Download - Trusts and Estates

Fundamentals of the Income Taxation of Trusts and Estates AICPA Advanced Estate PlanningJeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA July, 2006

What Well Coverl l l l l l l l l l l l l

Structure of Subchapter J Basic Rules Distributable Net Income (DNI) Types of Trusts Trust Accounting Income (TAI) Taxable Income Distribution Deduction/Tier System Separate Share Rule 65 Day Rule Charitable Deductions/Depreciation Terminations Administration Expenses Allocating Expenses to Tax Exempt Income

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Income Taxation of Trusts and Estates Code Outlinel

PART I, SUBCHAPTER J Subpart A - Sec. 641-646 - General Rules 641 Subpart B - Sec. 651-652 - Simple Trusts 651 Subpart C - Sec. 661-664 - Complex Trusts and CRT 661 Subpart D - Sec/ 665-668 - Accumulation Distributions 665 Subpart E - Sec. 671-678 - Grantor Trusts 671 Subpart F - Sec. 681-685 - Misc. Rules 681PART II, SUBCHAPTER J Sec. 691-692 - Income in Respect of a Decedent 691-

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Income Taxation of Trusts and Estatesl

Separate Taxable Entities Taxable Income Computed in Same Manner as Individuals (Sec. 641(b)) Own Tax Year and Method of Accounting Receive Income/Pay Expenses Income Taxed to Entity or Beneficiary

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Income Taxation of Trusts and Estatesl

Income Taxed to Either Entity or Beneficiary

If income is accumulated and not deemed distributed, it is taxed to the trust or estate If income distributed: distributed:l

Trust gets deduction for amount of distribution Beneficiary accounts for income distributed on his own tax return

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Income Taxation of Trusts and Estates DNIl

Distributable Net Income (DNI) governs:

Amount of trust or estates distribution deduction estate Amount beneficiary accounts for on his own return Character of income in beneficiarys hands beneficiary

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Income Taxation of Trusts and Estates DNIDNI acts as ceiling on entitys distribution deduction DNI acts as ceiling on amount beneficiary accounts for on his return

Trust/Estate

Beneficiary

DNI - Sec. 643(a)l

Start With Taxable Income and . . .

Add back the distribution deduction Add back the personal exemption Subtract out capital gains/add back capital losses gains/add allocable to principal (except in the year of termination) Subtract out extraordinary dividends and taxable stock dividends Add back net tax-exempt income tax-

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DNI - Sec. 643(a)l

Note: capital gains taxed to trust or estate

Exception: year of termination

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Note: The rules regarding DNI and the distribution deduction are applied differently to trusts and estates Distributions of principal as well as income will carry out DNI out

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Exception: Specific bequests under Sec. 663(a)(1)

Types of Trustsl

Simple Complex Grantor

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Simple Trustl

Required to distribute accounting income annually Makes no principal distributions, and Makes no distributions to charity

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Complex Trustl

Accumulates income Makes discretionary distributions of income or mandatory or discretionary distributions of principal, or Makes distributions to charity

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Grantor Trustl

Grantor or beneficiary has one or more powers powers described in Sec. 673-678 673Result: All income, expenses and credits flow through and are taxed to the Grantor or beneficiary through regardless of whether distributions are made Subpart A-D, Subchapter J (rules for taxation of trusts Aand estates) do not apply to Grantor trusts

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Concept of Trust Accounting Income (TAI)l

Governs amount of distributions Trustee allocates receipts/disbursements between accounting income and principal Accounting income and principal is determined by governing instrument or, if instrument silent, by state law

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Trust Accounting Income (TAI)TAI Corp Bond Int Capital Gains Muni Bond Int Expenses ? ? Taxable Income

2006 Fiduciary Income Tax RatesOver 0 2,050 4,850 7,400 10,050 Not Over 2,050 4,850 7,400 10,050 15% 25% 28% 33% 35%

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Taxable Income of Trust or Estatel l l l l l l

