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George F. Bearup, J.D. Senior Legal Trust Advisor

12-Dec-18

Primer on the ‘Separate Share’ Rule

Take-Away: The separate share rule is relatively simple provision under the Tax Code. However, the application of the separate share rule with regard to how it assigns taxable income (DNI) under an estate or trust is not so simple. The application of the rule can cause trust beneficiaries to be treated unequally. The separate share rule applies only to a complex trust for income tax reporting purposes. The rule might apply to a trust in some years, while in other years the rule may not be applied, as the rule’s application is determined each year depending on the facts and circumstances of the trust and its administration.

Background: The backstory to the separate share rule is that a non-grantor trust that accumulates income subjects that income to the highest marginal federal income tax bracket (37% + the 3.8% net investment income tax) once that trust’s accumulated income exceeds $12,500 in a year. A trust that distributes income to its beneficiaries can take an income tax deduction for that distribution of income, which reduces the accumulated income in the trust, by shifting that taxable income to the beneficiary who receives the distribution from the trust. Where that ultimate income tax liability rests depends on whether the separate share rule applies to the trust.

  • Definition of Separate Share: A separate share is defined as that portion of a trust that is administered as if it were a separate trust. [Treas. Reg. 1.663(c)-3.] Example: A trust instrument is created for the benefit of three beneficiaries which requires that distributions to each beneficiary may be made only from the respective share of that particular beneficiary, without affecting the shares of the other beneficiaries. The separate share rule will apply to this type of trust. In contrast, the separate share rule would not apply if the trust instrument actually directs the trustee to create and administer a separate trust for the benefit of each of the named trust beneficiaries. Similarly, the separate share rule will not apply to a trust where the trustee is given the discretion to sprinkle unequal distributions of income or principal from the entire trust among a group of trust beneficiaries, because a distribution to one beneficiary will affect the interests of the other trust beneficiaries. [Treas. Reg. 1.663(c)-3(b).] A specific bequest under a trust instrument that is paid in three or fewer installments is not considered to be a separate share because those distributions will not carry out distributable net income (DNI) from the trust to the recipient trust beneficiary. [Treas. Reg. 1.663(c)-4.]
  • Key point: the separate share rule is mandatory if the requisite facts are present- the rule is not an election made by the trustee. [Treas. Reg. 1.663(c)-1(d).]
  • Purpose of Separate Share Rule: The statute [IRC 663(c)] states that the separate share rule exists for the sole purpose to determine DNI in the application of IRC Sections 661 (authorizing the distribution tax deduction by the trustee of a complex trust) and IRC 662 (causing the inclusion of the trust distribution of taxable DNI in the gross income of the recipient trust beneficiary.) [Treas. Reg. 1.663(c)-1(b).] Thus, the separate share rule operates within a single trust to ensure that the tax attributes of one separate share held for the benefit of one beneficiary do not affect the taxation of any other shares that are held for the benefit of any of the other beneficiaries of the same trust (or estate.)
  • Key point: A trust beneficiary will not be taxed on income distributed to, or accumulated for the benefit of, another trust beneficiary due to the application of the separate share [Treas. Reg. 1.663(c)-1.]
  • Effect of Separate Share Rule: The effect of the separate share rule is that each separate share of the trust (or estate) calculates its own distributable net income (DNI), separate and apart from the other shares of the trust (or estate.) Consequently, the calculation of DNI within each share is independent of the calculation of DNI in any of the other shares under the same trust instrument. Less obvious is that the application of the separate share rule, and the division of the trust (or estate) into separate shares for income tax reporting purposes (if the separate share rule applies) takes place before the calculation of DNI within each share.
  • Application of the Separate Share Rule: Each share’s DNI is calculated, along with a separate distribution deduction for that same share. Once the separate distribution deductions are calculated for each share, the distribution deductions are then added together to create one distribution deduction for the entire trust. That aggregate distribution deduction amount is then subtracted from the adjusted total income (DNI) of the trust to determine the trust’s taxable income for the year. The trust then files a single income tax return for all of the shares. Therefore, application of the separate share rule does not result in separate trusts that each file their own separate income tax return.

Examples: Ebenezer creates a trust for the benefit of his three nephews, Huey, Dewey and Louie. The terms of Ebenezer’s trust provide that the trust is to be held as a single trust, but in shares, one share for each of Huey, Dewey and Louie. The trustee is authorized under Ebenezer’s trust instrument to distribute discretionary amounts of income and principal until each beneficiary attains age 35 years. At that time (age 35) each respective share will be distributed to the beneficiary of that share. Any distributions from the Ebenezer trust prior to the beneficiary’s age 35 will be considered an advancement from each respective share principal to that beneficiary, so that a beneficiary who receives discretionary principal distributions will receive less when age 35 is reached. Accordingly, any discretionary distributions by the trustee to one beneficiary (Huey) will not affect the respective shares of the other two beneficiaries (Dewey and Louie.)

