "income rule" trusts. Income rule trusts are trusts whose payout to current beneficiaries is measured by reference to the accounting income generated by the trust. Most existing trusts for benefit of surviving spouses, children, and grandchildren are "income rule" trusts, because they call for either mandatory or discretionary payment of net income to the current beneficiary. The trustee of such trusts is often given discretion to invade principal, but such discretion is usually circumscribed by a need-based standard, such as "health, education, support, and maintenance." Therefore, the trustee of such trusts must still concern itself with the level of accounting income generated by the trust.
The trustee’s dilemma in income rule trusts arises because the investment mix that produces the optimal total return appropriate for the trust generally does not produce enough traditional accounting income to satisfy the income beneficiary’s needs – or to fulfill the settlor’s intentions. Income rule trusts are inherently problematic, and have been for a long time, because accounting income is such a faulty measure of return on capital. What trustees of income rule trusts have historically done is to skew the investment mix (i.e., asset allocation) in favor of fixed income investments as necessary to beef up traditional accounting income – at least to the point necessary to keep the income beneficiary from bringing suit.
D. Financial Market Realities Compelled a Different Approach
The former trustee strategy of tilting the investment mix in favor of fixed income investments was never satisfactory, but now – because of the Prudent Investor Rule and the way the financial markets have been performing during the past decade – such a strategy is truly bankrupt. Dividend yields have plummeted during the past decade while bond interest rates have remained flat. The S & P 500 average dividend rate is currently around 1.1%. Long-term U.S. Treasury bonds are currently bearing interest at only 6% or so. Thus, where a trustee invests for optimal total return, which entails weighting the portfolio more heavily toward equities, the traditional accounting income component of that return is likely (under current market conditions) be only 2% – or less.
Conversely, based on these yields, if a trustee tries to achieve 5% accounting income under current market conditions, the investment mix will have to be about 88.5% fixed income instruments and just 11.5% in equities. A trustee who attempts to shore up accounting income with this type of asset allocation severely limits growth in the value of trust corpus, thereby breaching its duty under the Prudent Investor Act to treat different classes of beneficiaries impartially.
As a result of these market realities, a trustee’s duties under the Prudent Investor Act often conflict with the duty to treat different classes of beneficiaries impartially. Trustees needed a legal mechanism that would enable them to escape the bind of conflicting fiduciary duties inherent in income rule trusts.
II. THE ADJUSTMENT POWER UNDER THE UPAIA
The UPAIA contains a number of helpful and important changes to existing law, but the most significant change is the new power to adjust total return between principal and income, which is found in California Probate Code § 16336.
"Adjusting total return between principal and income" is merely a shorthand way of saying that the trustee may allocate principal or income (as defined under other provisions of the Act) to a different class of beneficiaries than would otherwise receive it. The adjustment power does not enable the trustee to actually convert principal to income (or vice versa) for either trust accounting or income tax purposes. This important distinction must be kept in mind when considering the income tax consequences of the Act.
A. The Basic Rule
There are three prerequisites to trustee’s having the power to adjust between principal and income:
1. First, the trustee must be investing and managing under the Prudent Investor Rule;
2. Second, the amount distributable to a beneficiary must described by reference to the trust’s "income" (regardless of whether the trustee could distribute less than all of the income or more than the income); and
3. Third, the trustee must determine that complying with the terms of the trust (including any power the trustee may have to invade principal or accumulate income) will not allow the truste to fulfill its duty to treat beneficiaries
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impartially.8
In deciding whether and to what extent to exercise the adjustment power, the trustee may (but is not required to) consider nine factors that are set out in § 16336(g).9
B. Exceptions to the Power to Adjust
There are numerous exceptions to the power to adjust. A trustee cannot make an adjustment in any of the following circumstances:
1. where it would diminish an income interest in a marital deduction trust, thereby disqualifying the trust for the marital deduction;
2. where it would cause an unintentional taxable gift by reducing the actuarial value of an income interest in a trust such that the resulting increase in the value of the remainder pushes its value over the annual exclusion amount within which the gift was intended to fall;
3. where it would change the amount payable to a beneficiary as a fixed annuity or percentage of the value of the trust;
4. where it would decrease the value of the charitable interest in a split interest trust;
5. where possessing or exercising the power to adjust would cause someone to be treated as the owner of the trust for income tax purposes (under the grantor trust rules);
6. where possessing or exercising the power would cause inclusion of trust assets in the taxable estate of someone who has the power to remove or appoint a trustee; or
7. where the trustee is also a beneficiary.10
These exclusions- and especially the last one – severely limit the number of trusts that can make use of the adjustment power.
A trustee may release the adjustment power if the trustee (a) is uncertain whether possessing or exercising the power will cause one of the problems described above, or (b) determines that possessing or exercising the power will or may deprive the trust of a tax benefit or impose a tax burden other than those described in the specific prohibitions.11 The release may be permanent or only for a specified period.12
C. Effect of Provisions in the Governing Instrument
The adjustment power, like all other UPAIA rules, is a default rule. It does not apply if the governing instrument negates the power. What kinds of provisions in the instrument are sufficient to negate the adjustment power? Section 16336(f) provides that a trust provision that would otherwise limit application of the adjustment power will not have that effect unless it is clear from the trust that the settlor intended to negate the adjustment power. For example, provisions that purport to prohibit invasion of principal or that prohibit equitable adjustments will not be sufficient to negate the adjustment power. Any instrument drafted after the effective date of the Act must specifically refer to the power to adjust if the settlor intends to forbid its use.
D. Alternatives to the Adjustment Power
1. Discretionary power to invade principal
This power can eliminate the need to adjust in favor of the income beneficiary. However, a discretionary power to invade principal will not solve the problem if the trustee needs to adjust from income to principal.
The power to invade principal is usually limited by some need-based standard. The duty of impartiality may require an adjustment that is not based on need – i.e., an adjustment that is necessary to allocate total return fairly (or as the settlor otherwise intended) between different classes of beneficiaries.
2. "Five-or-five" power
The so-called "five-or-five" power is the power to distribute to the income beneficiary each year the greater of $5,000 or 5% of fair market value of trust corpus. Again, such a power allows for some reallocation of benefit in favor of income, but does not allow an adjustment in favor of principal.