Computed same as individual Exemptions: $600/$300/$100 Different rules for charitable deductions Depreciation deduction allocated between entity and beneficiary Distribution deduction Administration expenses - some not subject to 2% floor AGI - same as individual except (a) personal exemption, (2) distribution deduction, (3) charitable deduction and (4) some administration expenses are subtracted off the top, i.e. subtracted from taxable top, income to arrive at AGI

Distributions - Simple TrustBeneficiary Taxed on Lower of TAI or DNI Gains Taxed to Trust Trust Gets Distribution Deduction Equal to DNI Simple Trust

Gains

DNIBeneficiary Accounts for DNI Beneficiary

Trust income retains its character in Beneficiarys hands

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Distributions - Complex Trusts and EstatesTrust/Estate Accumulates Income

Gains and DNI Taxed to Trust

Complex Trust

Gains DNI

Distributions - Complex Trusts and EstatesBeneficiary Taxed on Distributions Up to DNI Gains Taxed to Trust Trust Gets Distribution Deduction Equal to Distributions up to DNI Complex Trust

Gains

DNIBeneficiary Accounts for Distributions Up to DNI Beneficiary

Trust income retains its character in Beneficiarys hands

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Distributions - Applicable Code Sections

Simple Trusts

Complex Trusts/ Estates

651

661

652

662

Disributions - Applicable Code Sections

Simple Trusts Distribution Deduction


651

661

652

662

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Disributions - Applicable Code Sections

Simple Trusts Distribution Deduction Amt Bene Accounts For


651

661

652

662

Complex Trust and Estates Tier Systeml

Two tiers: First Tier - Distribution of income required to be distributed currently Second Tier - Distribution of all other amounts paid, credited or required to be distributed

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Complex Trust and Estates Tier System

DNI First Tier Beneficiary

Second Tier Beneficiary DNI is taxed first to FTB and any balance of DNI is taxed to STB

Complex Trust and Estates Tier System - Example Facts: $40,000 DNI and TAI Trust requires A receive 50% of income Trustee makes discretionary distributions of $20,000 to each B and C A is FTB (Gets 50% of $40,000 TAI) B and C are STB (Discretionary Benes)

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Complex Trust and Estates Tier System - Example $40,000 DNI ($20,000) DNI for FTB $20,000 DNI for STB 2 STB $10,000 DNI for Each STB

Complex Trust and Estates Tier System - Example $40,000 DNI

A $20,000 DNI FTB

B $10,000 DNI STB

C $10,000 DNI STB

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Separate Share Rule Solely for purposes of computing DNI, substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts. Effect: Treat multiple beneficiaries of single trust or estate as if each were the sole beneficiary of a single trust solely for determining how much DNI each distribution carries out.

Separate Share Rule Estate has $10,000 DNI for 2004 Two Equal Beneficiaries: A and B Distributes $10,000 to A in 2004 A taxed on $10,000 Estate has $5,000 DNI for 2005 Distributes $10,000 to B in 2005 B taxed on $5,000 Same amount paid in 2 different years, different tax result

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Separate Share Rule Estate has $10,000 DNI for 2004 Two Equal Beneficiaries: A and B Distributes $10,000 to A in 2004 A taxed on $5,000 ($10,000 DNI/2) Estate has $5,000 DNI for 2005 Distributes $10,000 to B in 2005 B taxed on $2,500 ($5,000 DNI/2) DNI computed based on 2 separate shares

Separate Share Rulel

Applies to estates and trusts DNI computed separately for each share Mandatory, not elective Only Affects share of DNI Doesnt allow filing multiple returns Doesnt allow separate calculation of tax

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65 Day Rule aka Sec. 663(b) Electionl l

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Applies to complex trusts and estates Allows fiduciary to treat distribution made within 65 days of Y/E as being made on 12/31 of preceding year Election must be made by due date of return Election is irrevocable Year by year election (e.g. good for 1 year only) Limited to > DNI less current year distributions or TAI not distributed