  • Example #1: As a result of the terms of Ebenezer’s trust, the separate share rule will apply and the trust’s DNI and its corresponding distribution deduction will be calculated separately for each of the respective shares of Huey, Dewey and Louie. If this year the entire Ebenezer trust receives $15,000 of net income (DNI), each share under the Ebenezer trust will have DNI of $5,000. If in that same year Huey receives a distribution of $12,000 from the Ebenezer trust, Huey will be deemed to have received from the Ebenezer trust $5,000 of taxable income (DNI) taxable to Huey, and $7,000 of trust principal (not taxable to Huey). The entire Ebenezer trust will take a distribution deduction of $5,000 (the amount of DNI that was distributed to Huey). The other $10,000 of the Ebenezer trust’s DNI will be taxed to the Ebenezer trust, and it will pay the income tax on that accumulated income amount. Dewey and Louie might not like the fact that ‘their’ trust was forced to pay income taxes; however, Ebenezer’s trust will not be taxed at the highest marginal federal income tax bracket since its reported income of $10,000 will be less than $12,500 (the 37% marginal bracket.) Consider, however, if the non-distributed DNI held in the Ebenezer trust exceeded $12,500 and the trust paid income taxes at 37% and 3.8% federal rates + state income tax of 4.25%. [Treas. Reg. 1.663(c)-5, Example 1.]
  • Example #2: Assume, instead, that Ebenezer’s trust directs that discretionary distributions made from the trust would be made from the entire Ebenezer trust, so that any distribution to one beneficiary, like to Huey, would reduce the shares of all three beneficiaries (Huey, Dewey, and Louie.) In that case the separate share rule will not apply to Ebenezer’s trust. Using the same distribution example above, when Huey receives a distribution from the Ebenezer trust of $12,000, he would be taxed on DNI of $12,000, and the Ebenezer trust would be taxed on the remaining $3,000 of the undistributed DNI. Dewey and Louie, who received no distribution from the Ebenezer trust, would not be taxed.

Scope of the Separate Share Rule:

  • Charity: Since the separate share rule only applies to IRC Sections 661 and 662 by its terms, it apparently will not affect a charitable deduction by the trust under IRC 642(c). Consequently, a charitable bequest or share will probably not be treated as a separate share under this Tax Code section. [IRC 663(c).] Thus, an attempt to use the separate share rule to allocate a class of taxable income from the trust, such as IRD, to a charity will not be successful. [Treas. Reg.1.642(c)-3(b)(2).]
  • Simple Trusts: The separate share rule only applies to a complex trust for income tax reporting purposes. IRC 663(c) makes no mention of IRC Sections 651 (deduction) and 652 (inclusion in income) which only apply to simple trusts for income tax reporting purposes. A simple trust is one where the trustee is directed under the instrument to distribute all income from the trust each year. Whether or not the income is actually distributed by the trustee to the beneficiary, the income will nonetheless be treated as having been distributed to the trust beneficiary, and thus the trust beneficiary will have to report the income and pay the tax on the deemed distributed trust income. In short, with a simple trust, the trustee has no discretion exists to accumulate income. [IRC 651.] The DNI of any separate shares contained within a simple trust will be fully allocated to each separate share in any event since all income must be distributed annually to the trust beneficiary.
  • Rule Applies Even if ‘Separate Share’ Term Not Used: For the separate share rule to apply, the trust document does not need to actually describe the shares as “separate shares.” Example: A trust instrument directs its residue is to be paid in equal one-thirds (33.3%) to each Huey, Dewey and Louie- which sounds like a single residue. Yet that that single residue is actually three separate shares. [Treas. Reg. 1.663(c)-5. Example 11.] If all three shares receive the same income and they are all distributed at the same time, then the income tax result caused by the separate share rule will be the same as if the rule had not applied. But if the three shares of the residue are distributed at different times, or in different tax years, then the separate share rule will produce a different tax result. Example: If Huey receives a distribution from the Ebenezer trust that exceeds the total of the DNI received by the Ebenezer trust, and Dewey and Louie receive no distribution from the trust in that same year, then only a one-third of the Ebenezer trust’s DNI will be carried out to Huey with his distribution, and he will be taxed on that one-third of the entire trust’s DNI; the other two-thirds of the Ebenezer trust’s DNI will be taxed to the trust, which then distorts the contemplated one-third of the residue to be distributed to each of the three trust beneficiaries.

Conclusion: If multiple trusts are established for the respective benefit of multiple beneficiaries, then each of those trusts will be treated for tax purposes as a separate and different trust and each will file its own income tax return; each trust will calculate its own income and deductions, and each will file its own Form 1041 income tax return. If a single trust is designed to benefit multiple beneficiaries and the terms of that trust instrument prevent distributions to one beneficiary from affecting the interests of the other trust beneficiaries, then the separate share rule will apply. If unequal distributions are made among the multiple beneficiaries, or the timing of the distributions is different, application of the separate share rule could result in the trust accumulating and paying income taxes at the highest marginal income tax rate.