Distributable Net Income, Retirement Distributions, and Trusts – Oh My!

Take-Away: Irrevocable trusts are heavily taxed when they accumulate income. A mistaken belief is when an IRA is paid to the Trust that taxable income can be distributed to the income beneficiary of the Trust and avoid the high income tax brackets at the Trust’s level. That is not the case when the Trust is governed by the Tax Code’s distributable net income (DNI) rules, which can lead to much of that retirement plan distribution exposed to income taxation at the Trust’s t high tax bracket.

Background: We have covered this before (many would say we have covered it ad nauseam.) An irrevocable trust ‘s income is subject to the Tax Code’s 37% rate when it reaches just $12,950. In contrast, an individual does not reach the 37% federal income tax bracket until he or she reports $518,400 of taxable income. Add to that tax rate of 37% the 3.8% net investment income tax (NIIT), and the Trust’s accumulated income is often taxed above 40%. [An individual does have to pay the NIIT until his or her income exceeds $250,000.] If an IRA is paid to an irrevocable Trust, that distribution will be exposed to these confiscatory federal income tax rates.

Distributable Net Income: Contrary to an individual, however, a Trust is entitled to take a distributable net income (DNI) tax deduction for money that is paid to human trust beneficiaries. As a result, the individual trust beneficiary will pay the income tax on the distributed income at their lower marginal income tax rate. Thus, with the DNI deduction, taxable income can be shifted away from the Trust and to the trust beneficiary in the lower income tax bracket. Any income not so shifted will remain in the Trust and taxed at its very high rate.

Limits on DNI Deduction: There are some limitations on the DNI deduction however. For example, the distribution to the individual trust beneficiary must be in the same year the income was received by the Trust, or soon thereafter. And not every distribution from a Trust carries out  DNI to avoid high income taxes faced by the Trust.

• Trust Accounting Income: If a Trust instrument directs the trustee to “pay all income to my child” that does not mean that the trustee will automatically pass out all taxable income to the child that the Trust receives, including 100% of the IRA distribution to the Trust. Rather, the trustee will pay the Trust’s accounting income to the child.

Example: Jan dies and leaves her $1.0 million IRA payable to a Trust that Jan has established for the lifetime benefit of her brother, Joe, who is to receive all income from this Trust. Jan’s sister, Marlene is the Trustee. Marlene takes a lump sum distribution of Jan’s entire $1.0 million IRA. The Trust now has $1.0 million of taxable income. Under most states’ trust accounting laws, only a small portion of that $1.0 million will be treated as trust accounting income. Marlene cannot pay all of the IRA money out to Joe. Consequently, the Trust will expose most of the lump sum IRA distribution to the 37% federal tax rate.

Observation: The trustee should be given the discretion, or be required, to pay out all retirement plan distributions regardless of whether they are considered income or principal for trust accounting purposes. With a conduit see-through trust the trustee is required to pass through all IRA distributions from the Trust to the trust beneficiaries. With an accumulation see-through trust, the Trust instrument may need to expressly opt-out of the application of the Uniform Fiduciary Principal and Income Act which treats a large portion of a retirement plan distribution to the Trust as principal.

• Pecuniary Bequests: A fixed dollar pecuniary bequest under a Trust instrument does not carry out DNI. In contrast, a pecuniary bequest that is determined by a formula, such as an amount based on the size of the decedent’s taxable estate, will carry out DNI and thus be eligible for the DNI tax deduction.

Example: Jan’s Trust instrument provides that on her death $1.0 million is to be paid to her brother Joe, with the balance of the Trust estate held in trust for Joe’s children. Marlene, the trustee, cashes out the $1.0 million IRA and distributes that amount to Joe from the Trust. That distribution will not carry out DNI, and no DNI deduction will be available to Jan’s Trust. Joe will receive the entire $1.0 million income tax-free, and the continuing trust for Joe’s children will owe the income tax on the $1.0 million IRA distribution to the Trust.