65 Day Rule aka Sec. 663(b) Election

65 Days 2005 12/31 2006

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65 Day Rule aka Sec. 663(b) Election Facts: $10,000 DNI for 2005 Distributes $6,000 in 2006 $4,000 65 Days $6,000 2005 12/31 2006

Specific Bequests - Sec. 663(a)(1)l

Bequest of specific sum of money or specific property do not carry out DNI Requirements: Paid all at once, or Paid in not more than 3 installments Not taxable by trust/estate or taxable to bene

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Charitable Deduction - Sec. 642(c)l

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Requirements: Paid from gross income Paid pursuant to the governing document Unlimited in amount No distribution deduction Taken as deduction in computing AGI Generally, must be actually paid in current year or preceding year Estates and pre- 1969 trusts get charitable prededuction if permanently set aside aside

Depreciation - Sec. 642(e)l

Trusts: Depreciation apportioned between income bene and the trust per trust document If no provisions in trust, depreciation apportioned on basis of trust income allocable between bene and trust Estates: Depreciation allocable on basis of income allocable to bene and estate

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Depreciation - Sec. 642(e) Examplel

Facts: Trust owns apartment building $2,500 depreciation deduction Trust pays all income to beneficiary Beneficiary is entitled to entire $2,500 depreciation deduction

Depreciation - Sec. 642(e) Exceptionsl

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GR: Depreciation allocated based in TAI allocated to trust/estate and beneficiary 2 exceptions - both apply to trusts: Trust inst or local law indicates who get depreciation deduction Trustee maintains depreciation reserve, trust gets deduction to extent trustee transfers income to reserve for depreciation

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Depreciation - Sec. 642(e) Examplel

Facts: Depreciation deduction is $5,000 TAI is $20,000 Inst requires trustee to maintain depr reserve Trustee transfers $5,000 of income for depr reserve Result: Entire $5,000 depr deduction is allocated to trust

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Termination of Trusts and Estates - Sec. 642(h) Unused Loss Carryovers and Excess Deductionsl

NOL, capital loss c/o and excess deductions pass to deductions the beneficiary on termination of an estate or trust Pass through only in the year of termination

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Capital Loss C/Ol

Unused capital loss c/o passes to beneficiary in year of termination of trust or estate No time limit on beneficiary to use capital loss c/o

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Capital Loss C/O Examplel

Facts: Trust incurs $30,000 LTCL in 2004. Trust terminates in 2005, LTCL c/o still $30,000 $30,000 LTCL c/o passes to beneficiary on termination Beneficiary can use LTCL c/o to offset his own personal capital gains or, if he has no gains, deduct up to $3,000 each year against ordinary income

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Excess Deductionsl

Excess deductions occur where trust/estate expenses deductions exceed income in year of termination Excess deductions pass through to beneficiary on deductions termination of trust/estate

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Beneficiary can deduct on his personal return

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Deductible as miscellaneous itemized deduction subject to 2% floor

If beneficiary doesnt itemize, he cant use deduction doesn can

Excess Deductions Examplel

Facts: Estate has $30,000 of income and $50,000 executors executor fee for 2005. Estate terminates in 2005 Excess deductions are $20,000 ($30,000 - $50,000) deductions Estate reports the $20,000 excess deduction to the beneficiary on a Form K-1 (tax letter) K- ( letter Beneficiary can take $20,000 excess deduction on deduction his own personal return as a miscellaneous itemized deduction subject to the 2% floor

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Administration Expensesl

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Consist of attorneys fees, accountants fees, executors attorney accountant executor commissions, filing fees, surety bonds premiums, appraisal fees, etc. Deductible on Federal estate tax return (706) or fiduciary income tax return (1041), but not both Fiduciary can elect where to take expenses (706 or 1041) - the so-called Sec. 642(g) election soGenerally, not subject to 2% floor Test: expenses would not have been incurred if property not held by estate or trust i.e. expenses are unique to the administration of estate or trust Generally, claim on return with highest tax rate

