SUBCHAPTER J: THE VERY BASICS (rev. 2019)

JOHNNY REX BUCKLES Professor of Law

University of Houston Law Center

ADAPTED FROM THE STATE BAR OF TEXAS ADVANCED ESTATE PLANNING

AND PROBATE COURSE 2003 June 4-6, 2003

San Antonio, Texas CHAPTER 4

Subchapter J: The Very Basics (rev. 2019) Page 1 SUBCHAPTER J: THE VERY BASICS (rev. 2019) I. OVERVIEW. A. In General.

This Article discusses the fundamental rules of income taxation set forth in Subchapter J of Subtitle A, Chapter 1 of the Internal Revenue Code of 1986, as amended (the “Code’). The general approach of this Article is not to present a specialized study of selected topics of trust and estate income taxation often overlooked or misunderstood. Rather, this Article suggests a simple approach for framing questions about the proper taxation of income under Subchapter J, and explains the most fundamental elements of such taxation at an introductory to intermediate level of detail. B. Coverage.

To understand the taxation regime of Subchapter J, it is helpful to organize the many complex rules by posing the following series of questions: 1. Who potentially pays taxes on the income of a trust or estate? 2. What “income” of a trust or estate is relevant in determining a taxpayer’s liability? 3. When is the settlor (grantor) of a trust taxed on trust income? 4. When is a non-grantor “power holder” taxed on trust income? 5. When is income taxed to the trust/estate and/or beneficiaries, and how is the tax burden

distributed among the parties? 6. What is income in respect of a decedent, and how is it taxed? 7. What are the not-so-obvious income tax effects of some common trust/estate transactions and

decisions of a fiduciary? The answers to the first two questions are general, and provide the “big picture” of how the

income of a trust or estate is taxed. The answers to questions numbered 3 through 7 require a more detailed description and analysis of Subchapter J. II. QUESTION #1: WHO POTENTIALLY PAYS TAXES ON THE INCOME OF A TRUST OR ESTATE? A. Two to Four Possible Taxpaying Parties.

Consider the parties involved in the creation and administration of a trust: the creator (or “settlor” or “grantor”), the beneficiary, the trustee, and any other person with a power of appointment over assets held in trust (which person may or may not be one of the foregoing parties). Depending on the terms of the trust instrument (and other facts, in some cases), any one or more of these parties may be responsible for payment of the tax on all, or some portion, of income realized from trust property. In the case of an estate, income earned thereby may be taxable to the estate (and payable by the personal representative thereof) or to the beneficiary, depending on the timing of distributions and the nature of the bequest or devise.

Subchapter J: The Very Basics (rev. 2019) Page 2 B. How Do We Determine the Proper Taxpayer? 1. Income of a Trust. a. When Grantor Is Taxed.

Under several Code sections in Subchapter J discussed below, the grantor of a trust is treated as the owner of all or a portion of the property held in trust. When the grantor is so treated, the grantor must calculate her own taxable income and income tax credits by including those items of income, deductions, and tax credits of the trust which are attributable to the portion of the trust which the grantor is treated as owning, to the extent that such items would be taken into account in computing an individual taxpayer’s taxable income or income tax credits. I.R.C. § 671. The rules taxing grantors on items of trust income, deduction, and credit override the general rules of trust income taxation. Id.

b. When Non-Grantor Power Holder Is Taxed. (1) In General.

A person other than the grantor is treated as the owner of any portion of a trust with respect to which the person possesses, or has partially released, certain powers (discussed below). I.R.C. § 678. Accordingly, when the power holder is treated as such an owner, he must calculate his own taxable income and income tax credits by including those items of income, deductions, and tax credits of the trust which are attributable to the portion of the trust which he is treated as owning, to the extent that such items would be taken into account in computing an individual taxpayer’s taxable income or income tax credits. I.R.C. § 671. As with the taxation of grantors, the rules taxing power holders on items of trust income, deduction, and credit override the general rules of trust income taxation. Id. (2) Exception: Grantor Taxation Trumps in Case of Powers over Income. (a) The Basic Exception.

Notwithstanding this special rule taxing power holders, Code section 678(b) states that this special rule does not apply “with respect to a power over income” if the grantor of the trust is otherwise treated as the owner of the trust under the provisions of Subchapter J. Thus, if the power holder has rights to appoint trust income to himself, but the grantor also has a power or interest that causes her to be treated as the owner of the trust income, the grantor is taxed as owner, rather than the power holder. Observe that this rule stating that grantor taxation trumps power holder taxation literally applies only with respect to powers over income. (b) When Grantor and Non-Grantor Have Overlapping Powers over Principal.

Section 678 is silent on the question of how to allocate tax burdens when both a grantor and a non-grantor power holder have overlapping powers over trust principal that do not affect payments of fiduciary accounting income. For example, assume that the grantor of a trust has a power to revoke the trust and thereby revest title to trust property in herself. In addition, a discretionary income beneficiary is given a lifetime power to appoint trust principal to himself. Who owns the trust principal for purposes of these rules? How this question is answered determines who pays income tax on gross income items allocable to principal (e.g., capital gains). Conceivably, one could argue for at least four alternative tax treatments:

i. One position would be that the grantor alone is treated as the owner of the principal. The argument would be that the “trumping” rule of Code section 678(b), though literally applying only to powers over income, should apply to powers over principal as well. One could assert that the failure to so provide is merely an unintentional omission by Congress, and that there is no logical basis for taxing grantors in the case of overlapping powers over income but not in the case of overlapping powers over principal. The major flaw of this approach is that it literally contravenes the letter of the statute.

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ii. A second position would be that when the grantor and a non-grantor power holder have powers over the same principal, the grantor and power holder should share in the principal proportionately. This view, advanced in a leading treatise on trust income taxation, is considered the most logical approach by its authors.i In its favor, this approach seems “fair” to both the grantor and the non-grantor power holder, and it respects equally (or, perhaps, “disrespects equally”) the rules imposing tax liability on grantors and the rules imposing tax liability on non-grantor power holders.

iii. A third position would be that the non-grantor power holder alone is treated as the

owner of the principal. The argument would be that because the “trumping rule” of Code section 678(b) (which taxes grantors) is an exception to Code section 678(a), the implication is that in the absence of the trumping rule, power holder taxation would “trump” grantor taxation under section 678(a).ii The weakness of this argument is that it probably proves too much. Although the “trumping” rule of section 678(b) is indeed an exception to Code section 678(a), the statute does not plainly state what the “general” rule of taxation is in the case of overlapping powers between grantors and power holders. In other words, the trumping rule tells us only that in the case of overlapping powers over income, the grantor alone is treated as owner of trust income subject to the power, and by implication, that this result is different from what it would be under section 678(a). However, the trumping rule does not necessarily imply that in its absence, the power holder alone would be taxed on trust income under section 678(a). As discussed in the preceding paragraph, one can argue that the proper treatment of grantor and power holder in instances of overlapping powers under the general rule of section 678(a) is to allocate income tax items between the grantor and the power holder. Such treatment is perfectly consistent with characterizing the trumping rule of section 678(b) as an exception thereto.