Because the five-or-five power is not based on the income beneficiary’s need, it offers the trustee flexibility. However, the existence of such a power can create severe potential income tax problems for the beneficiary under the grantor trust rules of Subchapter J where the beneficiary allows the power to lapse.
3. Power to Determine What Is Income and What Is Principal
This power allows the trustee to actually recharacterize a receipt as income rather than principal (or vice versa). By contrast, an exercise of the adjustment power does not actually convert principal into income (or vice versa); it merely enables the trustee to distribute the receipt – however it is characterized – to a different beneficiary class than would otherwise receive it.
The power to characterize receipts is a useful power, and it can offer the trustee the functional equivalent of the adjustment power.
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However, a trustee’s exercise of the power may be constrained by a need, for income tax purposes, to conform to basic principles of local law (i.e., in California, the UPAIA). The trustee’s characterization will control for income tax purposes only if it does not depart fundamentally from principles of local law. If the adjustment power does not apply to the trust in question, a trustee’s determination contrary to other provisions of UPAIA may not be respected by the IRS. (See discussion below regarding income taxation of total return trusts.)
Of course, use of the adjustment power does not place the trustee on more solid footing with regard to income tax reporting, because it is also uncertain how payouts that are adjusted pursuant to exercise of the adjustment power will be treated for income tax purposes.
III. OTHER PROVISIONS OF UPAIA THAT RAISE TAX ISSUES
A. Receipts From Entities Generally
Under UPAIA, a trust’s share of income generated by an entity (corporation, partnership, LLC, REIT, etc.) is allocated to income only to the extent that the trust receives actual distributions from the entity.13 Prior law created a problem with respect to income generated by pass-through entities: where the entity had non-deductible expenses (e.g., sinking fund for roof repair) that were not offset by depreciation (which is a deductible non-cash item), the trust’s share of the entity’s taxable income exceeded cash flow to the trust. The trustee was thus faced with a difficult choice:
1. Include the trust’s full share of taxable income in trust accounting income.
This approach would obligate the trustee to distribute to the beneficiary some income that it had not received. Where would the trustee get the funds to make such a distribution? The trustee’s choices were to (a) invade principal; (b) establish a trust level "depreciation" reserve under authority of old Probate Code § 16308(b); or (c) create an account payable from principal to income. Each of these options presented potential administration problems.
2. Include in accounting income only the actual receipts from the entity.
This approach would obligate the trustee to distribute to the income beneficiary only the income actually received, but the trust would have to pay income tax on excess taxable income that was trapped at the trust level. The trustee was required in that situation to pay the income tax out of principal. If charging such income tax to principal created an inequity, the trustee would have to consider whether to create an account payable from income to principal.
It is now clear that the trustee has no obligation to distribute to the income beneficiary taxable income that the trust has not actually received. Under the new law (which is similar to choice #2 described above), the trustee still has the problem of trapping the trust’s share of undistributed entity taxable income at the trust level for income tax purposes. However, we now have clear guidance as to the source for payment of the trust level income tax on the trapped income. A new rule (found in § 16374(c)) charges such income tax to principal.
Charging income taxes on such "phantom" income to principal may under some circumstances be unfair to the principal beneficiaries. If this is the case, the trustee has a remedy for the inequity: another new rule (found in § 16375(a)) allows the trustee to make adjustments between principal and income "as necessary to offset the shifting of economic interests or tax benefits" that result from charging such income tax to principal.
B. Treatment of Net Short-Term Capital Gains From Mutual Funds and REITs
Money received from a regulated investment company (e.g., a mutual fund) or from a real estate investment trust (REIT) is principal so long as the distribution is a "capital gain dividend" for federal income tax purposes.14 A "capital gain dividend" is defined in the Internal Revenue Code (I.R.C.) as the excess of net long-term capital gain over net short-term capital loss.15 Thus, by default, any net short-term capital gain distributed by a regulated investment company is allocated to income.
Net short-term capital gains distributed by mutual funds or REITs thus can no longer be netted against long-term capital losses realized by the trust. If the trust does not have enough long-term capital gains to offset its long-term capital losses, the excess capital losses will be trapped at the trust level, where their deductibility will be at least deferred, if not precluded.16
Prior California law17 provided that such mutual fund or REIT distributions "made from ordinary income" were income, while all other such distributions were principal. The effect of that provision was to permit the allocation of short-term capital gains to principal, thereby deferring their realization as taxable income.18 Given the high turnover rate within many mutual funds,19 this new rule may create a significant tax trap for trustees.
C. Separate Accounting for Unincorporated Business Activities
Under new § 16352, a trustee who is conducting an
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unincorporated business activity may now account separately for that activity rather than including it in the general accounting records of the trust, if the trustee determines that doing so is in the best interests of all of the beneficiaries.20 This new provision is intended to enable the trustee to account for business activities as though the business were in corporate form.21
Under this new provision, the trustee can account separately for all kinds of business activities, including farming and ranching activities and real estate rental activities, regardless of whether the activity is a continuation of the settlor’s own business activity. A trustee who accounts separately can then decide how much of the net receipts of the business should be retained for working capital, acquisition of fixed assets, etc. (which amount can be allocated to principal), and how much of the balance of net cash receipts should be accounted for as income versus principal in the general accounting records of the trust.
Section 16352 is an extremely important provision because it effectively creates a separate adjustment power that is not subject to the various limitations (and safeguards) found in § 16336. This provision offers a trustee great accounting flexibility. The critical importance of this provision as an "escape hatch" for avoiding unfavorable allocations will become clearer in the context of the new 90/10 rule for allocation of receipts from liquidating assets (discussed below).
D. New Rules for Allocating Receipts Normally Apportioned
New rules now exist for allocating receipts from the following kinds of assets, which are normally apportioned between principal and income:
1. deferred compensation arrangements(includ-ing retirement plans and individual retirement accounts), annuities, etc;22
2. liquidating assets generally (leaseholds, patents, copyrights, royalties, and rights to receive installment payments without interest);23
3. minerals and other natural resources;24
4. timber;25
5. derivatives and options;26 and
6. asset-backed securities.27
A few of these sections raise particular tax issues, which will be discussed below.