Non-Deductible Expenses - Sec. 265l

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Sec. 265 disallows any deduction attributable to T/E income Generally applies to deductions for production of income, usually trustees fees and executors fees trustee executor If trust/estate has T/E income, portion of trustees and trustee executors fees are nondeductible executor No specific allocation formula Fiduciary can use any reasonable method

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Non-Deductible Expenses - Sec. 265 Examplel

Facts: Trust has $30,000 taxable interest and $10,000 T/E interest Incurs $20,000 trustee fee Portion of trustee fee attributable to T/E income is non-deductible non-

$10,000 T/E income $40,000 Total income

x $20,000 fees = $5,000 Non-deductible Non-

Resourcesl

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Federal Income Taxation of Estates, Trusts and Beneficiaries, 3rd Edition by Ferguson, Freeland and Beneficiaries, Ascher (Aspen/CCH) 1041 Deskbook (Practitioners Publishing Co) Income Taxation of Trusts and Estates, 852-2nd (BNA Estates, 852portfolio Estate, Gift and Trust series) Federal Income Taxation of Decedents, Estates and Trusts, 21st Edition (CCH) Trusts, Federal Income Taxation of Trusts and Estates, by Estates, rd Edition (RIA/Thompson/West) Zaritsky and Lane, 3 Income Taxation of Fiduciaries and Beneficiaries by Abbin, 2 volumes, 2006 Edition (CCH) Abbin,

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Example of a 2005 Fiduciary Income Tax Return for a Complex Trust

Factsl

Trust provides that 50% of the income must be paid currently to Will During 2005 the trustee makes the following discretionary distributions: 25% of the income to Cam 25% of the income to charity No reserve for depreciation is required

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Question: What type of trust is this and why?

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

Distribution of Income

Required:

50% to Will

Discretionary: 25% to Cam 25% to Charity

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TAI 40,000 30,000 15,000 -

(14,000) (2,000)

69,000


TAI 40,000 30,000 15,000 -

(14,000) (2,000)

69,000

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TAI 40,000 30,000 15,000 -

(14,000) (2,000)

Enter on Form 1041, Sch. B, Line 8

69,000

Amount of TAI Received by Each Beneficiary

Will: Cam:

50% x 69,000 TAI = 34,500 25% x 69,000 TAI = 17,250

Charity: 25% x 69,000 TAI = 17,250 Total 69,000

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TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223


TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

Enter on Form 1041, Page 1, Line 17

69,000

47,223

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TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

Depreciation Deductionl

No reserve for depreciation Depreciation follows accounting income All accounting income is distributed to Will, Cam and the charity Therefore, the trust is not entitled to deduct any depreciation Beneficiaries are entitled to depreciation deduction

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TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

Trustee Fee Allocable to T/E Income

15,000 T/E Income x 3,000 Total 85,000 Gross TAI Tr Fees

529

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15,000 T/E Income x 3,000 Total = 529 85,000 Gross TAI Tr Fees Non-Deductible Deductible Tr Fees (529) 2,471


TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

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15,000 T/E Income x 17,250 TAI = 3,044 85,000 Gross TAI Charity Non-Deductible Charitable Deduction 3,044 14,206

Calculation of DNIDNI TI before Dist Ded Add: Exemption Add: Net T/E Income Less: ND Tr Fee Less: ND Char Ded Less: LTCG DNI 15,000 (529) (3,044) 11,427 (8,000) 50,750 47,223 100

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Calculation of DNIDNI TI before Dist Ded Add: Exemption Add: Net T/E Income Less: ND Tr Fee Less: ND Char Ded Less: LTCG DNI 15,000 (529) (3,044) 11,427 (8,000) 50,750 47,223 100

Enter on Form 1041, Sch. B, Line 7

Components of DNI47.06% 35.29% 17.65% Rental Taxable T/E Income Interest Interest 40,000 30,000 15,000 (14,000) (1,412) (8,118) 16,470 (1,059) (6,088) 22,853 (529) 11,427

Gross TAI LESS: Rental Exp Tr. Fees Char Ded Totals

100% Total 85,000 (14,000) (3,000) 50,750

(3,044) (17,250)

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Application of the Tier SystemWill is a FTB - entitled to 50% of the income or $34,500 Cam is a STB - discretionary distribution of $17,250 How do we allocate DNI between FTB and STB???