iv. A fourth position would be that neither the grantor nor the non-grantor power holder

should be treated as owner of a portion of the trust subject to each party’s powers over the same principal. The argument would be that when both parties hold powers over the same principal, the exercise of each power is subject to the consent of an adverse party (as defined in Code section 672(a)), and therefore neither the grantor nor the non-grantor power holder should be taxed as owner of the principal.iii Code section 678(a) taxes a non-grantor power holder only if the power is “exercisable solely by himself.” If the power can be exercised only with the consent of another (whether adverse or not to the power holder’s interest), the non-grantor power holder is not treated as owning the property subject to the power. A grantor’s power to revest trust principal in herself does not cause the grantor to be treated as owner of trust property if the power is exercisable only with the consent of an adverse party. Treas. Reg. § 1.676(a)-1. One could reason that, insofar as exercise of the power by the grantor would prevent the non-grantor power holder from exercising the power in his favor (and vice versa), neither party has a power exercisable solely by himself or herself. However, in this author’s opinion, this reasoning is problematic. One party’s power over principal does not, strictly speaking, prevent the other party from unilaterally exercising his or her power at any point in time with respect to the same property subject to each party’s power. Admittedly, if one power holder exercises the power in her favor with respect to some portion of trust principal, there is less property remaining which is subject to the other party’s power. But this mathematical reality is quite beside the point. After all, the statutory test of Code section 678(a) is not whether the non-grantor power holder has the “sole power” to vest trust property in himself, but whether that power is “exercisable solely by” such person.

Subchapter J: The Very Basics (rev. 2019) Page 4 c. When Neither Grantor nor Non-Grantor Power Holder Is Taxed: The General Scheme for Taxing Trust Income.

When neither the grantor nor a non-grantor power holder is taxed as the owner of the trust (or a part thereof) under the rules introduced above (and described in more detail below), the potential taxpayers are the trust (as a taxpaying entity) and the beneficiaries of the trust (on amounts distributed or, in some cases, on amounts simply required to be distributed, to the beneficiaries). Allocating the burden of recognizing income between the trust itself and its beneficiaries hinges upon whether the trust is a simple trust or a complex trust. The detailed rules for allocating this income between the trust and the beneficiaries are discussed in Part VI, below. This section simply defines the two types of trusts and describes the general tax treatment of each, as well as the general tax treatment of estates. (1) Definition and General Taxation of Simple Trust. (a) Definition of Simple Trust.

A “simple trust” is the common name given a trust described in Code section 651(a). Under that Code section, a simple trust must meet the following three requirements:

i. The trust terms require all of the trust’s fiduciary accounting income to be distributed in the current taxable year.

ii. The trust terms do not provide for the payment, permanent setting aside, or use of any

amount for charitable, etc. purposes described in Code section 642(c).

iii. In the current taxable year, no distributions from trust principal (determined under fiduciary accounting principles) are actually made.

(b) General Taxation of Simple Trust. Although a simple trust is a taxable entity, it is in large part treated as though it were a pass-

through entity for federal income tax purposes. That is to say, in general, the amount of fiduciary accounting income is deducted by the trust in computing its taxable income, and the amount of such income is included in the gross income of the beneficiaries to whom distributions are required to be made. I.R.C. §§ 651(a), 652(a). The character of the income in the hands of the beneficiaries is the same as that of the income in the hands of the trustee. I.R.C. § 652(b). The trust itself is taxable upon its capital gains properly allocated to principal, however, as well as on any other item of “gross income” that is not allocable to fiduciary accounting income. (2) Definition and General Taxation of Complex Trust. (a) Definition of Complex Trust.

A complex trust is the name given any trust that does not meet the definition of a simple trust. For example, if the trust terms do not require all fiduciary accounting income to be distributed annually (i.e., the trust is not a “mandatory income trust”), it is a complex trust. Even a trust that normally is taxed as a simple trust would be a complex trust in a taxable year in which distributions from principal are made. (b) General Taxation of Complex Trust.

A complex trust is a taxable entity, and can expect to have “taxable income” upon which its fiduciary must pay income tax. However, a complex trust still can effectively “pass through” some of its income to beneficiaries. Subject to certain limitations, a complex trust is entitled to receive a deduction in computing taxable income equal to any amount of fiduciary accounting income required to be distributed currently to beneficiaries and for other amounts properly paid or credited or required to be distributed for the taxable year. I.R.C. § 661(a). Correspondingly, subject to the same limitations, any amount of fiduciary accounting income required to be distributed currently, together with all other amounts properly paid, credited, or required to be distributed to the beneficiaries for the taxable year, must be included in the gross income of the beneficiaries. I.R.C. § 662(a). The

Subchapter J: The Very Basics (rev. 2019) Page 5 character of the amounts received by the beneficiaries is the same as that of such amounts in the hands of the trustee. I.R.C. § 662(b). 2. Income of an Estate.

An estate is a taxable entity for federal income tax purposes. This does not mean, however, that the personal representative of a decedent’s estate must pay income tax on all items of income received by an estate. In general, an estate is taxed in the same manner as a so-called “complex trust” (see above), with legatees and devisees treated as “beneficiaries.” It is important to understand that the “estate” for federal income tax purposes is not synonymous with the “taxable estate” or “gross estate” for federal estate tax purposes. Rather, the “estate” for income tax purposes is essentially a legal personification of the property subject to probate administration under state law. Cf., e.g., Rev. Rul. 57-133, 1957-1 C.B. 200 (ruling that the net income from property subject to administration is includible in the gross income of the estate during the period of administration). 3. Computing the Taxable Income of an Estate or Trust.

In general, when an estate or trust is the taxpayer, its taxable income is computed in the same manner as that of an individual. I.R.C. § 641(b). A few fundamental differences between an individual taxpayer’s taxable income computation and a trust’s or estate’s taxable income computation exist, and are discussed below. The trustee (in the case of a trust) or personal representative (i.e., the executor or administrator, in the case of an estate) must pay any resulting income tax liability. Id. III. QUESTION #2: WHAT “INCOME” OF A TRUST OR ESTATE IS RELEVANT IN DETERMINING A TAXPAYER’S LIABILITY? A. In General: Necessary Distinctions.

Subchapter J refers to numerous types of “income” in imposing liability on the various potential taxpayers. Among the most important types of income are the following: gross income, taxable income, distributable net income (“DNI”), and fiduciary accounting income. Gross income is defined in Code section 61(a) and should be familiar to anyone with a working knowledge of federal income taxation. The other three types of income require elaboration. B. Taxable Income. 1. In General.