E. Power to Make Equitable Adjustments
A trustee (or executor) now has the power to adjust between principal and income, apart from § 16336 adjustment power, as necessary "to offset the shifting of economic interests or tax benefits between income beneficiaries and remainder beneficiaries" that arise from:
1. trustee decisions;
2. distributions the fiduciary makes; or
3. the pass-through of an entity’s taxable income to the trust or estate, or to a beneficiary.28
One particular adjustment is mandatory. Section 16375(b) requires the trustee to reimburse principal from income for any increase in estate tax resulting from trustee’s decision to claim expenses paid out of principal as an income tax deduction rather than an estate tax deduction, thereby reducing the marital or charitable deduction.
IV. THE NEW "90/10" APPROACH TO RECEIPTS FROM WASTING ASSETS
A new and important theme runs through new §§ 16360-16367, relating to allocation of receipts that are normally apportioned. UPAIA takes a new, "90/10" approach to various assets that are liquidating or wasting in nature: 90% of such receipts is allocated to principal, and just 10% is allocated to income.
The 90/10 rule is biased in the short-term in favor of principal, on the theory that an allocation to principal will enable the trustee to acquire income-producing assets to replace the wasting asset, thereby maintaining the longer-term income flow for the income beneficiary. A related rationale for the rule is that a mistake in favor of principal will tend to correct itself over time as the income beneficiary receives increased income from the enhanced principal base, whereas a mistake in favor of income cannot be corrected because no part of the overpayment to income will ever be available to principal.
This is a big change from California’s prior approach, which was heavily biased in favor of the income beneficiary.29 The old rule tended to "front-load" income. The new rule will significantly reduce – at least in the short run – the amount allocated to income. Over time, the rule will presumably be fair
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to the income beneficiary, because it will increase the principal base available to generate income. Whether the new rule will actually be fair to the income interest depends upon length of income interest. The longer the term of the income interest, the greater the opportunity for the income interest to recover its fair share of the receipt.
A. Receipts From Liquidating Assets Generally
Receipts from " liquidating assets" – i.e., assets whose value will diminish or terminate because the asset is expected to produce receipts for a period of limited duration – are covered in § 16362.
The definition of liquidating assets includes leasehold, patent, copyright, and royalty rights. It also includes any right to receive payments under an arrangement that does not call for payment of interest on the unpaid balance (in particular, lottery payments).
B. Receipts From Retirement Plans, IRAs, Deferred Compensation Plans, Etc.
Deferred compensation plans, annuities, qualified retirement plans, individual retirement accounts (IRAs), stock ownership plans and the like are given separate statutory treatment (in § 16361) because of their special tax characteristics.30 A payment qualifies for special treatment under this section where it is a payment that " a trustee may receive over a fixed number of years or during the life of one or more individuals because of services rendered or property transferred to the payer in exchange for future payments."31
1. General Rule for Allocation
To the extent that a payment " is characterized as interest or a dividend or a payment made in lieu of interest or a dividend," the trustee must allocate it to income. The balance goes to principal.32 If no part of the payment is characterized as interest or a dividend or the equivalent thereof, the entire payment is principal.33
2. Special Rule for Required Minimum Distributions
If a required minimum distribution from a qualified plan or IRA would otherwise be allocated entirely to principal (because no part of the payment is characterized as interest, a dividend, or an equivalent payment), 10% is allocated to income and 90% to principal.34 An exception to the 90/10 rule is provided for required minaimum distributions to a QTIP Trust, if more must be allocated to income in order to obtain an estate tax marital deduction for a trust.35
3. Criticisms of 90/10 Default Rule
Numerous retirement benefits experts have been critical of 90/10 rule for required minimum distributions, especially as it applies to IRAs and other "individual account" plans (e.g., 401(k)s, 403(b)s, and Keogh plans).36 These critics point out that individual account plans – or at least those in custodial form rather than trusteed form – are the functional equivalent of direct ownership of the underlying assets by the participant or account owner and that the activity inside the account, including receipt of interest and dividends, is transparent. Thus, even where the payer does not identify on its Form 1099 what portion of distributions for the year represents interest and dividends, the trustee could readily determine such amount.37
a. Traps Income at Trust Level
The critics contend that the default rule should pass through the accounting income earned within an individual account to the income beneficiary because failure to do so will likely trap taxable income at the trust level.38 Income trapping occurs because 100% of a required minimum distribution is likely to be taxed to the trust as ordinary income, while only 10% of the same distribution can be deducted by the trust under I.R.C. § 661(a).39 Given the highly compressed income tax rates applicable to trusts, trapping of income at the trust level is likely to result in a greater overall income tax burden than would be imposed if all dividends and interest earned inside the plan or account were instead treated as accounting income for purposes of the Act, thereby justifying its distribution to the income beneficiary and a corresponding distribution deduction under I.R.C. § 661.40
b. Unclear Application to Distributions Under "Five-Year Rule"
Another problem with § 16361 that has been identified by critics is its unclear treatment of distributions made under the so-called "five-year rule" of I.R.C. § 401(a)(9)(B)(ii). The five-year rule, where it applies, requires that distribution of the entire plan or account be taken within five years after the death of the plan participant or account holder. That distribution can be taken in equal installments during the five-year period, or at irregular intervals and amounts, or all at once at any point during the five-year period. The Act creates some confusion about whether periodic distributions under the five-year rule would be considered payments that are "required to be made," which characterization is necessary to trigger the 90/10 rule. If none of such payments falls within the 90/10 rule, the entire plan or account payout is treated as principal.41
The Act does clearly characterize a single lump-sum withdrawal of the entire account balance, regardless when during the five-year period it may be taken. Section 16361(c) states, in part, that if a payment received "is the entire amount to which the trustee is entitled," the trustee shall allocate the entire payment to principal.42 The Act also supports treating partial distributions within the five-year period as entirely principal, although the characterization of such distributions is not entirely clear.43
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c. Long Distribution Period Shortchanges IncomeBeneficiary
Apart from these tax and accounting problems, critics also note that where the distribution period is long, the 90/10 rule will likely result in distributions to the income beneficiary (other than a spouse) that are much smaller that the settlor would have intended. One such critic offers the simple example of required minimum distributions from an IRA being paid out over a 20-year life expectancy (assuming no recalculation). In that case, the annual income distribution would amount to only .5% (10% of 1/20) of the value of the IRA. The beneficiary would thus receive only $5000 per year on a $1 million IRA. The settlor would presumably have intended that the beneficiary receive much more than this. Given the 90/10 rule for required minimum distribution, "success" in terms of income tax planning could thus be "failure" in terms of trust distribution planning.