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Now Weve Got a Problem!!!FTB Will gets distribution of Total Distributions $34,500 $51,750

STB Cam gets distribution of $17,250

But DNI is only $50,750!!!

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The Tier System Solves Our ProblemShare of DNI FTB Will - Receives $34,500; limited to DNI of $50,750 STB Cam - Receives $17,250; limited to remaining DNI: 50,750 less 34,500 or $16,250 Total (Equal to DNI) $34,500

$16,250 $50,750

The Tier System Solves Our ProblemShare of DNI FTB Will - Receives $34,500; limited to DNI of $50,750 STB Cam - Receives $17,250; limited to remaining DNI: 50,750 less 34,500 or $16,250 Total (Equal to DNI) $34,500 % of DNI 67.98

$16,250 $50,750

32.02 100

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Remember This??? Components of DNI47.06% 35.29% 17.65% Rental Taxable T/E Income Interest Interest 40,000 30,000 15,000 (14,000) (1,412) (8,118) 16,470 (1,059) (6,088) 22,853 (529) 100% Total 85,000 (14,000) (3,000)

Gross TAI LESS: Rental Exp Tr. Fees Char Ded Totals

(3,044) (17,250) 11,427 50,750

Will and Cam get 67.98% and 32.02%, respectively, of each of these items

Trustee reports these amounts to Will and Cam on separate K-1s67.98% Will Rental Income Taxable Interest T/E Interest Total 11,196 15,536 7,768 34,500 32.02% Cam 5,274 7,317 3,659 16,250

Total 16,470 22,853 11,427 50,750

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Will Reports $26,731 of TI

67.98% Will Rental Income 31 11,196 Taxable 26,7 Interest $ 15,536 T/E Interest 7,768 Total 34,500

32.02% Cam 5,274 7,317 3,659 16,250

Total 16,470 22,853 11,427 50,750

Cam Reports $12,592 of TI67.98% Will Rental Income Taxable Interest T/E Interest Total 11,196 15,536$ 7,768 34,500 32.02% Cam

Total 16,470 22,853 11,427 50,750

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2 ,5 9 2

5,274 7,317 3,659 16,250

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But . . Arent We Missing Something??? Will Reports Taxable Income $26,731 Cam Reports $12,592

YES! - DepreciationWill Reports Taxable Income Depreciation $26,731 (3,000) Cam Reports $12,592 (1,500) $11,092

Net Taxable Income $23,731

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Wheres the Other $1,500 of Depreciation?Will Reports Taxable Income Depreciation $26,731 (3,000) Cam Reports $12,592 (1,500) $11,092

Net Taxable Income $23,731

It is Allocated to Charity and is Wasted!!!

The Distribution Deduction is $39,323

67.98% Will Rental Income Taxable Interest T/E Interest Total 11,196 15,536 7,768 34,500

32.02% Cam 5,274 7,317 3,659 16,250

Total 16,470 22,853 11,427 50,750

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Trusts Taxable Income TI Before Dist Deduction $47,223 Distribution Deduction Taxable Income $39,323 $7,900

The taxable income is the LTCG less the $100 exemption

Trusts Taxable Income TI Before Dist Deduction $47,223 Distribution Deduction Taxable Income $39,323 $7,900

Report on Form 1041, Page1, Line22

The taxable income is the LTCG less the $100 exemption

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Compute TAI Figure Distribution Beneficiaries Get Calculate Taxable Income Allocate Depreciation Allocate Expenses to T/E Income Calculate DNI Apply Tier System Allocate DNI Send K-1s to Beneficiaries KComplete 1041

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Thank God for Tax Software!!!

