Can A Trust Distribute Capital Gains To The Income Beneficiary?

Can A Trust Distribute Capital Gains To The Income Beneficiary? Yes, a trust can distribute capital gains to the income beneficiary, offering a potential strategy to optimize tax liabilities. At income-partners.net, we provide expert guidance on how to navigate trust distributions, enabling you to make informed decisions that align with your financial goals and foster lucrative partnerships. Discover effective methods for wealth management, financial partnerships, and strategic income distribution.

Table of Contents

1. Understanding Fiduciary Accounting Income (FAI) and Its Role
2. The Challenge of Capital Gains Taxation in Trusts
3. Navigating Regulations for Capital Gains Inclusion in Distributable Net Income (DNI)
4. Exception 1: Allocating Capital Gains to Income
   • The Power to Adjust
   • Unitrust Provisions
5. Exception 2: Consistently Treating Capital Gains as Part of a Distribution
6. Exception 3: Allocating Capital Gains to Corpus but Actually Distributing
7. Exploring Grantor Trusts as an Alternative
   • Crummey Powers and “5 and 5” Powers
8. Conclusion: Balancing Tax Minimization with Broader Considerations
9. FAQ: Key Questions About Trust Distributions and Capital Gains

1. What Is Fiduciary Accounting Income (FAI) and How Does It Impact Trust Distributions?

Fiduciary Accounting Income, or FAI, is crucial in determining how a trust’s income is taxed, dictated by the trust’s governing documents and local laws. FAI determines whether the trust or the beneficiaries pay taxes on the income generated by the trust. Understanding FAI is essential for proper trust management and can greatly impact your financial outcomes.

FAI, also known as trust accounting income, is defined by the governing instrument and local laws. While it is not a tax concept, FAI is important to determine whether the fiduciary or beneficiaries pay tax on the trust’s income. When the Internal Revenue Code refers to “income,” the reference is to the definition of FAI in the governing instrument and applicable local law (Sec. 643(b)). Understanding FAI is fundamental to effective trust management.

Key Considerations for FAI:

• Governing Instrument: The trust document itself sets the stage. It details how income and principal are defined and allocated.
• Local Law: State laws, particularly the Uniform Principal and Income Act (UPAIA), provide default rules for income and principal allocation if the trust document is silent.
• Impact on Taxation: FAI directly influences who pays taxes on the trust’s income. Income allocated to FAI is potentially distributable to beneficiaries and taxed at their individual rates. Income retained within the trust is taxed at trust tax rates, which can be significantly higher.
• Total Return Investing: Modern investment strategies focus on total return (appreciation plus income). This can create a mismatch if the trust requires income distributions but the portfolio generates mostly capital gains.

Example:

Consider a trust requiring all income to be distributed to a beneficiary. If the trust earns $10,000 in dividends (typically considered income) and $25,000 in capital gains (typically allocated to principal), the FAI is only $10,000. The beneficiary receives $10,000, and the trust pays taxes on the $25,000 capital gain.

2. What Is the Challenge of Capital Gains Taxation in Trusts?

The challenge of capital gains taxation in trusts arises because trusts can face significantly higher tax rates compared to individuals, making strategic distribution crucial. Given that the top marginal tax rate plus the net investment income tax can apply to trusts with relatively low taxable income, the tax impact of retaining capital gains within the trust can be substantial. This creates a need for strategies to minimize taxes on undistributed capital gains, especially when beneficiaries are in lower tax brackets.

Given that the top marginal tax rate of 39.6% and the 3.8% net investment income tax apply to estates and trusts with taxable income in excess of only $12,150 in 2014 (not to mention state income taxes), the tax impact of retaining capital gains in a trust can be severe.

Why Capital Gains in Trusts Pose a Tax Challenge:

• High Tax Rates: Trusts hit the highest federal income tax bracket at a much lower income level than individuals. This means capital gains retained in the trust are taxed at a higher rate.
• Net Investment Income Tax (NIIT): Trusts are subject to the 3.8% NIIT on investment income, including capital gains, further increasing their tax burden.
• Traditional FAI Rules: Traditional rules often allocate capital gains to the trust’s principal, not income. This prevents them from being distributed to beneficiaries in lower tax brackets.