4. Impact of New Separate Share Rules
Retirement accounts are, as a general rule, entirely income in respect of a decedent (IRD).45 The new separate share rules under I.R.C. § 663(c) allocate the principal portion of IRD in a manner that may cause unintended and unfavorable income tax consequences.46
On December 27, 1999, the I.R.S. promulgated final regulations under I.R.C. § 663(c).47 Given the 1997 amendments to I.R.C. § 663, these new regulations apply to decedent’s estates, including former revocable trusts (referred to in the regulations and hereinafter as "qualified revocable trusts"), as well as to non-grantor trusts. The purpose of the regulations is to determine the amount of distributable net income (DNI) that will be taxable to trust beneficiaries and to the trust itself. In general, the regulations provide that DNI will be allocated prorata among those separate shares of the estate or trust that are entitled to share in the appreciation or depreciation during administration or in the income generated during administration.48 In the case of estates and qualified revocable trusts, a separate share ordinarily exists "if the economic interests of the beneficiary or class of beneficiaries neither affect nor are affected by the economic interests accruing to another beneficiary or class of beneficiaries."49 Normally, distributions to a separate share of an estate or trust do not carry out DNI where that share is not entitled to share in the income generated during administration or in the appreciation or depreciation of the estate or trust during administration. Distributions to such shares, therefore, are not deductible by the estate or trust, and the recipient beneficiary is not required to include the distribution in income. Thus, for example, the funding of a pecuniary marital bequest or a pecuniary gift to a bypass trust (which, in California, is entitled only to interest and not to a share of income earned during administration50) does not carry out DNI, at least where it is funded at date of distribution values.51
A full discussion of the separate share rules is beyond the scope of this article. However, one aspect of the rules is particularly relevant here, namely, their treatment of IRD. Contrary to the general rule cited in the preceding paragraph, Treasury Regulation § 1.663(c)-2(b)(3) provides that the principal portion of IRD is to be allocated prorata among the separate shares that could potentially be funded with such IRD, according to the relative value of each share, "irrespective of whether the share is entitled to receive any income under the terms of the governing instrument or applicable local law."52 Thus, where a retirement account is made payable to an estate or to a qualified revocable trust as a whole, and the will or trust in question calls for division of the estate into marital and nonmarital shares, both shares will be deemed to have received a prorata portion of retirement account distributions (to the extent such distributions are principal for accounting purposes), regardless what kind of formula is used to effect the division into shares and regardless how the retirement account payments were in fact allocated by the executor or trustee.
The effect of this deemed allocation is to require even a pecuniary bypass gift to pay a portion of income taxes generated by
the principal portion of the retirement account distributions, even where (as normally occurs) the trustee actually allocates this IRD away from the pecuniary gift in order to avoid acceleration of income.53 The problem can be avoided by including a provision in the governing instrument that specifically directs an allocation of the retirement account payments to the surviving spouse or to the marital deduction trust. However, directing a particular allocation of retirement account payments will often defeat the funding flexibility that the testator or settlor was trying to achieve by having the account payable to the estate or the trust as a whole.
The potential problem created by this deemed allocation of IRD is exacerbated in the case of retirement accounts because the Act allocates a minimum of 90% of most retirement account distributions to principal.54 The separate share rules thus create yet another argument for avoiding the default rule of § 16361, either through appropriate drafting or by use of the adjustment power where it is available.
5. Can and Should § 16361 Be Amended?
The State Bar and other interested parties are currently considering whether and how to amend § 16361. Critics say that the default rule in that section should require the trustee to identify the accounting income inside the individual plan or account and assume that such income is distributed first.55 Drafting such a rule, however, has proved to be difficult, and not everyone agrees that it would make a good default rule. Such a "look-through" approach would place a burden on trustees. Institutional trustees may have trouble applying the rule to a large volume of trusts, and individual trustees may have trouble knowing how to administer it. However, the Act already requires trustees to
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determine accounting income generated inside a tax-deferred account where the benefits are payable to a marital deduction trust.56 If trustees are capable of determining inside accounting income in marital deduction trusts, they are presumably capable of doing so in the context of other trusts.
The reader should keep in mind that § 16361 is a default rule and may be superceded by contrary provisions in the governing instrument.57 Also, if the § 16336 adjustment power is available, use of the power can help cure problems produced by the 90/10 rule. There is some question about whether the adjustment power applies to receipts from retirement plans and accounts. In particular, has the third condition of § 16336 been met? Is there any investment decision involved that invokes a duty which conflicts with trustee’s duty to treat beneficiaries impartially? The primary author of the Uniform Act (E. James Gamble) has stated in unpublished comments that there is such an investment decision involved and that the adjustment power was intended to apply.
C. Receipts From Minerals, Water, and Other Natural Resources
Receipts from minerals, water, and other natural resources (other than nominal delay rental or bonus on a mineral lease or a production payment that contains an interest factor) are treated in § 16363. A nominal bonus, nominal delay rental, or nominal annual rent on a lease is allocated to income. Where the receipt is from a production payment, it is allocated to income " if and to the extent that the agreement creating the production payment provides a factor for interest or its equivalent." The balance is allocated to principal.58
This rule should be contrasted with the former rule on production payments, which also allocated the interest factor amount to income but apportioned the balance to principal only in the proportion that the unrecovered cost of the production payment bore to the balance owed on the production payment.59 The new rule is thus more biased in favor of principal than the former rule (or less biased in favor of income, depending upon one’s point of view).
Any other payments from an interest in minerals or natural resources is allocated 90% to principal and 10% to income. Again this represents a substantial contrast with the former rule, which allocated all of such payments entirely to income unless the trustee exercised its discretion to apportion the payments. The former rule allowed the trustee to apportion all royalty payments, bonus payments, and payments from a working interest or a net profit interest, but it limited the amount allocable to principal to the lesser of the percentage allowed as a depletion deduction for federal income tax purposes or 50% of the net receipts.60 Given the federal tax law in recent years, the old rule generally limited the principal allocation to 22% or less.61
The Uniform Act comment to this section notes that the old provision caused too much to be paid out as income. As wells were depleted, income fell drastically. Allocating a larger proportion to principal enables the trustee to acquire other income-producing assets that will continue producing income after the mineral reserves are exhausted.