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Income Tax Consequences of Funding BequestsJeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA March 7, 2006

Funding Bequests In Kind - 6 Issues1 2 3 4 5 6 Does the distribution carry out DNI? If DNI carried out, how much? Is the Estate/Trust required to recognize gain? Can the Estate/Trust elect to recognize gain? What is the basis of property to distributee beneficiary? What is the holding period for distributee beneficiary?

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Facts Funding trust makes a specific bequest of $100,000 painting to A Funding trust distributes balance to marital and family trust Marital is pecuniary formula bequest and family trust is residuary bequest Value of Funding trust is $2,100,000 Marital and family trust each get $1,000,000 Fund both trusts in-kind with 25,000 shares of Mellon stock Basis of Mellon stock: $20/sh FMV of Mellon stock: $40/sh Mellon shares have long-term holding period in funding trust Painting distributed to A and marital trust funded in 2003 Family trust funded in 2004 Funding trust DNI is $150,000 in 2003, $75,000 in 2004 Separate share rule applies

2003 DNI = $150,000

Funding Trust

$100,000 Painting 50,000 sh Mellon stock - $40/sh FMV ($2,000,000) - $20/sh Basis ($1,000,000)

$100,000 Painting to A

Marital Trust$1MM Pecuniary Bequest

Family Trust$1MM Residuary Bequest

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2003 DNI = $150,000

Funding Trust $100,000 Painting to A DNI Gain 0 0$1MM Pecuniary Bequest

Marital Trust

Family Trust

$1MM Residuary Bequest

Basis $100,000 HP HP Carryover

2003 DNI = $150,000

Funding Trust

Each trust gets 25,000 sh of Mellon stock with FMV of $1,000,000 and basis of $500,000

$100,000 Painting to A

Marital Trust$1MM Pecuniary Bequest

Family Trust$1MM Residuary Bequest

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2003 DNI = $150,000


Marital Trust

Family Trust


$

75,000

$ 500,000 $1,000,000 New HP


DNI = $150,000


$500,000 gain taxed to Funding Trust Family Trust$1MM Residuary Bequest

Marital Trust

$

75,000

$ 500,000 $1,000,000 New HP


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Section 643(e) Election (Residuary Bequests) Estate/Trust may elect, but is not required, to recognize G/L Distribution carries out DNI, but amount of DNI depends on whether the Section 643(e) election was made No Election: DNI carried out is lesser of basis or FMV of distributed property Election: DNI carried out is FMV of distributed property Basis of property to beneficiary is basis of property to estate/trust plus or minus any gain or loss the estate/trust elects to recognize on the distribution

2004 DNI = $75,000


Marital Trust

Family Trust No 643(e)


$

75,000

$ $ 75,000 No Gain $ 500,000 HP Carryover

$ 500,000 $1,000,000 New HP


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2004 DNI = $75,000


Marital Trust



643(e) $ 75,000 $ 500,000 $1,000,000 HP Carryover

$

75,000


$ 500,000 $1,000,000 New HP


2004 DNI = $75,000


Marital Trust



643(e) $ 75,000 $ 500,000 $1,000,000 HP Carryover

$

75,000


$ 500,000 $1,000,000 New HP


Gain taxed to family trust. Reason: year of termination of Funding Trust so gains are included in DNI and passed out to the beneficiary

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Conclusion Funding Bequests In Kind - 6 Issues1 2 3 4 5 6 Does the distribution carry out DNI? If DNI carried out, how much? Is the Estate/Trust required to recognize gain? Can the Estate/Trust elect to recognize gain? What is the basis of property to distributee beneficiary? What is the holding period for distributee beneficiary?