Example:

A trust realizes a $25,000 long-term capital gain. If retained in the trust, it could be subject to a federal tax rate of 23.8% (20% capital gains rate + 3.8% NIIT). If the beneficiary is in a lower tax bracket, distributing the gain to them could result in a lower overall tax liability.

Addressing the Challenge:

Fiduciaries need to explore options to include capital gains in the trust’s Distributable Net Income (DNI). DNI determines the amount of income that can be distributed to beneficiaries, shifting the tax burden to them.

3. Navigating Regulations for Capital Gains Inclusion in Distributable Net Income (DNI)

How can regulations help include capital gains in Distributable Net Income? Navigating regulations is essential because they provide specific exceptions that allow capital gains to be included in DNI, potentially shifting the tax burden to beneficiaries. Understanding these regulations is key to optimizing tax outcomes for trusts and their beneficiaries.

Generally, capital gains are excluded from DNI to the extent they are allocated to corpus and are not paid, credited, or required to be distributed to any beneficiary during the tax year (Sec. 643(a)(3)).

Key Regulatory Provision:

• Treas. Reg. Section 1.643(a)-3(b): This regulation is the cornerstone. It outlines the circumstances under which capital gains can be included in DNI. It allows inclusion if authorized by the governing instrument and local law or through a reasonable and impartial exercise of discretion by the fiduciary, provided one of three exceptions applies.

Three Exceptions for Including Capital Gains in DNI:

1. Allocated to Income: Capital gains allocated to income according to the governing instrument or a reasonable and impartial exercise of the fiduciary’s discretion can be included in DNI.
2. Consistently Treated as Part of a Distribution: Capital gains allocated to corpus but consistently treated as part of a distribution to a beneficiary on the trust’s books, records, and tax returns can be included in DNI.
3. Allocated to Corpus but Actually Distributed: Capital gains allocated to corpus but actually distributed to the beneficiary or used by the fiduciary in determining the distribution amount can be included in DNI.

Understanding the Exceptions:

Each exception has specific requirements and implications. Fiduciaries must carefully evaluate their trust documents, state law, and the specific circumstances to determine if an exception applies and how to implement it.

4. Exception 1: Allocating Capital Gains to Income

How can capital gains be allocated to income? Capital gains can be allocated to income through the governing instrument or a reasonable and impartial exercise of discretion by the fiduciary. This exception allows capital gains to be included in DNI and distributed to a beneficiary.

Capital gains actually allocated to income per the governing instrument or a reasonable and impartial exercise of discretion by the fiduciary may be included in DNI (Regs. Sec. 1.643(a)-3(b)(1)).

Methods for Allocating Capital Gains to Income:

• Governing Instrument: If the trust document explicitly allows for capital gains to be allocated to income, the fiduciary has the authority to do so.
• Power to Adjust: In states that have adopted the Uniform Principal and Income Act (UPAIA), fiduciaries may have the “power to adjust” between income and principal to ensure fairness among beneficiaries.
• Unitrust Provisions: State laws may allow a trust to convert to a unitrust, where income is defined as a percentage of the trust’s assets.

The Power to Adjust

What is the Power to Adjust, and how does it affect capital gains? The Power to Adjust, granted by the UPAIA, allows fiduciaries to reallocate between income and principal to ensure fairness. This can enable the inclusion of capital gains in DNI, but the tax treatment may be unclear.

Section 104 of the UPAIA provides the fiduciary with the “power to adjust” between income and principal to ensure a fair result for all beneficiaries.

How the Power to Adjust Works:

1. Prudent Investor Standard: The fiduciary must invest and manage trust assets as a prudent investor.
2. Income Reference: The trust terms must describe the distributable amount by referring to the trust’s income.
3. Impartiality: The trustee must exercise the power impartially and reasonably to all beneficiaries.

Example:

A trust mandates all income to be distributed to a surviving spouse, with the remainder to children. The trustee shifts from a conservative 20/80 equity/fixed income allocation to a more aggressive 70/30 allocation to align with modern investment strategies. This shift decreases FAI, negatively impacting the spouse. Utilizing the power to adjust, the trustee can transfer a portion of the capital gains from principal to income, ensuring fairness.