As discussed above, when the grantor or a non-grantor power holder is treated as owning all or a portion of a trust, such person must calculate her own taxable income and income tax credits by including those income tax items of the trust which are attributable to the portion of the trust which the person is treated as owning. In such circumstances, Subchapter J merely directs what income tax items are to be taken into account in computing “taxable income”; it does not modify the general rules for computing the taxable income of the grantor or other power holder. In contrast, when the trust is the taxpaying entity, and in the case of an estate, the “taxable income” of the estate or trust is computed with several modifications to the general method for computing the taxable income of an individual. I.R.C. §§ 641(b); 642. 2. Modifications to Method for Computing the Taxable Income of an Individual.

The taxable income of an estate or trust is computed in the same way that an individual taxpayer calculates taxable income, with a few modifications. The following are the most important to the majority of trusts and estates. a. Deduction in Lieu of Exemption.

In lieu of the deduction for personal exemptions allowed for individuals (outside of the TCJA window),iv Code section 642(b) provides for the following:

(1) An estate receives a deduction of $600.

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(2) A trust which by its terms must distribute all of its income currently receives a deduction of $300. A simple trust by definition so qualifies. A complex trust would also so qualify, if all of its income must be distributed currently.

(3) Every other trust receives a deduction of $100. b. Charitable Distributions and Set Asides.

An estate or complex trust is allowed a deduction (in lieu of the charitable contribution deduction allowed individuals under Code section 170) for any amount of gross income (not tax-exempt income or principal) that is paid for a charitable, etc. purpose described in Code section 170(c), if the payment is made “pursuant to the terms of the governing instrument.” I.R.C. § 642(c)(1). The United States Supreme Court has held that payments are made “pursuant to” the terms of the governing instrument where the trustee has discretion to distribute the amount to charity, not simply where the trustee must do so. Old Colony Trust Co. v. Commissioner, 301 U.S. 379 (1937). The deduction is not limited by any counterpart to the adjusted gross income limitation of Code section 170, and the trustee or executor may elect to treat payments made in one year as having been made in the prior taxable year. An estate, and certain complex trusts (primarily including only certain trusts created on or before October 9, 1969), are also entitled to deduct charitable set asides made pursuant to the terms of the will or trust instrument. I.R.C. § 642(c)(2). c. Net Operating Losses (“NOLs”).

If an estate or trust operates a business, it will have a NOL to the extent that the expenses of the business exceed both the gross income from the business and the taxable income (if any) from other activities. Cf. I.R.C. § 172(c), (d)(4). The deduction for NOLs is allowed estates and trusts to the extent provided in the regulations. I.R.C. § 642(d). The NOL must be computed without taking into account the deduction for charitable distributions and distributions to beneficiaries. Treas. Reg. § 1.642(d)-1. The rules for computing carrybacks and carryforwards of NOLs are set forth in Code section 172. These rules are applied at the entity level. NOLs incurred or carried forward to the final taxable year of the estate or trust pass through to the beneficiaries. I.R.C. § 642(h). d. Depletion, Depreciation and Amortization.

Under Code section 642(e), an estate or trust is allowed a deduction for depletion and depreciation to the extent that a beneficiary is not allowed a deduction for such items under Code sections 611(b) and 167(d). Under these rules, in the case of a trust, the deduction will be allocated between the trustee and the income beneficiary. The allocation is made in accordance with the terms of the governing trust instrument, or in the absence of such terms, on the basis of the fiduciary accounting income allocable to the trustee and to the beneficiaries.v In the case of an estate, the deduction is apportioned between the estate and the heirs, legatees, and devisees according to the fiduciary accounting income of the estate allocable to each (rather than in accordance with any specific provision of the will attempting to apportion the deduction). Similar rules apply to the deduction for amortization of intangibles (under Code section 197) and amortization of certain pollution control facilities (under Code section 169). I.R.C. § 642(f); Treas. Reg. § 1.642(f)-1. e. Deduction for Administrative Expenses of an Estate.

Under Code section 642(g), an executor of an estate may elect to deduct certain administrative expenses in computing the taxable income of the estate, in lieu of deducting such amounts in computing the taxable estate of the decedent for estate tax purposes. Such administrative expenses include the fees of executors, attorneys, accountants, and appraisers, as well as court costs and other administration expenses, provided that they are ordinary and necessary in the collection, preservation, and management of the estate. f. Deductions for Required and/or Actual Distributions.

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As discussed in Part II.B, above, a simple trust, a complex trust and an estate deduct certain amounts required to be distributed, or actually distributed, to its beneficiaries. The deduction is limited by the amount of the entity’s DNI, as discussed below in Part III, C. C. DNI. 1. In General.

Another extremely significant “income” type is DNI. The amount of DNI of a trust or estate limits the deduction for required or actual distributions to beneficiaries that may be claimed by a fiduciary in computing the taxable income of the estate or trust, and also limits the amount of income upon which a beneficiary can be taxed. DNI also impacts the relative tax burdens of distributions upon beneficiaries. 2. Computation of DNI.

Code section 643(a) defines DNI as the “taxable income” of the estate or trust, computed with certain modifications. The major modifications, set forth in Code section 643(a), are as follows. a. No Deduction for Distributions.

The deduction allowed estates and trusts for required and/or actual distributions to beneficiaries is not allowed for purposes of computing DNI. I.R.C. § 643(a)(1). This rule is a logical structural feature of the overall taxing regime of Subchapter J, insofar as DNI serves to limit the deduction for distributions that may be claimed by the trust or estate and the inclusion of the same in the gross income of beneficiaries. Accordingly, in computing DNI, begin with the estate’s or trusts’s taxable income, calculated without any deduction for distributions to non-charitable beneficiaries. b. No Deduction for Exemption Substitute.

The deduction in lieu of the personal exemption under Code section 642(b) is not allowed. I.R.C. § 643(a)(2). Accordingly, in computing DNI, add back the amount of the deduction in lieu of the personal exemption to the amount of the estate’s or trusts’s taxable income. c. Capital Gains and Losses Generally Excluded. (1) Capital Gains. (a) General Rule.

Capital gains allocated to corpus are generally excluded in computing DNI. I.R.C. § 643(a)(3). (b) Special Allocations to Income, etc.

Notwithstanding the general rule, capital gains are included in computing DNI to the extent that, 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), the capital gains are —

• Allocated to income; o However, 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 the rules for including capital gains in DNI);

• 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

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• 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.

Treas. Reg. § 1.643(a)-3(b).

(c) Charitable Payments and Set Asides. If capital gains are paid, permanently set aside, or to be used for the purposes specified in section 642(c), so that a charitable deduction is allowed under that section in respect of the gains, they must be included in the computation of distributable net income. Treas. Reg. § 1.643(a)-3(c).

Accordingly, in general, in computing DNI, reduce the amount of taxable income by capital gains, except those which are allocable to income or distributable to beneficiaries, and except those which qualify for the charitable deduction. (2) Capital Losses.