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38-1INCOME TAX CONSEQUENCES OF FUNDING BEQUESTS Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA March, 2006 CONTENTS I. II. III. IV. V. Introduction Distribution System and Separate Share Rule Types of Distributions Six Income Tax Issues Discussion of the Six Income Tax Issues for Each of the Four Types of Distributions A. Bequest or Devise of Specific Property B. Bequest of Specific Sum of Money Ascertainable at Focal Date C. Bequest of Specific Dollar Amount Not Ascertainable at Focal Date D. Residuary Bequest VI. VII. Nonrecognition of Loss IRC 267 Funding a Bequest with Income in Respect of a Decedent (IRD) 38-2 38-2 38-3 38-3

38-4 38-4 38-6 38-8 38-10 38-15 38-16

A. Allocation of IRD and the 691(c) Deduction When IRD is Payable to an Estate or Trust 38-16 B. Transfer of Right to IRD C. Coordination with the Separate Share Rule D. Funding a Pecuniary Bequest with IRD E. Funding a Bequest with Installment Obligations VIII. Conclusion 38-17 38-18 38-21 38-22 38-23

38-2INCOME TAX CONSEQUENCES OF FUNDING BEQUESTS Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA March, 2006

I. INTRODUCTION At some point during the administration of an estate or trust, the fiduciary will make one or more distributions from the estate or trust to the beneficiaries. The income tax consequences of the distributions are discussed in this article. As discussed below, there are four types of distributions. Each type of distribution raises six income tax issues that must be addressed. The fiduciary must classify the distribution as one of the four types discussed below and then address the six income tax issues for that type of distribution.

The first section of this outline discusses the distribution system of estates and trusts. The next section discusses the four types of distributions. Next, the six income tax issues that arise when a distribution is made are discussed. The discussion then turns to a detailed analysis of the six income tax issues for each type of distribution. The final two sections discuss the application of 267, which disallows the recognition of a loss on a sale or exchange between related parties, and funding bequests with income in respect of a decedent and installment notes. II. DISTRIBUTION SYSTEM AND SEPARATE SHARE RULE The distribution system for trusts and estates is governed primarily by four sections of the Internal Revenue Code. Generally speaking, an estate or trust is entitled to a distribution deduction for the amount it distributes to its beneficiaries (limited to distributable net income or DNI) and the beneficiaries are required to account for the distribution on their income tax returns (limited by DNI). Simple trusts are governed by 651 and 652. Estates and complex trusts are governed by 661 and 662. The amount of the distribution deduction is governed by 651 for simple trusts and 661 for estates and complex trusts. The amount that a beneficiary must account for on his income tax return is governed by 652 for simple trusts and 662 for estates and complex trusts. Distributions by estates and complex trusts may be either a required distribution (referred to as a first tier distribution) or a discretionary distribution (referred to as a second tier distribution). First tier (mandatory) distributions are governed by 661(a)(1) and 662(a)(1). Second tier (discretionary) distributions are governed by 661(a)(2) and 662(a)(2). The amount of DNI carried out to beneficiaries of an estate or trust may be limited by the separate share rule. If a single trust has more than one beneficiary and if different beneficiaries have substantially separate and independent shares, their shares are treated separately for the sole purpose of determining the amount of DNI allocable to the beneficiaries under 661 and 662.1 Thus, the effect of the separate share rule is to treat multiple beneficiaries of a single trust or