Amounts received for a renewable interest in water are income. If the water source is not renewable, the payments are allocated 90% to principal and 10% to income. The old law did not specifically refer to water, but former § 16310 presumably applied, limiting the principal allocation to "a reasonable allowance for depletion or amortization." Thus, the treatment of receipts from water under the Act, like the treatment of other natural resources, reflects a shift in the allocation approach away from income and in favor of principal.
D. Receipts from Timber
The 90/10 rule does not apply to receipts from the sale of timber and related products. Net receipts from such items are to be allocated to income "to the extent that the amount of timber removed from the land does not exceed the rate of growth of the timber during the accounting periods in which the beneficiary has a mandatory income interest." Net receipts are to be allocated to principal to the extent that the amount of timber removed exceeds the rate of growth.62 In arriving at net receipts, the trustee must deduct a reasonable allowance for depletion and transfer that amount to principal. Miscellaneous payments (such as bonuses and advance payments) are allocated to principal.63
E. Effect of Separate Accounting for Business Activity Under § 16352
The rules of §§ 16363 and 16364 relating to natural resources and timber operations do not necessarily apply if the trustee accounts separately for receipts from such activities under § 16352. As discussed above, § 16352 gives the trustee very broad discretion to determine how much of net receipts from an unincorporated business activity to retain as a reserve and how much of the balance should be allocated to income versus principal. That section explicitly applies to the extraction of minerals and other natural resources and to timber operations.64 Thus, if the trustee finds that applying the default rules of § 16363 and § 16364 would not be in the best interests of all of the beneficiaries, the trustee can adopt a different approach.
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V. INCOME TAXATION OF AN ADJUSTED PAYOUT
The key to the income tax treatment of trust distributions, both at the trust level and the beneficiary level, is the concept of distributable net income ("DNI"), which is defined in I.R.C. § 643(a). The deduction for trust distributions allowed under I.R.C. § 661 is limited to the DNI of the trust. Taxable income received by the trust that cannot be offset by a distribution deduction is, of course, trapped at the trust level. As noted earlier, it is generally undesirable to trap taxable income at the trust level because of the highly compressed rate brackets for trusts. In general, therefore, it is desirable to maximize DNI.
A. The Result Where Current Income Exceeds Distributions
Whenever current income exceeds the unitrust amount or other amount to be distributed (pursuant to trustee’s exercise of adjustment power in favor of principal, or otherwise), excess income will be accumulated. Distributions to a beneficiary will be deductible by the trust under I.R.C. § 661 and includible in the taxable income of the beneficiary under I.R.C. § 662. The balance of income will be taxed to the trust. Although trapping of income at the trust level is generally undesirable, there are no particular uncertainties here.
B. The Issue Presented Where Payout Exceeds Current Income
The problem arises where the payout amount exceeds current income so that some principal must be distributed. Under I.R.C. § 643, capital gains are excluded from DNI unless they are " paid, credited, or required to be distributed to any beneficiary during the taxable year." The only way to make capital gains part of DNI is to somehow allocate them to income.
Treasury Regulation § 1.643(a)-3(a) describes three limited conditions under which capital gain can be included in DNI.65 None of the three conditions described in the regulation clearly covers an allocation of capital gain to income pursuant to exercise of the adjustment power. The only one of the three conditions described in the Treasury Regulation § 1.643(a)-3(a) that could potentially be read to permit inclusion of capital gain in DNI is the first of the three, that is, where capital gains are "allocated to income under the terms of the governing instrument or local law."66
C. Is a UPAIA Adjustment an Allocation "Under Local Law"?
Is exercise of the adjustment power an allocation to income "under local law"? Existing law does not offer a clear answer to this critical question. Treasury Regulation § 1.643(b)-1 provides that "trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for this purpose [i.e., defining ‘income’]." By analogy, a discretionary allocation decision by a fiduciary that departs fundamentally from concepts of local law would also presumably not be recognized for income tax purposes. Capital gain, of course, is normally allocated to principal. If the IRS were to treat that general rule as the operative " concept of local law," then taxpayers would have trouble successfully including capital gains in DNI.
Fortunately, the IRS has just addressed this question in proposed amendments to the regulations. On January 18, 2001, the IRS published proposed amendments to the regulations under various code sections that are designed to respond to changing definitions of income under state law.67 These proposed amendments deal specifically with state statutes that authorize unitrust distributions and those that authorize a fiduciary to make equitable adjustments between principal and income to fulfill the fiduciary’s duty of impartiality between the income and remainder beneficiaries.
The proposed amendment to § 1.643(a)-3 of the regulations still requires fiduciaries to meet one of the same three conditions for including realized capital gains in DNI. However, the proposed amendment clarifies that fiduciaries may meet these conditions " pursuant to a reasonable and consistent exercise of discretion … (in accordance with a power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law)", as well as pursuant to a more specific authorization granted by the terms of the governing instrument or state law.68
The proposed amendment to § 1.643(b)-1 of the regulations still provides generally that trust provisions that depart fundamentally from traditional principles of income and principal (e.g., allocating ordinary income to income and capital gains to principal) will not be recognized for income tax purposes. However, the proposed amendment adds the following very helpful language:
"… 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 fair market value of the trust assets is a reasonable apportionment of the total return of the trust. Similarly, 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
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apportionment of the total return of the trust. These 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 by the governing instrument, if not inconsistent with local law."69 (Emphasis supplied.)
The obvious intent of this proposed amendment is to give income tax effect to adjustments made under the Uniform Act. Despite a couple of technical problems,70 this proposed amendment offers trustees reassurance that capital gains allocated to income pursuant to an adjustment under UPAIA can safely be included in DNI so long as the trustee consistently treats them in that manner.
VI. EFFECT OF ADJUSTMENTS ON GSTT EXEMPT TRUSTS
The Tax Reform Act of 1986 (TRA 86) repealed the old 1976 generation-skipping transfer tax retroactively and enacted a new generation-skipping transfer tax (GSTT), which applies to all generation-skipping transfers made after October 22, 1986.71 TRA 86 provided that the GSTT would not apply to any transfer from a trust that was irrevocable on September 25, 1985, so long as the transfer was not made out of additions to the trust made after that date.72 TRA 86 said nothing, however, about the effect of modifications or constructions on otherwise exempt trusts (often referred to as "grandfathered" trusts).