Capital losses are generally excluded in determining the amount of net capital gains included in DNI for reasons discussed above. I.R.C. § 643(a)(3). Under the regulations, losses from the sale or exchange of capital assets are first netted at the trust level against any gains from the sale or exchange of capital assets, except for a capital gain that is allocated to corpus and utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a particular beneficiary. Treas. Reg. § 1.643(a)-3(d). Accordingly, in general, in computing DNI, increase the amount of taxable income by capital losses that are not taken into account in determining the amount of net capital gains included in DNI. d. Certain Dividends of Simple Trusts Excluded.

Extraordinary dividends and taxable stock dividends received by the trustee of a simple trust are excluded if the trustee does not pay or credit such amounts to any beneficiary because of the good faith belief that such dividends are allocable to corpus under the terms of the trust instrument and state law. I.R.C. § 643(a)(4). Accordingly, in computing DNI, reduce the amount of taxable income by extraordinary dividends and taxable stock dividends received by the trustee of a simple trust who in good faith allocates such amounts to corpus. e. Tax-Exempt Interest Included.

The amount of interest income exempt from tax under section 103 is included in DNI, less expenses directly allocable to such interest, and less any amount that would have been deductible as charitable distributions under Code section 642(c) had such amount been an item of gross income. I.R.C. § 643(a)(5); Treas. Reg. §§ 1.643(a)-5(b). Accordingly, in computing DNI, add back the amount that would constitute “net” tax-exempt interest income were expenses allocable thereto deductible for general taxation purposes, except with respect to any portion of such amount that would (if taxable) be deductible under section 642(c). f. Special Rule for Income from Foreign Trusts.

The DNI of a foreign trust must be adjusted for certain other income items, as required by Code section 643(a)(6). D. Fiduciary Accounting Income. 1. General Significance of Fiduciary Accounting Income.

Estate planners must understand the critical importance of determining “income” of a trust and

Subchapter J: The Very Basics (rev. 2019) Page 9 estate for fiduciary accounting purposes (i.e., in deciding what amounts are allocable to principal and what amounts are allocable to income for purposes of accounting for the relative rights of income beneficiaries and those with rights to principal). This is so for at least two reasons. First, under Code section 643(b), the definition of “income” – when not modified by some other statutory term of art – is “the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law.” Hence, whenever the term “income” appears in Subchapter J, it means “fiduciary accounting income.” Ignorance of fiduciary accounting income therefore necessarily limits the estate planner’s ability to understand and apply Subchapter J.

A second reason that one must grasp the concept of fiduciary accounting income is that some

provisions of Subchapter J that do not specifically refer to “income” nonetheless assume a determination of whether an item is properly allocable to principal or income for fiduciary accounting purposes. See, e.g., I.R.C. § 643(a)(3), (4). 2. Relevant State Law.

Fiduciary accounting income is determined under the terms of the trust instrument and state law. Thus, the estate planner must be familiar with how state law allocates receipts to income and principal. Texas has adopted the Uniform Principal and Income Act, codified in Chapter 116 of the Texas Property Code. The statute contains default rules for allocating receipts and disbursements between principal and income, and generally empowers a trustee to adjust between the two when necessary to comply with the duty of impartiality owed trust beneficiaries. 3. When Trust Instrument’s Allocations Differ from those under State Law.

Under the Treasury regulations, definitions of “income” for fiduciary accounting purposes set forth in the trust instrument will not be respected by the Internal Revenue Service (“IRS”) if they fundamentally depart from the concept of income under state law. Treas. Reg. § 1.643(b)-1. However, the regulations now define “income” for federal income tax purposes to reflect the trend in state law governing fiduciary accounting. The trend in state law, as in Texas, is to authorize explicitly a “total return” investment strategy by the trustee, and to permit the trustee to apportion income and principal in some fashion (equitably, or through a unitrust computation) so as to treat the income beneficiary and remainderman impartially, quite apart from actual receipt of traditional fiduciary accounting “income” items.vi The regulations plainly respect allocations between income and principal if they are made in accordance with state laws that provide for a reasonable apportionment of total return. Further, an allocation to income of all or a part of the gains from the sale or exchange of trust assets will generally be respected if the allocation is made either pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law. IV. QUESTION #3: WHEN IS THE SETTLOR (GRANTOR) OF A TRUST TAXED ON TRUST INCOME?

Code sections 671-677 describe the types of interests and powers retained by the grantor of a trust that will cause her to be treated as owner of all or part of a trust. The most important of these rules are explained in this section of the Article. These rules exclusively determine whether a grantor is treated as owner of any part of the property held in trust; forms of dominion and control retained by the grantor which are not described in these Code sections will not cause the grantor to be treated as owning a portion of the trust. I.R.C. § 671 (last sentence). A. Reversionary interests. 1. In General.

The grantor is treated as the owner of any portion of a trust in which she has a reversionary interest in either the corpus or the trust income, if, as of the inception of that portion of the trust, the

Subchapter J: The Very Basics (rev. 2019) Page 10 value of such interest exceeds 5 percent of the value of such portion. I.R.C. § 673(a). The statute does not state how to determine “value ” (although section 673(c) does require the reversionary interest’s “value” to be determined by assuming the maximum exercise of discretion in favor of the grantor). A reasonable approach is to use the actuarial tables published under Code section 7520. Cf. Priv. Ltr. Rul. 200030010 (April 26, 2000) (apparently applying this approach to value a reversionary interest in a grantor retained annuity trust). 2. Exception.

If the grantor’s reversion becomes possessory solely upon the death of a beneficiary prior to the beneficiary’s 21st birthday, which beneficiary is a descendant of the grantor and holds all of the present interests in the trust, that fact alone will not cause the grantor to be treated as an owner of the trust. I.R.C. § 673(b). B. Power to control beneficial enjoyment. 1. In General.

Code section 674(a) sets forth the seemingly broad rule that the grantor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the trust income is subject to a power of disposition that is exercisable by the grantor (and/or a nonadverse party), without the approval or consent of any adverse party. This sweeping general rule is substantially limited, however, by several major exceptions, some of the most important of which follow. 2. Excepted Powers Held by Anyone.

The general rule does not apply to a number of powers held by anyone (including the grantor). The following are noteworthy among this class of excepted powers: a. Power to Apply Income to Support Dependent.

A power described in section 677(b) to the extent that the grantor would not be subject to tax under that section. I.R.C. § 674(b)(1). Such a power is the discretionary power (even if held by the grantor, provided she is acting as trustee or co-trustee) to apply or distribute income for the support or maintenance of a beneficiary (other than the grantor's spouse) whom the grantor is legally obligated to support or maintain, except to the extent that such income is so applied or distributed. b. Certain Testamentary Powers.