Tax Implications and Considerations:

• Uncertainty: The IRS has not provided definitive guidance on the tax treatment of adjustments, citing variations in circumstances and state laws.
• Consistency: The IRS suggests that consistent treatment is not required, but the power must be exercised reasonably and impartially.
• Discretionary Power: If the trustee has discretionary power to distribute principal, the power to adjust should be exercised independently of realized capital gains.
• Economic Sense: Exercise of the power must make economic sense and align with the trust’s objectives.

Unitrust Provisions

What are Unitrust Provisions, and how do they relate to capital gains distribution? Unitrust provisions, available under state law, define trust income as a percentage of the trust’s assets. They provide a consistent method for including capital gains in DNI, easing administrative burdens and aligning with total return investing.

While the IRS declined to provide any examples illustrating the power to adjust, it did provide several examples of the application of a unitrust statute.

How Unitrust Provisions Work:

1. Conversion: The trustee elects to convert the trust to a unitrust under state law.
2. Percentage Calculation: Income is calculated as a percentage of the trust’s assets, typically based on the asset value at the beginning of the year or averaged over a period.
3. Distribution: The unitrust amount is distributed to the beneficiary.

Example:

A trust converts to a 4% unitrust, with the trust valued at $500,000 at the beginning of the year. The trust income is defined as $20,000 ($500,000 x 4%). The beneficiary receives $20,000.

Tax Implications and Considerations:

• Ordering Rules: Tax treatment depends on whether the governing instrument or state law has an ordering rule for the character of the unitrust amount (i.e., specifying whether it comes from ordinary income, capital gains, or return of principal).
• Consistent Practice: In states without an ordering rule, the trustee must follow a consistent and regular practice of including capital gains in the unitrust distribution.
• Income Shifting: While a unitrust provision enables some income shifting, it may not enable complete shifting, and consistent application is essential.

Advantages of Unitrusts:

• Simplicity: Easier to administer than calculating FAI.
• Total Return Investing: Aligns with modern investment strategies.
• Consistent Method: The trustee can establish a consistent method for including or not including capital gains in DNI.

5. Exception 2: Consistently Treating Capital Gains as Part of a Distribution

How can consistently treating capital gains as part of a distribution impact DNI? By consistently treating capital gains as part of a distribution, a fiduciary can include them in DNI, shifting the tax burden to the beneficiary. This requires a documented, consistent practice on the trust’s books and tax returns.

Capital gains allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary may be included in DNI (Regs. Sec. 1.643(a)-3(b)(2)).

Requirements for Consistent Treatment:

1. Discretionary Power: The trustee must have discretionary power to distribute principal to the beneficiary.
2. Regular Practice: The trustee must follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains realized by the trust during the year.
3. Documentation: The practice must be documented consistently on the trust’s books, records, and tax returns.

Example:

A trustee has the discretion to distribute principal to a beneficiary for health, maintenance, and support. After calculating FAI of $10,000, the trustee distributes $10,000 of income plus an additional $25,000 of principal. If the trustee intends to treat the $25,000 principal distribution as coming from the capital gains realized by the trust during the year, the trustee can include it in DNI.

Tax Implications and Considerations:

• Initial Tax Year: The consistent practice must be adopted during the trust’s initial tax year.
• Future Consistency: The trustee must continue to treat principal distributions as coming from realized capital gains for all future years.
• IRS Scrutiny: The IRS has indicated that existing trusts for which the statute of limitation has expired on prior tax returns may be unable to adopt a new consistent practice.

Challenges and Limitations:

• New Tax Legislation: Following new tax legislation, existing trusts may not be allowed to adopt a new consistent practice.
• IRS Concerns: The IRS is concerned about fiduciaries adopting a new consistent practice to take advantage of tax rules not contemplated when the initial tax return was prepared.

6. Exception 3: Allocating Capital Gains to Corpus but Actually Distributing

What happens when capital gains are allocated to corpus but actually distributed? Capital gains allocated to corpus but actually distributed to the beneficiary can be included in DNI. This exception applies when the trust distributes capital gains to a beneficiary or uses the amount of capital gains in determining the distribution amount.