A. Is an Adjustment a Prohibited Modification?
No Tax Court decision, Revenue Ruling, or other citable precedent has thus far addressed the effect of modifications and constructions on GSTT grandfathered trusts. In numerous private letter rulings, however, the IRS has held that a modification will not cause a trust to lose its grandfathered status so long as the modification does not result in any change in the "quality, value, or timing" of any beneficial interest in the trust.73 These rulings appeared to sanction modifications that may incidentally increase the amount passing to lower generation beneficiaries, so long as the modification was clearly authorized under the applicable state law and consistent with the settlor’s intent. However, the "quality, value, or timing" standard was disturbingly broad. The IRS then announced several years ago that it would no longer issue private letter rulings on this subject.
B. Proposed Amendments to Regulations Failed to Address the Issue
The IRS issued proposed amendments to their regulations on this subject on November 18, 1999.74 These amendments appeared to articulate a more liberal standard than that applied in the prior private letter rulings. Under the proposed amendments, a modification of the governing instrument would not cause an exempt trust to lose its exempt status if:
1. The modification did not shift a beneficial interest in the trust to any beneficiary who occupied a lower generation (as defined in I.R.C. § 2651) than the person or persons who held the beneficial interest prior to the modification; and
2. The modification did not extend the time for vesting of any beneficial interest in the trust beyond the period provided in the original trust.75
The proposed amendments gave seven examples of the application of this rule. Unfortunately, none of the examples addressed the exercise of an adjustment power. The proposed amendments, therefore, still left taxpayers without adequate guidance as to when the exercise of an adjustment power would or would not cause an exempt trust to lose its exempt status.
C. Final Regulations and Latest Proposed Regulations Do Address the Issue
On December 19, 2000, the IRS issued its final generation-skipping transfer tax regulations.76 Almost exactly one month later, on January 18, 2001, the IRS issued proposed amendments to those new final regulations simultaneously with their proposed amendments concerning the definition of income for trust purposes. The proposed amendments to the GSTT regulations address the modification of GSTT grandfathered trusts in one very helpful sentence (discussed below).77 These proposed amendments provide critical guidance that was lacking under prior law.
The final regulations under IRC § 2601 retain the same basic test for determining when a modification of the trust instrument will cause a trust to lose its exempt status. Thus, the inquiry will continue to turn, as a rule, on whether the modification results in a shift of a beneficial interest to a lower generation member, a criterion that, without further explication, tends to beg the question rather than answer it. However, the final regulations do include a general statement of the circumstances under which a modification will be considered to shift a beneficial interest to a lower generation beneficiary. Such a shift will be deemed to have occurred if the modification " can result in either an increase in the amount of a GST transfer or the creation of a new GST transfer."78 This determination is to be made by measuring the effect of the
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governing instrument on the date of the modification against the effect of the instrument in existence immediately before the modification. If the effect of the modification cannot be immediately determined, it is deemed to shift a beneficial interest to a lower generation beneficiary.79
Two new examples have been added in the final § 2601 regulations that bear on the effect of a trustee’s exercise of an adjustment power under the Uniform Act. Again, none of the examples deals directly with this issue. However, these two new examples offer helpful guidance by analogy. Example 8 deals with the conversion of an income rule trust to a unitrust. The example involves a court ordered modification of a trust that previously provided for payment of income to A for life and remainder to A’s issue. The modification converts A’s income interest into a right to receive the greater of the income or a fixed percentage of the trust assets valued annually. The example states that such a modification does not shift a beneficial interest to a lower generation because the change "can only operate to increase the amount distributable to A and decrease the amount distributable to A’s issue." Nor does such a modification extend the time for vesting of any beneficial interest beyond the period provided for in the original trust.80
Example 8 of course, is not directly applicable to the exercise of an adjustment power because it involves a court ordered modification of the instrument itself rather than the exercise of an administrative power conferred by statute. Nevertheless, its conclusion is instructive. According to its logic, if a trustee makes a one-time adjustment in favor of an income beneficiary who is a member of a generation senior to that of the remainder beneficiaries (which is most often the case), the adjustment has the effect of shifting value " upstream" rather than " downstream" in the generational flow and would therefore pass muster under the final regulations. Likewise, if a trustee makes a standing adjustment that operates prospectively in a manner similar to the modification described in Example 8 (i.e., converting the trust from an income only payout to a payout that is the greater of income or a unitrust amount), the final regulations should protect the exempt status of the trust.81 However, an adjustment (or a court ordered modification) that simply converted the trust to a straight unitrust would probably fail the test, because a unitrust payout provision could under some market conditions have the effect of decreasing the amount that the senior generation income beneficiary would otherwise receive, thereby presumably increasing the amount ultimately passing to the lower generation remainder beneficiary.
Example 9, likewise deals with a modification of an income rule trust that provides for payment of income to A for life and remainder to A’s issue. In that example, applicable state law allocates capital gain to principal, and the trust is modified to enable the trustee to allocate capital gain to income. Once again, the modification does not shift a beneficial interest to a lower generation beneficiary because it can only have the effect of increasing the amount distributable to the senior generation beneficiary (i.e., to A, the income beneficiary). Nor does such a modification extend the time for vesting of any beneficial interest beyond the period provided for in the original trust.82
Example 9, again involves a modification of the trust instrument itself rather than the exercise of an administrative power conferred by statute.83 However, Example 9 is potentially even more useful than Example 8 for protecting a trustee who exercises the adjustment power. Under current financial market conditions, adjustments under the Uniform Act will generally be made in favor of the income beneficiary, who will usually be a member of a generation senior to that of the remainder beneficiaries. Such adjustments will often entail the reallocation of capital gain to income. Such adjustments, like those adding a unitrust parameter to the current payout, have the effect of shifting value "upstream" rather than "downstream" in the generational flow and should therefore pass muster under the final regulations. The fact that the change is being made pursuant to the exercise of an administrative power rather than a court order should not change the result under the regulations, because the regulations properly focus on the economic effect of the change rather than the procedure used to effect the change. Nor should the result turn on whether the trustee’s exercise of an administrative power has the effect of actually modifying the terms of the governing instrument. The regulations are clearly intended to apply to administrative actions as well as to modifications, so long as such actions have the economic effect of shifting beneficial interests in more than an incidental way.84
The new proposed regulations concerning the definition of income for trust purposes have proposed the addition of one sentence to the end of Regulations § 26.2601-1(b)(4)(i)(D)(2). That sentence reads as follows: "In addition, administration of a trust in conformance with applicable state law that defines the term 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 § 1.643(b)-1 of this chapter."85 These proposed regulations also add a new Example 12 that specifically deals with a trustee’s equitable adjustment of total return between principal and income pursuant to a state statute authorizing adjustments as necessary to achieve impartiality.86 While proposed regulations are not the law unless and until they become final, these proposed additions to the final regulations are a strong indication that reasonable exercises of the adjustment power will not jeopardize the GSTT exempt status of a grandfathered trust.