A power exercisable only by will, other than a power in the grantor to appoint by will trust income, which income is accumulated for such disposition by the grantor, or may be so accumulated in the discretion of the grantor (or a nonadverse party, or both), without the approval or consent of any adverse party. I.R.C. § 674(b)(3). c. Power to Allocate Among Charitable Beneficiaries.

A power to determine the beneficial enjoyment of the corpus or the trust income if the same is irrevocably payable for a charitable, etc. purpose specified in Code section 170(c) or to an employee stock ownership plan (as defined in Code section 4975(e)(7)) in the case of certain transfers. I.R.C. § 674(b)(4). d. Certain Powers to Distribute Corpus.

A power to distribute corpus, if limited by a reasonably definite standard set forth in the trust instrument; or a power to distribute corpus to or for any current income beneficiary, provided that the distribution of corpus is chargeable against the proportionate share of corpus held in trust for the payment of income to such beneficiary. I.R.C. § 674(b)(5). However, this exception does not apply if any person has a power to add beneficiaries, except to provide for after-born or after-adopted children. Id. e. Certain Powers to Withhold Income Temporarily.

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Certain powers to accumulate income under Code sections 674(b)(6) and (7). In general, any accumulated income ultimately must be payable to the beneficiary or his estate, or to his appointees under a power of appointment, or the power to accumulate must cease when the beneficiary is not legally incapacitated. f. Power to Allocate between Corpus and Income.

A power to allocate receipts and disbursements between corpus and income. I.R.C. § 674(b)(8). 3. Excepted Powers Held by Independent Trustees.

The general rule also does not apply to certain powers solely exercisable by one or more trustees, none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor. Such powers include the power (1) to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries; and (2) to pay out corpus to or for a beneficiary or beneficiaries or to or for a class of beneficiaries. I.R.C. § 674(c). However, this exception does not apply if any person has a power to add beneficiaries, except to provide for after-born or after-adopted children. Id. 4. Excepted Powers Held by Anyone Except Grantor and Spouse.

Finally, the general rule does not apply to a power solely exercisable by a trustee or trustees, none of whom is the grantor or spouse living with the grantor, to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries, if such power is limited by a reasonably definite external standard which is set forth in the trust instrument. I.R.C. § 674(d). However, this exception does not apply if any person has a power to add beneficiaries, except to provide for after-born or after-adopted children. Id. C. Administrative Powers.

The grantor is treated as the owner of any portion of a trust in respect of which the grantor has, or has exercised, certain administrative powers. The following circumstances involving such powers result in such treatment: 1. Power to Deal for Less than Adequate Consideration.

A power exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party, enables any person (including the grantor) to purchase, exchange, or otherwise deal with or dispose of the corpus or trust income for less than adequate consideration. I.R.C. § 675(1). 2. Power to Borrow without Adequate Interest or Security.

A power exercisable by the grantor or a nonadverse party, or both, enables the grantor to borrow (directly or indirectly) the corpus or trust income, without adequate interest or security, unless a trustee (who is not the grantor) is authorized to make loans to any person without regard to interest or security. I.R.C. § 675(2). 3. Borrowing of Trust Funds.

The grantor has directly or indirectly borrowed the corpus or trust income and has not completely repaid the loan (with interest) before the beginning of the taxable year, unless the loan carries adequate interest, is adequately secured, and has been made by an independent trustee. I.R.C. § 675(3). 4. General Powers of Administration.

Any of the following powers is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity: (a) a power to vote or direct the voting

Subchapter J: The Very Basics (rev. 2019) Page 12 of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant in terms of voting control; (b) a power to control the investment of the trust funds (by directing investments or vetoing proposed investments), to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant in terms of voting control; or (c) a power to reacquire the trust corpus by substituting other property of the same value. I.R.C. § 675(4). D. Power to Revoke.

The grantor is treated as the owner of any portion of a trust if the grantor or a non-adverse party, or both, can revest title to trust property in the grantor. I.R.C. § 676(a). However, this rule does not apply to a power, the exercise of which can merely affect the beneficial enjoyment of the income after the occurrence of an event such that a grantor would not be treated as the owner under section 673 if the power were a reversionary interest. I.R.C. § 676(b). Nevertheless, the grantor may be treated as the owner after the occurrence of such event if the power is not relinquished. Id.

E. Income for Benefit of Grantor

The grantor is generally treated as the owner of any portion of a trust, the income of which without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be, (1) distributed to the grantor or the grantor's spouse; (2) held or accumulated for future distribution to the grantor or the grantor's spouse; or (3) applied to the payment of premiums on insurance policies on the life of the grantor or the grantor's spouse (except policies irrevocably payable for a purpose specified in Code section 170(c)). I.R.C. § 677(a)(1)-(3). However, this rule does not apply to a power, the exercise of which can merely affect the beneficial enjoyment of the income after the occurrence of an event such that a grantor would not be treated as the owner under section 673 if the power were a reversionary interest. Nevertheless, the grantor may be treated as the owner after the occurrence of such event if the power is not relinquished. Id. Further, income of a trust is not taxable to the grantor merely because such income, in the discretion of the grantor (acting as trustee or co-trustee) or another person, may be applied or distributed for the support or maintenance of a beneficiary (other than the grantor's spouse) whom the grantor is legally obligated to support or maintain, except to the extent that such income is so applied or distributed. I.R.C. § 677(b). F. Special Rules. 1. Meaning of Adverse Party.

For purposes of these rules, an “adverse party" means any person who has a substantial beneficial interest in the trust that would be adversely affected by the exercise (or non-exercise) of such person’s power. The holder of a general power of appointment over the trust property is deemed to have a beneficial interest in the trust for these purposes. I.R.C. § 672(a). 2. Interests and Powers Held by Grantor’s Spouse.

For purposes of these rules, a grantor is treated as holding any power or interest held by her spouse. I.R.C. § 672(e). V. QUESTION #4: WHEN IS A NON-GRANTOR “POWER HOLDER” TAXED ON TRUST INCOME? A. In General.

As discussed above, a non-grantor power holder may be taxed as the owner of all or a portion of a trust. In general, a person other than the grantor is treated as the owner of any portion of a trust with respect to which such person: (1) has a power exercisable solely by himself to vest the corpus or trust income in himself, or (2) has previously partially released or otherwise modified such a power, and after the release or modification retains such control as would cause a grantor to be treated as the owner of the trust. I.R.C. § 678(a). A Crummey withdrawal right is an example of the type of power

Subchapter J: The Very Basics (rev. 2019) Page 13 addressed by the statute. Of course, as discussed in detail previously, this rule does not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust is otherwise treated as the owner. I.R.C. § 678(b). B. Special Rules.

