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

5-Apr-19

Taxable Trust Distributions: A Primer Revisited

Take-Away: With the emphasis these days on saving income taxes more than gift and estate taxes, it is important to have a working knowledge of the income taxation of irrevocable trusts. Trustees that are aware of these income taxes are inclined to make distributions of income to trust beneficiaries in order to shift that taxable income to a lower marginal income tax bracket faced by the trust beneficiary. But trustees will need to also be aware of some of the possible situations when not to make distributions to beneficiaries that carry out the trust’s distributable net income (DNI). In short, shifting taxable income away from an irrevocable trust to its beneficiary often makes sense, but not all the time.

Background: We are all too familiar with the recent changes in the federal gift and estate tax exemption amounts that have greatly de-emphasized planning to avoid federal gift and estate taxes. Thus, the planning shift to avoid income taxes. The problem, in a nutshell, is that irrevocable trusts face far more draconian income tax rates than do individuals.

  • Income Tax Rates: A single taxpayer will pay income taxes at the 37% federal income tax rate when his/her taxable income is above $510,300. For a married couple, their taxable income must exceed $612,350 before they face the 37% marginal federal income tax rate. In the case of an estate or irrevocable trust, the trust faces the marginal 37% tax rate at accumulated income in excess of $12,750, thus compressing the trust’s tax brackets.
  • Net Investment Income Tax: A single taxpayer will have to pay the 3.8% Medicare surtax once his/her adjusted gross income exceeds $200,000. A married couple will have to pay this surtax if their adjusted gross income exceeds $250,000. An irrevocable trust pays the surtax once its taxable income exceeds $12,750.
  • Combined Taxes Thus Lead to the Income Shifting Strategy: In summary, if an irrevocable trust accumulates income in excess of $12,750, it will face a combined federal income tax of 40.8% [37%+ 3.8%] along with any state income taxes that are imposed. Thus the desire to shift the income tax burden from the trust to the individual trust beneficiaries who will usually be in a lower marginal income tax bracket.

Distributable Net Income: If an irrevocable trust makes a distribution of income to a trust beneficiary from its distributable net income (referred to as DNI) then that distribution carries out the trust’s taxable income to the trust beneficiary. [IRC 661 and 662.] The trust then takes a deduction from its income for that distribution, and the trust beneficiary must then pick up that distribution and include it as part of the beneficiary’s taxable income for the year. Thus, the focus of many trustees is to make such distributions from a discretionary trust, carrying out DNI, in order to expose that taxable income to the beneficiary’s lower marginal income tax bracket.

Limitations to Consider: While it is tempting to pursue this income-shifting strategy which is intended to save, over-all, income taxes, income-shifting may not always be the wisest path for the trustee to take. Some limitations or considerations follow before the trustee should engage in income-shifting through distributions to the trust beneficiary:

  • Kiddie Tax: A trustee should not overlook the potential impact of the Tax Code’s kiddie tax, which is imposed on a portion of a child’s unearned income. This applies in situations where a trust distribution carries out DNI to younger trust beneficiaries. [IRC 1(g).] Under these circumstances, the shift of the trust’s taxable income to the young beneficiary will be no more beneficial from an income tax perspective than simply retaining that income in the trust and having it subjected to the highly compressed income tax brackets the trust faces. [IRC 1(j)(4).] Under the ‘old’ kiddie tax rules that unearned income was taxed at the child’s parents’ marginal income tax rate. Under the 2017 Tax Act, the kiddie tax rules were changed so that the taxpayer who would have paid the income tax [in this case the irrevocable trust] has its marginal income tax rate now applied to the unearned income that is distributed to the trust beneficiary. In sum, there is nothing to be gained by shifting income from the irrevocable trust to the kiddie beneficiary, as the trust’s income tax rate will be imposed on that distributed income.
  • Principal and Income Act: As a broad generalization, capital gains that are realized within a trust are not included in the trust’s DNI, except in the final year of the trust when the trust terminates. [IRC 643(a)(3); Reg. 1.643(a)-3(a).] Accordingly, those realized capital gains are not considered paid/distributed to the trust beneficiary. In short, the trustee will pay the income tax on the trust’s net capital gains, and those gains are ordinarily allocated to trust principal at the end of the tax year. [Uniform Principal and Income Act (UPIA) section 404.]
  • Consistency Rule: Notwithstanding the ordinary UPIA rules with regard to capital gains, it is possible for a discretionary trust to have realized capital gains carried out as part of that trust’s DNI. The trust instrument may expressly allocate capital gains to trust income, but that permanent allocation of all capital gains to income could grossly distort the traditional economic relationship between income and remainder beneficiaries of the trust. [Reg. 1.643(a)-3(b).] However, in order for this treatment of realized gains as income to be accepted by the IRS, the trustee must treat such gains consistently on the trust’s books, records and tax returns as part of a distribution each year. [Reg. 1.643(a)-3-(b)(2).] This consistent treatment must be declared by the trustee, or evidenced by the trustee’s actions in the trust’s first taxable year, or the first time that capital gains are recognized by the trust. In all future years the trustee must treat all discretionary distributions as being made first from any realized capital gains. [Reg. 1.643(a)-3(e), Example 2.] In other words, if the first time capital gains are realized and distributions are made from the trust, the trustee does NOT treat such distributions as being paid from such realized gains, the trustee is foreclosed from doing so thereafter. [Reg. 1.643(a)-3(e), Example 1.] The failure to treat capital gains as income in the past by the trustee could prevent a future effort to treat realized gains as part of DNI.
  • Jeopardize Benefits: While shifting the trust’s taxable income to the beneficiary may make sense from the overriding perspective of saving income taxes, the impact of that additional taxable income could have a negative impact on the trust beneficiary, since along with the additional income goes the additional income tax liability imposed on the beneficiary, and the additional income received may jeopardize other benefits the beneficiary may then be receiving from other sources, e.g. scholarships or governmental benefits.
  • Fiduciary Constraints: Finally, not to be overlooked when a trustee is considering a distribution from the trust to shift taxable income to a lower tax bracket trust beneficiary is the trustee’s overriding fiduciary duty to all trust beneficiaries, i.e. current, future, and residuary trust beneficiaries. While the current distribution of income to the trust beneficiary is intended to reduce income taxes of the trust, those distributions may be viewed as excessive in relation with the needs of the trust beneficiary, or perhaps contrary to the distribution standards imposed in the trust instrument itself. In addition, by making larger, deductible, distributions currently to escape high trust income tax rates, the trustee’s distributions may at the same time jeopardize the interests of the remainder beneficiaries in the same trust by depleting the trust’s asset base. Restated, while the current income beneficiary of the trust may be delighted to receive generous (albeit taxable) distributions from the trust, the remainder trust beneficiaries may view the trustee’s generosity as a violation of the trustee’s fiduciary duty to impartially treat all trust beneficiaries.

Conclusion: Due to the compressed income tax brackets an irrevocable trust faces, it is expected that the trustee will explore all options in order to reduce the trust’s overall income tax liability. Distributing that taxable income to the trust beneficiaries is one obvious way to reduce that exposure to a combined federal income tax rate of 40.8%. But there are also limitations and duties that the trustee needs to first consider before it pursues the income-shifting strategy of making large distributions of taxable income to the current income beneficiary of the trust. It is a sound strategy; it just comes with lots of complications.