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VII. CONCLUSION
The Uniform Act is a significant advance in the law relating to trust and estate administration. In particular, the power to adjust total return between principal and income is helpful, because it enables trustees to invest appropriately under the Prudent Investor Rule without breaching their duty to treat both current and future beneficiaries impartially.
Unfortunately, uncertainties concerning tax treatment of adjustments between principal and income have thus far limited the ability of fiduciaries to make full use of the adjustment power. However, within the past few months, the IRS has offered helpful clarifications that should encourage fiduciaries to exercise the adjustment power where it is otherwise available. While the very helpful clarifications issued most recently are only in the form of proposed amendments to regulations and are therefore not yet law, the proposed amendments, together with the final regulations in the GSTT arena, are a clear signal that the IRS intends to take a reasonable, liberal approach to income taxation of adjusted payouts. The IRS is clearly attempting to fashion rules that facilitate rather than frustrate adjustments under the Uniform Act.
Although the proposed amendments to §§ 643(a) and (b) of the regulations are not yet law, fiduciaries would be well advised not to decline to exercise the adjustment power solely on the ground that income tax treatment may still be uncertain. The calculus of financial risk supports such advice. The financial consequences of reporting capital gain in a manner that is later determined to have been faulty are not likely to be disastrous, and the fiduciary has a statutory tool available to adjust for any resulting inequities as between principal and income. The financial consequences of failing to adjust, on the other hand, are likely to be considerable over time, especially if failure to adjust compels the trustee to continue investing in a manner that does not achieve appropriate total return. Given a choice between the risk of an adverse audit outcome on this income tax issue if the trustee makes an adjustment and, on the other hand, the near certainty of breaching either (or both) its investment duties or its duty of impartiality if the trustee declines to make an adjustment, making the adjustment will generally be the wiser choice. The potential financial cost to the beneficiaries (and perhaps ultimately to the trustee) of continuing inadequate investment performance should make use of the adjustment power a compelling option in cases where the power is available.
The potential effect of an adjustment on a GSTT exempt trust is a more daunting question, because, in many if not most instances, loss of the GSTT exemption will be disastrous economically. Where the GSTT exemption is at stake, a fiduciary simply cannot afford to be wrong in its decision to adjust. The final regulations on this subject are a substantial improvement over the proposed regulations and prior private letter rulings, and the recent proposed amendments to the final GSTT regulations specifically sanction adjustments properly made under the Uniform Act. Even given this guidance, however, trustees will have to carefully examine every proposed adjustment to determine whether it could result in a potential shift of benefit to a lower generation and err on the side of caution.
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Notes:
*. Downey, Brand, Seymour & Rohwer LLP, Sacramento, California.
1. Chapter 145, California 1999 Statutes.
2. Unless otherwise noted, all references to section numbers will be to the California Probate Code.
3. Former California Probate Code §§ 16300-16350.
4. For the text of the Uniform Act plus NCCUSL’s prefatory note and official comments, see the University of Pennsylvania Law School website at http://www.law.upenn.edu/bll/ulc/fnact99/1990s/upaia97.htm
5. The Uniform Prudent Investor Act was adopted by NCCUSL in 1994 and enacted in California in 1995 as Probate Code §§ 16045-16054.
6. The Prudent Investor Rule was originally formulated as the Restatement (Third) of Trusts: Prudent Investor Rule (1992) and was later incorporated into the Uniform Prudent Investor Act.
7. California Probate Code § 16047(b).
8. California Probate Code § 16336(a).
9. These factors, which include the anticipated tax consequences of an adjustment, are drawn from § 2(c) of the Uniform Prudent Investor Act.
10. California Probate Code § 16336(b).
11. Id. § 16336(d).
12. Id. § 16336(e).
13. California Probate Code § 16350(b).
14. Id. § 16350(c)(4).
15. I.R.C. § 852(b)(3)(C) (1986).
16. I.R.C. §§ 1211(b), 1212(b), and 642(h)(1).
17. Former California Probate Code § 16306(c).
18. The new UPAIA rule on short-term capital gains can create trust accounting problems as well as income tax problems. If the trustee elects to reinvest mutual fund capital gains, short-term capital gains will inadvertently be reallocated from income to principal.
19. John C. Bogel has noted that the average turnover rate for U.S. equity funds in 1997 was 85%! See John C. Bogel, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, John Wiley & Sons, Inc., 1999, at page 25. Former § 16308(a) allowed a trustee to account separately for a business or farming activity, but only where the settlor previously conducted that activity as a sole proprietor or partner.
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21. See official comment to § 401 of the Uniform Act.
22. California Probate Code § 16361.
23. Id. § 16362.
24. Id. § 16363.
25. Id. § 16364.
26. Id. § 16366.
27. Id. § 16367.
28. Id. § 16375(a).
29. The general rule under prior California law (former § 16310) was that receipts from property subject to depletion or amortization could be allocated in the trustee’s discretion, but in not event could the amount allocated to principal exceed "a reasonable allowance for depletion or amortization." That rule, which was a departure from the 1962 Uniform Act, typically limited the principal allocation to 15% or less.
30. The special tax characteristics that such assets have in common are income tax deferred earnings inside the plan or account and ordinary income treatment (generally) of payments made from the plan or account. See I.R.C. §§ 401(a), 402(a), 408(d), and 72.
31. California Probate Code § 16361(a).
32. Id. § 16361(b). Neither the statute nor the official comments states by whom the payment is to be characterized. Presumably, the characterization must be made by the payer rather than the trustee. In fact, such characterizations are rarely made by the payer.