Capital gains may also be included in DNI when they are allocated to corpus but actually distributed to the beneficiary or used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary (Regs. Sec. 1.643(a)-3(b)(3)).

Scenarios for Applying This Exception:

1. Actual Distribution: The trust actually distributes the capital gains to the beneficiary.
2. Distribution Amount Based on Capital Gains: The trust uses the amount of capital gains in determining the amount distributed to the beneficiary.

Examples:

• Age-Attainment Trust: A trust requires distribution of one-half of the principal at age 35. If the trust sells one-half of its assets and distributes the proceeds to the beneficiary at age 35, all or a portion of the capital gain distributed to the beneficiary is included in DNI.
• Discretionary Distributions: The trustee elects to make discretionary distributions to the beneficiary based on the trust’s realized capital gains. If the trustee decides to make distributions to the extent the trust has realized capital gains, the trustee would distribute the capital gains to the beneficiary and include them in DNI.

Tax Implications and Considerations:

• Mandatory Principal Distributions: This exception is valuable in situations involving mandatory principal distributions and situations when the proceeds of a specific asset are to be distributed to a beneficiary.
• IRS Interpretation: The IRS has noted that the inclusion of capital gains in DNI applies only where there is a distribution required by the terms of the governing instrument upon the happening of a specified event.
• Consistency: Any discretionary power to include capital gains in DNI seems to require a consistent exercise.

Ordering Rule for Capital Losses:

Any capital losses will first be netted against capital gains at the trust level (Regs. Sec. 1.643(a)-3(d)). Any net remaining capital gains are available for inclusion in DNI. However, netting does not apply when capital gains are distributed under this third exception; rather, the distributed capital gains are taxed to the beneficiary prior to netting.

7. Exploring Grantor Trusts as an Alternative

What are Grantor Trusts, and how can they help with capital gains? Grantor trusts, where the grantor is taxed on the trust’s income, offer an alternative for managing capital gains. In a grantor trust, all income, deductions, and credits, including capital gains, are taxed to the grantor.

Perhaps the regulations are not even necessary if the trust or part of the trust is treated as a grantor trust.

Types of Grantor Trusts:

• Whole Grantor Trust: The entire trust is treated as owned by the grantor.
• Partial Grantor Trust: Only a portion of the trust is treated as owned by the grantor.

Tax Implications:

• Grantor Taxation: All income, deductions, and credits, including capital gains attributable to the grantor portion of the trust, are taxed to the grantor.
• Partial Grantor Trust Tax Return: The trustee files a partial grantor trust tax return including the income and realized capital gains attributable to the grantor portion of the trust on a grantor information letter to the beneficiary.
• Form 1041: The trustee prepares Form 1041, U.S. Income Tax Return for Estates and Trusts, under the normal subchapter J rules for the remaining portion of the trust.

Crummey Powers and “5 and 5” Powers

How do Crummey and “5 and 5” powers affect grantor trust status? Crummey and “5 and 5” powers can create partial grantor trusts, shifting capital gains to beneficiaries in lower tax brackets. These powers give beneficiaries the ability to control a portion of the trust.

Trusts with “Crummey” powers or “5 and 5” powers are also subject to Sec. 678(a), resulting in partial grantor trusts.

Crummey Power:

A power held by the trust beneficiary to vest a portion of the principal for a specified period of time, typically 30 to 60 days. During the withdrawal period, the beneficiary is treated as owner of the portion of the trust over which he or she has the right of withdrawal, plus any related income and realized capital gains.

“5 and 5” Power:

The beneficiary has the right to withdraw up to the greater of $5,000 or 5% of the trust assets each year. The IRS has ruled that the beneficiary will be treated as the owner until the power is exercised, released, or lapses, over the portion of the trust subject to the withdrawal power.

Tax Implications:

Each year of an unexercised power will result in the beneficiary’s owning an increasing percentage of the trust’s corpus. While this section can produce unintended tax results, it can also facilitate shifting capital gains to a beneficiary in a lower tax bracket.

