Trusts and the 23.8% Cap Gains Tax: Having Capital Gains Included in DNI and Distributed John Goldsbury john.goldsbury@ustrust.com
Disclosure Any examples presented are hypothetical and do not reflect specific strategies we may have developed for actual clients. They are for illustrative purposes only. The availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. This material is current as of the date specified and is for informational purposes only. It is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. U.S. Trust, Bank of America Private Wealth Management, operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. Jan2016JGO 2
New increased rate differential Trust has $ 50,000 of taxable income; Beneficiary has $ 150,000 Federal Ordinary Federal Capital Gain Income Bracket Bracket Beneficiary Trust Beneficiary Trust Regular Tax 28% 39.6% 15% 20% Surtax 0% 3.8% 0% 3.8% Total 28% 43.4% 15% 23.8% Difference -15.4% 15.4% -8.8% 8.8% 3
That extra 3.8%: How is a trust surtaxed? 4
How is a trust surtaxed -- the DNI results dictate the NII results The rules for the surtax: – Step #1 : A trust calculates its DNI under the usual rules; – Step #2 : A trust must now also track whether each item of income in DNI is NII or not; – Step #3 : Items of income that both – are considered distributed under the DNI rules, and – are items of NII are considered distributions of NII – Step #4 : The beneficiary includes distributed NII in his/her NII; and – Step #5 : The trust’s undistributed NII will be (i) the total NII of the trust, less (ii) the amounts deemed distributed under #3. 5
How is a trust surtaxed -- Example 1 from final surtax regs Total In DNI In NII Income Dividend $ 15,000 $ 15,000 $ 15,000 Interest $ 10,000 $ 10,000 $ 10,000 Capital Gain $ 5,000 X $ 5,000 X IRA Distribution $ 75,000 $ 75,000 TOTAL $ 105,000 $ 100,000 $ 30,000 6
Example 1 cont’d: $10,000 discretionary distribution Income tax (DNI) results Surtax (NII) results DNI Distributed Total Distributed Retained Dividend $ 15,000 $ 1,500 $ 15,000 $ 1,500 $ 13,500 Interest $ 10,000 $ 1,000 $ 10,000 $ 1,000 $ 9,000 Capital Gain $ 5,000 $ 0 $ 5,000 IRA $ 75,000 $ 7,500 Distribution TOTAL $ 100,000 $ 10,000 $ 30,000 $ 2,500 $ 27,500 7
Having Capital Gains Taxed to Beneficiaries – Preliminaries 8
Before we go over examples . . . 1. Any distribution must be consistent with the trust’s terms and the trustee’s fiduciary obligations. 2. Must be aware of collateral effects of increasing a bene’s income. 3. Reverse thinking: In many scenarios, it’s a given that there is an $X distribution. • Given that, then we ask “can it carry out capital gain?” 4. It is not always a choice! 9
Short ‘n’ Sweet: The rules for including capital gain in DNI: Reg. §1.643(a)-3(b) (b) Capital gains included in distributable net income. Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law) – 1) Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph §1.643(a)-3(b)); 2) 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; or 3) Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary. 10
5 Ways to Have Cap Gain in DNI Summary of Reg. §1.643(a)-3(b) Income 1. Allocation Method #1(a): Allocated to income 2. Allocation Method #1(b): For a total return unitrust, allocated to income as a matter of discretion, but such discretion must be exercised consistently (we’ll go over what that means) Principal 1. Allocation Method #2: Allocated to corpus but treated consistently as part of a distribution to a beneficiary 2. Allocation Method #3(a): Allocated to corpus but actually distributed to a beneficiary 3. Allocation Method #3(b): Allocated to corpus but utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary 11
Organizing the Regulation and its 14 Examples Authorization #1 Authorization #2 (mandatory) (discretionary) Allocation #1(a) Example 4, 11 Allocation #1(b) Example 1, 2, 3, Allocation #2 12, 13, 14 Example 10 Allocation #3(a) Example 6, 7, 8, 9 (unclear) Allocation #3(b) Example 5 12
Having Capital Gains Taxed to Beneficiaries Examples of some of the 21 ways 13
Authorization #1 Authorization #2 (mandatory) (discretionary) Allocated to trust Allocation #1(a) “income” Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) 14
#1: Capital Gains are allocated to trust “income” (1/21) Trus ust • Allocation Method #1(a): Allocated to income “Capi pital al g gains ns Example 4 of the Regulations. • realize zed b by th the Once an item of federal • taxable income is in Trus ust s shall b ll be fiduciary accounting allocat cated t d to “income,” it is in DNI. incom ome.” No discretion; no choice! • Planning opportunity -- fully • discretionary trusts. Drafting to require that capital gain be allocated to income will cause that capital gain to be in DNI. 15
Authorization Authorization #2 #1 (mandatory) (discretionary) Allocation #1(a) Allocation #1(b) Allocation #2 Allocated to corpus but actually Allocation #3(a) distributed to the beneficiary Allocation #3(b) 16
#2: Distributions in Kind (14, 15, 19/21) Allocation Method #3(a): Allocated to corpus but actually • distributed to the beneficiary • Distributions in kind – 3 variations 1. The distribution triggers gain. • Meeting a fixed obligation with appreciated property 2. The distribution does not trigger gain, but an election is made to recognize gain 3. The distribution does not trigger gain. 17
Authorization #1 Authorization #2 (mandatory) (discretionary) UPIA Power to Allocation #1(a) Adjust Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) 18
#3: UPIA Power of Adjustment (5/21) Allocation Method #1(a): Allocated to income • • Once an item of federal taxable income is in fiduciary accounting “income,” it is in DNI. • There are no examples in the Regulations for the power of adjustment. That is intentional. • Regs seem to confuse “principal” with “capital gain” • There is no “consistency” requirement (because of statutory requirements) • The grid offers a fascinating way to extrapolate from this . . . 19
#3: cont’d Authorization #1 Authorization #2 (mandatory) (discretionary) Allocation #1(a) What else???? Allocation #1(b) Allocation #2 Allocation #3(a) Allocation #3(b) 20
#3 cont’d: My “Too Good To Be True” Example (5/21) Trus ust “ The trustee shall have the power to allocate capital gains to income, whenever the trustee feels like it.” 21
Authorization #1 Authorization #2 (mandatory) (discretionary) Allocation #1(a) Allocation #1(b) Discretionary Allocation #2 principal distributions Allocation #3(a) Allocation #3(b) 22
#4: Discretionary Principal Distributions (9/21) • Allocation Method #2: Trus ust “Allocated to corpus but treated “T “Trus uste tee has consistently by the fiduciary on the trust's books, records, and disc scretion t to invad vade tax returns as part of a principal al an and to distribution to a beneficiary.” deem di deem discre retionary Regulations: “consistently” = • dis istr tribut butions ns to to be be one bite at the apple. mad ade f from c m cap apital al • If you treat capital gains as gai ains. s.” distributed in the first year you can, you are obligated to do to the same in the future. • If you fail to do so, you are prohibited in the future. 23
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