33. Id. § 16361(b).
34. Id. § 16361(c).
35. Id. § 16361(d).
36. See, for example: Steven E. Trytten, Trusts That Receive Retirement Plan Distributions Need to Define "Income" to Avoid Problems Under the 1997 Uniform Principal and Income Act, ALI-ABA Video Law Review course materials, May 18, 2000; Jeffrey A. Dennis-Strathmeyer, 21 CEB Estate Planning Reporter 66 (December, 1999); Michael J. Jones, How the New California Uniform Principal and Income Act Treats Distributions to Trusts from Qualified Retirement Plans and IRAs, 6 California Trusts and Estates Quarterly, Summer 2000, at 12-14.
37. Trytten, op. cit., at 5.
38. Dennis-Strathmeyer, op. cit., at 66.
39. For the year 2000, estates and non-grantor trusts reached the 28% marginal federal income tax bracket at just $1750 of taxable income, and the top 39.5% marginal bracket at just $8650 of taxable income.
40. Jones, op. cit., at 13.
41. California Probate Code § 16361(c).
42. Id.
43. Id. The last sentence of § 16361(c) provides that a payment is not "required to be made" to the extent that it is made because the trustee exercises a right of withdrawal. One can argue that because any partial distribution during the five-year period is not mandatory under the I.R.C. minimum distribution rules, it is necessarily made pursuant to the trustee’s exercise of a right of withdrawal, thereby causing the entire distribution to be treated as principal under the Act.
44 Dennis-Strathmeyer, op. cit., at 66. See Michael J. Jones, op. cit., at 13 for an even more dramatic example of low income distributions and trapping problems over a long payout period.
45. I.R.C. § 691(a).
46. See the very helpful discussion of this issue in Jerry A. Kasner, New Separate Share Regulations Have Substantial Impact on Postmortem Estate and Qualified Trust Administration, 22 CEB Est Plan Rep (August, 2000), pp. 5-9.
47. Treas. Reg. § 1.663(c).
48. Id. §§ 1.663(c)-2(b)(2) and 1.663(c)-4(b).
49. Id. § 1.663(c)-4(a).
50. California Probate Code § 16340(b).
51. Treas. Reg. § 1.663(c)-4(b) and § 1.663(c)-5, Example 4(ii).
52. Id. § 1.663(c)-2(b)(3).
53. Treas. Reg. § 1.1014-4(3).
54. California Probate Code § 16361. As noted above, if the distribution is not a required minimum distribution and no part of the distribution is characterized as interest or a dividend or an equivalent payment, the entire distribution is principal for accounting purposes.
55. Trytten, op. cit., at 5-6.
56. California Probate Code § 16361(d).
57. Id. § 16335(a).
58. Id. § 16363(a).
59. See former California Probate Code § 16309(a)(2).
60. Id. § 16309(a)(3).
61. I.R.C. § 613(b).
62. California Probate Code § 16364(a).
63. Id. § 16364(b).
64. Id. § 16352(c).
65. In order to be included in DNI, realized capital gains must be (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 utilized by the fiduciary in determining the amount which is required to be distributed to a beneficiary.
66. Treas. Reg. § 1.643(a)-3(a)(1) (as amended in 1975).
67. In addition to the comments in the text, these regulations are discussed at length in another article in this issue by James R. Chisholm, Subchapter J – The Proposed Section 643(b) Regulations, the Definition of Income and the Alloction of Capital Gains
68. Prop. Reg. § 1.643(a)-3(b).
69. Prop. Reg. § 1.643(b)-1.
70. The proposed amendment misstates the second pre-condition for the trustee’s having the power to adjust. The proposed amendment states that it refers to equitable adjustments that are permitted when … "the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust’s income …" (emphasis added). The reference should be to equitable adjustments that are permitted when the trust describes the amount that shall or may be distributed to a beneficiary by referring to the trust’s income. Also, the reference in the last sentence of the proposed amendment to "the terms of the governing instrument and local law" should be to "the terms of the governing instrument or local law."
71. Tax Reform Act of 1986, Pub. L. No. 99-514, § 1431(a), 100 Stat. 2085 (codified at scattered sections of 26 U.S.C.) [hereinafter TRA 86].
72. TRA 86 § 1433(b)(2).
73. See, for example, Private Letter Rulings 9610014, 9602016, and 9528012.
74. Prop. Treas. Reg. § 26.2601-1(b)(4).
75. Prop. Treas. Reg. § 26.2601-1(b)(4)(D).
76. Treas. Reg. § 26.2601-1; T.D. 8912; 65 Fed. Reg. 79735, 79738, Dec. 20, 2000.
77. REG-106513-00; see, in particular, Prop. Reg. § 26.2601-1(b)(4)(i)(D)(2).
78. Treas. Reg. § 26.2601-1(b)(4)(i)(D)(2).
79. Id.
80. Treas. Reg. § 26.2601-1(b)(4)(i)(E), Ex. 8.
81. One may question whether such a prospective adjustment is really authorized under the Uniform Act or the California Act. The author believes that such an adjustment can fall within the authority of the statute, under appropriate circumstances, but an express conversion provision, such as that being considered in Pennsylvania, would make the trustee’s power to do so clearer.
82. Treas. Reg. § 26.2601-1(b)(4)(i)(E), Ex. 9.
83. Interestingly, Example 9, unlike all of the other modification examples, does not specify that the modification is made pursuant to a court order. One might infer from this omission that the modification permitting the trustee to allocate capital gain to income could be made pursuant to the trustee’s administrative powers conferred by statute or under the instrument. New Proposed Regulation 26.2601-1(b)(4)(i)(D)(2), discussed below, reinforces this inference.
84. The preamble to the relevant portion of the regulations states that it provides rules governing "a modification, judicial construction, settlement agreement, or trustee action" with respect to an exempt trust. Example 10 under Treas. Reg. § 26.2601-1(b)(4)(i)(E) involves an administrative action to reduce the number of trustees. The example concludes that such change will not be deemed to shift a beneficial interest to a lower generation even though it reduces administrative costs, presumably because any economic benefit to the lower generation is merely incidental. By implication, even a mere administrative change will cause a trust to lose its exempt status if that change shifts a beneficial interest to a lower generation to more than an incidental degree.
85. Proposed Regulation § 26.2601-1(b)(4)(i)(D)(2).
86. Proposed Regulation § 26.2601-1(b)(4)(i)(E).