The general rule taxing the non-grantor power holder does not apply to a power which enables such person, in the capacity of trustee or co-trustee, merely to apply trust income to the support or maintenance of a person whom the holder of the power is obligated to support or maintain, except to the extent that such income is so applied. I.R.C. § 678(c). Additionally, the general rule does not apply with respect to a power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of it. I.R.C. § 678(d). The statute does not define a “reasonable time.” Resort to the rules governing qualified disclaimers for transfer tax purposes (cf. Code section 2518) would seem appropriate. VI. QUESTION #5: WHEN IS INCOME TAXED TO THE TRUST/ESTATE AND/OR BENEFICIARIES, AND HOW IS THE TAX BURDEN DISTRIBUTED AMONG THE PARTIES?

If the grantor or non-grantor power holder is not properly treated as owner of the trust, trust income that is subject to income tax will be taxed to the trustee, the beneficiary, or both. Of course, estate income will be similarly taxed – to the executor (or administrator), the devisees and legatees (or heirs), or all of them. This section, building on the discussion in Parts II and III, above, sets forth the general steps to follow in determining the income tax liability of the fiduciary and beneficiaries.vii A. Taxation of Simple Trust and Its Beneficiaries. 1. Taxation of Entity.

The taxable income of a simple trust is computed as follows:

(a) Compute the trust’s taxable income, before deducting the amount required to be distributed currently to beneficiaries (i.e., the current year’s fiduciary accounting income). As discussed above, the deductions taken in computing taxable income are the same as those allowed for an individual, except as modified by Subchapter J.

(b) Compute the trust’s DNI under section 643. (c) Compute the amount of required distributions to beneficiaries under section 651(a)

(i.e., fiduciary accounting income). The deduction for amounts required to be distributed currently is the lesser of (1) DNI (adjusted to exclude tax-exempt income and any deductions allocable thereto) and (2) fiduciary accounting income.

(d) The trust’s taxable income is the income computed under step (a) minus the deduction for required distributions (step (c)).

See I.R.C. §§ 641(a); 642; 651(a)&(b). The taxable income is taxed under the rates of Code section 1(e). 2. Taxation of Beneficiaries.

The trust income of a simple trust to be included in the beneficiary’s gross income is determined as follows:

(a) If DNI exceeds the amount of income required to be distributed currently (i.e., all fiduciary accounting income), all fiduciary accounting income is included in the gross income of the beneficiaries entitled to the distribution, whether or not actually distributed.

(b) If DNI is less than the amount of income required to be distributed currently (i.e., all fiduciary accounting income), a proportionate share (based upon relative amounts of

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income required to be distributed to beneficiaries) of DNI is included in the gross income of each beneficiary.

(c) The character of the item of income (e.g., dividends, tax-exempt interest) in the hands of the beneficiary is the same as that in the hands of the trust.

See I.R.C. § 652(a)&(b). B. Taxation of Estates and Complex Trusts, and Their Beneficiaries. 1. Taxation of Entity.

The taxable income of a complex trust or an estate is computed as follows:

(a) Compute the taxable income of the estate or complex trust, before deducting any amount attributable to distributions to beneficiaries. As discussed above, the deductions taken in computing taxable income are the same as those allowed for an individual, except as modified by Subchapter J.

(b) Compute the DNI of the trust or estate under section 643. (c) Compute the deduction available to the trust or estate for distributions to beneficiaries

under section 661. The deduction is the lesser of (1) DNI (effectively adjusted to exclude items that are excluded from the gross

income of the trust or estate),viii and (2) the sum of

(i) the fiduciary accounting income required to be distributed currently (including any amount required to be distributed from income or principal, to the extent it is actually paid from income for the taxable year), and (ii) any other amounts “properly paid or credited or required to be distributed” for the taxable year (such as discretionary distributions of income or principal).

(d) The taxable income of the trust or estate is the income computed under step (a) minus the deduction for distributions (step (c)).

See I.R.C. §§ 641(a); 642; 661(a)-(c). The taxable income is taxed under the rates of section 1(e). 2. Taxation of Beneficiaries. a. In General.

The income of a complex trust or estate to be included in the beneficiary’s gross income is generally determined as follows

(a) If total distributions made (and required to be made out of current income) for the year do not exceed DNI for the year, the beneficiaries include all distributions in income, other than the portion attributable to tax-exempt items.

(b) If total distributions exceed current DNI, DNI is carried out first to recipients of mandatory distributions of current fiduciary accounting income (so-called “first-tier beneficiaries”), and then any remaining DNI is carried out to the other beneficiaries (so-called “second-tier beneficiaries”). The gross income of the beneficiaries includes each beneficiary’s allocable share of DNI, less the portion attributable to tax-exempt items.

(c) Distributions exceeding DNI are tax-free. (d) The character of the items of income (e.g., dividends, tax-exempt interest) in the hands

of the beneficiaries is the same as that in the hands of the trust or estate. Determining which items having a particular character are treated as having been distributed to specific beneficiaries depends on DNI. Unless the governing instrument provides otherwise, distributions of items included in DNI consist of a pro rate share of each type of income included in DNI.

Subchapter J: The Very Basics (rev. 2019) Page 15 I.R.C. § 662(a)&(b). b. Special Rules. (1) Separate Share Rule. (a) In General. If the beneficiaries have substantially separate and independent shares, each share is treated as a separate trust for purposes of allocating DNI to the various beneficiaries (but not for other purposes). I.R.C. § 663(c). The rule’s application does not depend on the keeping of separate accounts for each share in the fiduciary’s books of account, or on any physical segregation of assets in the hands of the trustee. Treas. Reg. § 1.663(c)-1(c). For example, assume a trust instrument providing that one-half of income may be paid to or accumulated for beneficiary A, and the other half paid to or accumulated for beneficiary B, and also providing for discretionary distributions of corpus. Also assume that total DNI equals fiduciary accounting income. If B receives a distribution exceeding the amount of income allocable to him, the excess will not be treated as consisting of DNI in B’s hands. (b) Application to Estates.

The separate share rule applies to estates, as well as trusts. I.R.C. § 663(c). The regulations state that the existence of a separate share of an estate depends on whether the will and local law create separate economic interests in one beneficiary or class of beneficiaries of the estate. Treas. Reg. § 1.663(c)-4(a). A separate share ordinarily exists if the economic interests of one beneficiary (or class of beneficiaries) do not affect and are not affected by the economic interests of others. Id. Examples of separate shares include income on a bequest where the legatee is entitled to such income (as in the case of income from specific devises under section 310.004(b) of the Texas Estates Code), and a qualified revocable trust for which an election is made under Code section 645. However, a gift or bequest of a specific sum of money or of property is not treated as a separate share. (2) How Charitable Distributions Affect Non-Charitable Beneficiaries.

Code section 662(a)(1) provides that, for purposes of apportioning DNI to and among first-tier beneficiaries, DNI is computed without regard to the deduction for charitable payments described in Code section 642(c). The general effect is to cause the charitable distribution deduction to benefit only second-tier beneficiaries.ix VII. QUESTION #6: WHAT IS INCOME IN RESPECT OF A DECEDENT, AND HOW IS IT TAXED? A. Definition of Income in Respect of a Decedent.