Grantor Trust Rules Override:

Under Sec. 678(b), any other grantor trust power trumps grantor treatment under Sec. 678(a). For example, if a trust were grantor with respect to the settlor because he or she possessed a power of substitution under Sec. 675, then the trust would be a grantor trust with respect to the settlor rather than beneficiaries holding a Crummey power.

8. Conclusion: Balancing Tax Minimization with Broader Considerations

What is the overall conclusion regarding capital gains distribution from trusts? Balancing tax minimization with broader considerations such as spendthrift protection, estate inclusion, and asset protection is crucial. Fiduciaries need to weigh the benefits of distributing capital gains against potential drawbacks.

Although this item focuses on minimizing income tax, there are numerous nontax issues to consider, such as spendthrift protection, estate inclusion, asset protection, and balancing the competing interests of beneficiaries.

Key Considerations:

• Nontax Issues: Spendthrift protection, estate inclusion, asset protection, and balancing the competing interests of beneficiaries.
• Limitations of Regulations: The limitations of the regulations have been noted above. If the regulations do not provide the fiduciary sufficient flexibility to distribute capital gains from an existing trust, it is appropriate to consider whether a trust amendment or decanting could be used to add the necessary administrative language to the governing instrument.
• Newly Drafted Governing Instruments: For newly drafted governing instruments, it is appropriate to consider whether the document will provide the fiduciary the flexibility needed to distribute capital gains and minimize income tax.

Final Thoughts:

At income-partners.net, we can help you navigate the complexities of trust distributions and identify the best strategies for your specific circumstances. Our team of experts provides valuable insights and resources to help you make informed decisions. Contact us today to discover partnership opportunities that can help you optimize your financial outcomes. Address: 1 University Station, Austin, TX 78712, United States. Phone: +1 (512) 471-3434. Website: income-partners.net.

9. FAQ: Key Questions About Trust Distributions and Capital Gains

• Can a trust distribute capital gains to an income beneficiary?
  • Yes, under certain conditions outlined in Treasury Regulation Section 1.643(a)-3(b). These conditions involve specific exceptions related to how capital gains are allocated and distributed.
• What is Fiduciary Accounting Income (FAI)?
  • FAI, or trust accounting income, is determined by the governing instrument of the trust and applicable local law. It dictates whether the fiduciary or the beneficiaries pay tax on the trust’s income.
• Why is capital gains taxation in trusts a challenge?
  • Trusts can face significantly higher tax rates compared to individuals. Additionally, traditional rules often allocate capital gains to the trust’s principal, preventing distribution to beneficiaries in lower tax brackets.
• What are the three exceptions for including capital gains in Distributable Net Income (DNI)?
  1. Capital gains allocated to income according to the governing instrument.
  2. Capital gains consistently treated as part of a distribution to a beneficiary.
  3. Capital gains allocated to corpus but actually distributed to the beneficiary.
• What is the “power to adjust” under the Uniform Principal and Income Act (UPAIA)?
  • The “power to adjust” allows fiduciaries to reallocate between income and principal to ensure fairness among beneficiaries, potentially including capital gains in DNI.
• How do unitrust provisions affect capital gains distribution?
  • Unitrust provisions define trust income as a percentage of the trust’s assets, providing a consistent method for including capital gains in DNI and aligning with total return investing.
• What are the requirements for consistently treating capital gains as part of a distribution?
  • The trustee must have discretionary power to distribute principal, follow a regular practice of treating distributions as paid first from capital gains, and document the practice consistently.
• How do Crummey powers and “5 and 5” powers affect grantor trust status?
  • These powers can create partial grantor trusts, shifting capital gains to beneficiaries in lower tax brackets by giving them control over a portion of the trust.
• What are Grantor Trusts?
  • Grantor trusts are those in which the grantor is taxed on the trust’s income, offering an alternative for managing capital gains and related tax liabilities. In a grantor trust, all income, deductions, and credits, including capital gains, are taxed to the grantor.
• What should be considered when distributing capital gains from trusts?
  • Broader considerations such as spendthrift protection, estate inclusion, asset protection, and balancing the competing interests of beneficiaries must be considered.