Observation: If the decedent’s Trust is to be funded with a large IRA, it is wise to avoid making a substantial pecuniary bequest from the Trust. The bequest shifts the income tax burden arising from the IRA distribution onto the remaining assets held in the trust (usually for the benefit of other trust beneficiaries.)

• Separate Share Rule: The separate share rule applies to a Trust that is allocated into separate shares, which is the equivalent to creating separate multiple subtrusts. A distribution to one beneficiary reduces that individual’s share of the Trust’s assets assigned to his or her share, but it does not reduce other beneficiaries’ shares. In contrast, with a spray or ‘pot trust’ there is just one share, where the trustee makes distributions from the one share based upon many factors, usually in the trustee’s discretion. When an IRA is distributed to a Trust that is subject to the separate share rule, that gross income generally must be allocated proportionately among the shares, regardless of who actually receives a payment.

Example: A separate share rule Trust is established for Huey, Dewey and Louie. Donald is the Trustee. A $1.0 million IRA is payable to the Trust. Donald takes a lump sum distribution of the entire $1.0 million IRA. Donald plans to distribute $1.0 million from the Trust to Huey, who independently has business losses outside of the Trust that he can use to offset the resulting income tax bill on the $1.0 distribution to him. Donald’s plan is to make comparable $1.0 million distributions from the Trust to Dewey and Louie the following year. Donald’s plan will not work. The separate share rule requires that each of the shares created for Huey, Dewey and Louie will receive $333,333 taxable income from the IRA, even though the shares created for Dewey and Louie might receive other assets or non-cash assets in the division of the Trust estate.

Observation: In the administration of a Trust that is to receive a large IRA distribution, thought needs to be given to how to intentionally move gross income from the retirement plan distribution to the trust beneficiaries in the lowest marginal income tax brackets, in effect circumventing the separate share rule.

• Charitable Bequests: In a surprise to many, even if a Trust distributes DNI to a charity, the Trust does not receive a DNI tax deduction. There is no DNI deduction for payments to a charity. An entirely different Tax Code section applies to the charitable deduction taken by the trustee. A pecuniary bequest to a charity from the Trust can qualify for the charitable income tax deduction, even though it cannot qualify for a DNI deduction, but an entirely different set of rules and restrictions apply for a charitable income tax deduction that is claimed by a Trust.

Observation: It is usually more tax efficient (and simpler) to name the charity as a direct beneficiary of the IRA as opposed to paying the IRA to the Trust and then making a charitable bequest from the Trust.

• Distributions of (not from) The IRA: A distribution from an IRA is gross income. A distribution of the IRA itself (of the IRA) is not gross income. The Tax Code characterizes an IRA as the ‘right to receive” gross income. As a result, a trustee can avoid some of the DNI problems just described by transferring the IRA itself to the beneficiary.

Example: Ebenezer creates a separate share Trust for Huey, Dewey and Louie. He names Donald as Trustee. A $1.0 million IRA is made payable to the Trust. Donald transfers the IRA directly to Huey, with assets of equivalent value transferred to Dewey and Louie. The transfer of the IRA to Huey will not trigger any income tax at the Trust level. Nor does Donald have to allocate gross income proportionately among the trust shares created for Huey, Dewey and Louie, because there is no gross income to allocate from the Trust.

Observation: This distribution of the IRA will not work with a pecuniary bequest, but it might be useful if the goal is to steer the IRA’s taxable income to a trust beneficiary who is in a much lower income tax bracket or who has other available deductions or losses to minimize the tax burden on receiving the IRA.

Conclusion: While we struggle with learning the new distribution rules under the SECURE Act, it is best to not forget how distributions from the IRA will be taxed if an accumulation see-through Trust is named as the IRA beneficiary. It is bad enough having to empty the inherited IRA within 10 years of the owner’s death. It is even worse if the distributions to the Trust at taxed at a 37% federal income tax rate.