Stated very (and, perhaps, “overly”) simply, “income in respect of a decedent" (“IRD”) refers to any amount of gross income that a decedent had a right to receive, and would have received had he lived longer, but which cannot properly be reported as income in the decedent’s final income tax return.x For a cash basis taxpayer, IRD generally refers to amounts of income that the decedent has not actually or constructively received as of his death. More technically, IRD is defined by the regulations as those amounts of gross income to which a decedent was entitled but which were not properly includible in taxable income for the taxable year of the decedent’s death (or for a previous taxable year) under the decedent’s method of accounting. Treas. Reg. § 1.691(a)-1(b). The regulations provide the following examples of IRD:

1. All accrued income of a decedent who reported his income by use of the cash receipts

and disbursements method of accounting;

2. Income accrued solely by reason of the decedent's death in case of a decedent who reports his income by use of an accrual method of accounting; and

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3. Income to which the decedent had a contingent claim at the time of his death. Id. IRD also includes the amount of all items of gross income in respect of a prior decedent not properly included in taxable income reported in the decedent’s final income tax return (or in a prior year’s return), if the right to receive such amount was acquired by the decedent by reason of the death of the prior decedent or by testamentary disposition or intestate distribution from the prior decedent. Treas. Reg. § 1.691(a)-1(c). B. General Taxation of IRD. 1. Statutory Scheme.

Who must include an item of IRD in gross income? Section 691(a)(1) states that the following persons must include IRD in gross income “for the taxable year when received” in the stated circumstances:

a. The estate of the decedent, if such entity acquired the right to receive the amount from the decedent;

b. The person who, by reason of the death of the decedent, acquired the right to receive

the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent; or

c. The person who acquired from the decedent the right to receive the amount by bequest,

devise, or inheritance, if the amount is received after a distribution of the right by the decedent's estate.

I.R.C. § 691(a)(1)(A)-(C). Observe that the item of IRD is generally included in the gross income of the recipient when the recipient receives the income from the decedent’s right thereto, not when the recipient receives the right to the income.

2. Examples. a. Salary.

Assume that the decedent died with a right to a significant salary payment, payable in equal annual installments over five years. His estate, after collecting two installment payments, distributed the right to the remaining payments to the residuary legatee of the estate. The estate must include in its gross income the two installments that it received, and the legatee must include in gross income each of the three installments that she receives. Treas. Reg. § 1.691(a)-2(b) Example (1). b. Proceeds of Sale.

Who must report proceeds of sale depends not only upon who receives them, but also upon whether the decedent had effectively established his right to the proceeds by his death. Assume A owned and operated an apple orchard. A sold and delivered 1,000 bushels of apples to X, a canning factory, but did not receive payment before A’s death. A also entered into negotiations to sell 3,000 bushels of apples to Y, a canning factory, but did not complete the sale before A’s death. After A's death, the executor received payment from X. The executor also completed the sale to Y and transferred to Y 1,200 bushels of apples on hand at A's death and harvested and transferred an additional 1,800 bushels. The gain from the sale of apples by A to X constitutes IRD when received. However, the gain from the sale of apples by the executor to Y does not. Treas. Reg. § 1.691(a)-2(b) Example (5). c. Accrued, Unpaid Interest.

Assume the decedent owned a Series E United States savings bond, with his wife as co-owner or beneficiary, but died before the bond was paid. The entire amount of interest accruing on the bond and not includible in income by the decedent, not just the amount accruing after his death, is treated as

Subchapter J: The Very Basics (rev. 2019) Page 17 income to his wife when the bond is paid. Treas. Reg. § 1.691(a)-2(b) Example (3). C. Special Rules. 1. Character of IRD.

Code section 691(a)(2) states that the right to an item of IRD is treated, in the hands of the decedent’s estate (or in the hands of any person who acquired the right to IRD by reason of the death of the decedent, or by bequest, devise, or inheritance from the decedent), as if it had been acquired by such entity or person in the transaction in which the right to receive the income was originally derived. Consequently, the amount of IRD received is considered to have the same character in the hands of such entity or person as it would have had in the hands of the decedent had the decedent received the item of income. I.R.C. § 691(a)(3). 2. Transfer of IRD. a. Transfers Which Accelerate Income Recognition.

What if an item of IRD is transferred by the estate, or by the person entitled to the item of IRD by bequest, devise, or inheritance, or by reason of the death of the decedent? In general, the transferor must include in her gross income for the taxable period of the transfer the amount of the consideration, if any, that she received for the right to IRD or its fair market value at the date of the transfer, whichever is greater. I.R.C. § 691(a)(2); Treas. Reg. § 1.691(a)-4(a). This treatment generally applies to any form of transfer, be it a sale, exchange, or other disposition (such as a gift). I.R.C. § 691(a)(2). b. Transfers to Certain Beneficiaries Do Not Accelerate Income Recognition.

Notwithstanding this general rule, if the estate of a decedent or any person transmits a right to IRD to another who would be required by Code section 691(a)(1) to include the item of IRD in gross income when received, only the transferee includes the item of IRD in gross income when received. For example, if a person entitled to IRD dies before receiving such income, only his estate (or such other person who is entitled to the income item under his will or by intestate distribution, or by reason of the death of the latter decedent), must include the IRD in gross income when received. Similarly, if a right to IRD is transferred by an estate to a specific or residuary legatee entitled to receive the IRD under the will, only the specific or residuary legatee must include the IRD in gross income when received. I.R.C. § 691(a)(2); Treas. Reg. § 1.691(a)-4(b)(1)&(2). 3. Treatment of Instalment Obligations.

Special rules apply to instalment obligations. See I.R.C. §§ 691(a)(4), (5). A detailed explanation of these rules is most assuredly not within the scope of the “very basics” of Subchapter J. Suffice it to say that the disposition (including a cancellation) of an instalment note received from a decedent can accelerate the recognition of IRD, and can do so with surprisingly harsh consequences in the case of related party transactions. 4. Deductions in Respect of a Decedent.

Code section 691(b) allows a deduction – to the estate or other person liable for discharging the obligation of the decedent to which the deduction relates – for certain expenses paid by such person. The deduction must not be allowable in the taxable year of the decedent’s death. 5. Deduction for Estate Tax.

Code section 691(c) allows a deduction for estate taxes to a person who includes an item of IRD in her gross income. The deduction essentially equals that portion of the estate tax attributable to all IRD items which was generated by the particular income taxpayer’s item of IRD in the decedent’s taxable estate.

Subchapter J: The Very Basics (rev. 2019) Page 18 VIII. QUESTION #7: WHAT ARE THE NOT-SO-OBVIOUS INCOME TAX EFFECTS OF SOME COMMON TRUST/ESTATE TRANSACTIONS AND DECISIONS OF A FIDUCIARY?

This section focuses briefly on the income tax effects of a selected number of transactions and fiduciary decisions that an estate planner is likely to encounter. The treatment of these issues is by no means exhaustive. For a more complete discussion of these and similar issues (from which the author has borrowed in this section of the Article), see Mickey R. Davis, Ten Things Estate Planners Need to Know about Income Tax Matters, 24th Annual Advanced Estate Planning and Probate Course, State Bar of Texas, Chapter 19 (June 7-9, 2000). A. Qualified Revocable Trust Election.

Upon the death of a settlor of a “qualified revocable trust,” the trustee and the executor of the settlor’s estate (if any) may irrevocably elect to treat the trust as part of the settlor’s estate for federal income tax purposes. I.R.C. § 645. A “qualified revocable trust” is a trust that, during the life of the settlor, was treated as a grantor trust because of her right of revocation under Code section 676. The election enables the trustee to take advantage of certain differences in the treatment of estates and trusts under federal income tax law. Final regulations governing this election were issued in December of 2002, and should be consulted for detailed guidance. See Treas. Reg. § 1.645-1.

B. Distributions of an Estate that Carry Out DNI. 1. In General.

From the discussion above, it should be clear that a distribution from an estate generally will carry with it a portion of the estate’s DNI. Code section 663 (b) permits the executor of an estate (as well as the trustee of a complex trust) to treat distributions made during the first 65 days of the entity’s tax year as though they were made on the last day of the preceding tax year. This election facilitates income tax planning by enabling the fiduciary to determine more accurately the entity’s DNI when deciding to make distributions that economically shift taxable income to beneficiaries. 2. Special Exceptions.

Code section 663(a)(1) provides that if the executor pays gifts or bequests of “a specific sum of money” or “specific property” all at once, or in not more than three installments, the distributions will not carry out DNI to the beneficiaries. These gifts are essentially treated as part of the “corpus” of the estate. (Amounts that an executor can pay, under the express terms of the will, only from current or accumulated income of the estate do not qualify under this special rule. Treas. Reg. § 1.663(a)-1(b)(2)(i).) Further, under the Treasury regulations, the transfer of real estate does not carry out DNI when conveyed to the devisee thereof if, under local law (as under section 101.001 of the Texas Estates Code), title vests immediately in the distributee. Treas. Reg. § 1.661(a)-2(e). This latter rule has caused some confusion in the case of a residuary devise of real estate. Generally, a residuary gift is not treated as a gift of a sum of money or of specific property. Treas. Reg. § 1.663(a)-1(b)(2)(iii). 3. Amount of “In-Kind Distribution” Carrying Out DNI.

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Generally, if an in-kind distribution carries out DNI, the amount of DNI carried out by the in-kind distribution to a beneficiary is the lesser of the adjusted basis of the property prior to distribution (adjusted for any gain or loss recognized to the entity on the distribution), or the fair market value of the property at the time of the distribution. I.R.C. § 643(e)(2). C. When Distributions Trigger Income Tax to the Estate. 1. In General.

The estate does not generally recognize gain or loss upon making a distribution to a beneficiary. However, gain must be recognized when appreciated property is used to fund a bequest of a specific dollar amount, including certain pecuniary formula bequests. See Treas. Reg. § 1.1014-4(a)(3); Rev. Rul. 60-87, 1960-1 C.B. 286.

2. Special Election.

The fiduciary may elect under Code section 643(e)(3) to recognize gain and loss on the distribution of appreciated and depreciated property. If this election is made, the amount of the distribution for income tax purposes will be the fair market value of the property at the time of the distribution. The election, if made, applies to all property distributed during the year. D. Effect of Non Pro Rata Distributions In Kind by an Estate.

If the executor of an estate makes non-pro rata distributions of property to its beneficiaries without authorization, the IRS has ruled that the distributions are equivalent to a pro rata distribution of undivided interests in the property, followed by an exchange of interests by the beneficiaries. This deemed exchange presumably is taxable to both beneficiaries to the extent that value received differs from basis. Rev. Rul. 69-486, 1969-2 C.B. 159. To avoid this result with certainty, the will should expressly authorize non-pro rata distributions of property. IX. CONCLUSION.

Subchapter J sets forth a rather complicated system for taxing trusts and estates, and their beneficiaries. This Article has summarized the fundamentals of taxation embodied in Subchapter J. At a minimum, an estate planner should understand these basic rules of income taxation in order to advise clients (including individual taxpayers and fiduciaries) comprehensively. Of course, estate planning involves a consideration of transfer taxes, as well as income taxes. It is hoped that this Article will provide a helpful foundation for more advanced planning that accounts for all taxes of relevance to the client.

NOTES

i. See HOWARD M. ZARITSKY AND NORMAN H. LANE, FEDERAL INCOME TAXATION OF ESTATES AND TRUSTS, 12-18 to 12-19 (3rd ed. 2001).

ii. One could also argue that Code section 678 is more “specific” than the several provisions of Subchapter J taxing grantors as owners of the trust, and then invoke the principle of statutory construction that a specific statute controls a more general one. However, the rules taxing a grantor as the owner of a trust are hardly less specific than Code section 678; they are simply more numerous than the general rule of Code section 678.

iii. See ZARITSKY & LANE, supra note 1, at 12-19 n. 42 (postulating (and then rejecting) the argument that when the grantor and other power holder each hold powers over the same principal, “the exercise of either power is subject to the consent of the other.”

Subchapter J: The Very Basics (rev. 2019) Page 20 iv. See I.R.C. § 151(d)(5). v. The regulations state that if the trust instrument or local law directs or permits the trustee to

maintain a reserve for depreciation or depletion, the deduction must initially be allocated to the trustee (to the extent of the reserve), with any remaining deduction allocable to the trustee and to the beneficiaries on the basis of trust income allocated to each. Treas. Reg. §§ 1.167(h)-1(b); 1.611-1(c)(4).

vi. See ZARITSKY & LANE, supra note 1, at supplement to page 3-14.

vii. Cf. BORIS I. BITTKER AND LAWRENCE LOKKEN, 3 FEDERAL TAXATION OF INCOME, ESTATES AND GIFTS 81-7 to 81-9 (2d ed. 1991).

viii. The Code accomplishes this adjustment by providing generally that distributions are treated as consisting of the same proportion of each class of items included in the computation of DNI as the total of each such class bears to total DNI. I.R.C. § 661(b). If a portion of the distribution under this rule consists of an item excluded from gross income, Code section 661(c) treats such portion as non-deductible.

ix. See ZARITSKY & LANE, supra note 1, at 5-10 to 5-11.

x. Cf. CCH EDITORIAL STAFF, FEDERAL INCOME TAXES OF DECEDENTS, ESTATES, AND TRUSTS 17-18 (20th ed. 2001) (describing IRD similarly in lay terms).