38-3estate as if each were the sole beneficiary of a single trust for the purposes of determining how much DNI each distribution carries out. The separate share rule prevents one trust or estate beneficiary who receives a distribution from receiving more than his pro-rata share of DNI. If separate shares exist, DNI is computed separately for each share.2 After the fiduciary has identified the separate shares, the fiduciary must allocate the items of income and deductions among those shares to compute the DNI for each share. In computing DNI for each separate share, the portion of gross income that is income under 643(b) must be allocated among the separate shares in accordance with the amount of income each share is entitled to under the terms of the governing instrument or applicable local law.3 In reviewing the material below, it must be kept in mind that the amount of DNI carried out to a particular beneficiary may be governed by the application of the separate share rule.4 A specific bequest as defined in 663(a)(1) falls outside the traditional distribution system the estate or trust is not entitled to a distribution deduction and the beneficiary is not required to account for the distribution on his income tax return. III. TYPES OF DISTRIBUTIONS There are four possible types of distributions, each of which have different income tax consequences. The four types of distributions are as follows: 1. A distribution of specific property, a particular identifiable item ascertainable under the terms of the instrument e.g. I leave my pink Cadillac to my son, Bruce.5 2. A distribution of a specific sum of money, the amount of which is ascertainable on the focal date (usually the date of the decedents death) e.g. I leave $10,000 to my aunt, Edna. 6 3. A bequest of a specific dollar amount that is not ascertainable on the focal date (usually the date of the decedents death) but becomes ascertainable before distribution.7 The most common example of this type of bequest is a pecuniary formula marital deduction bequest e.g. I leave to my spouse the minimum amount needed to reduce my Federal estate tax to zero. The identity of the property and the amount of the bequest remains unascertained until the fiduciary makes certain decisions regarding tax elections after the focal date.8 For example, the amount of the formula marital deduction is dependent on the executors discretion and on the election to deduct the payment of administration expenses on the estate tax return or the fiduciary income tax return, which are not facts existing on the date of the decedents death. 4. A residuary bequest e.g. I leave all the rest, residue and remainder of my estate to my cousin, Vinny. IV. SIX INCOME TAX ISSUES Whenever an estate or trust makes a distribution to a beneficiary, there are six income tax issues that must be addressed:

38-41. Does the distribution carry out distributable net income (DNI)? 2. If the distribution carries out DNI, how much DNI does it carry out? 3. If the distribution is made in-kind (i.e. property rather than cash), is the estate or trust required to recognize gain or loss on the distribution? 4. If the distribution is made in-kind and the estate or trust is not required to recognize gain or loss, may it elect to recognize gain or loss? 5. If the distribution is made in-kind, what is the basis of the property in the hands of the distributee beneficiary? 6. If the distribution is made in-kind, what is the holding period of the property in the hands of the distributee beneficiary? V. DISCUSSION OF THE SIX INCOME TAX ISSUES FOR EACH OF THE FOUR TYPES OF DISTRIBUTIONS The following discussion assumes an estate or trust with DNI in excess of the aggregate distributions. A distribution carries out DNI only to the extent that the estate or trust has DNI. A. Bequest or Devise of Specific Property 663(a)(1) is an exception to the 661 and 662 rules governing distributions from estates and complex trusts. If a distribution meets the requirements of 663(a)(1), the estate or trust is not entitled to a distribution deduction under 661 and the beneficiary is not required to include the distribution in income under 662. 663(a)(1) states that any amount which, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of a specific sum of money or of specific property and which is paid or credited all at once or in not more than three installments falls outside the distribution rules of 661(a) and 662(a) i.e. the distribution does not carry out DNI. Three requirements must be met for a distribution to qualify under 663(a)(1). First, the distribution must be of specific property or a specific, pecuniary sum of money. The regulations indicate that a gift or bequest is specific if the amount of money or the identity of the property is ascertainable under the terms of the testators will as of the date of death or under the terms of an inter vivos trust instrument as of the date of the inception of the trust.9 Second, the distribution must be paid either all at once or in not more than three installments.10 Third, 663(a)(1) provides that a distribution is not considered to be a gift or bequest of a specific sum of money if it can be paid only from income.11 Under 663(a)(1), the distribution of the actual property bequeathed will not carry out DNI so long as the terms of the bequest do not require payment of the bequest in more than three installments and the bequest is not required to be paid out of income of the estate or trust.12 Reg. 1.663(a)-1(c)(1)(iv) states that the number of installments required by the trust instrument governs regardless of the number of installments actually made. In addition, Reg. 1.663(a)-(1)(c) further refines the application of the three installment rule.

38-5The income tax results are as follows: a. Under 663(a)(1) the bequest or devise of specific property does not carry out DNI. The distributee beneficiary does not include the value of the distribution in his gross income and the estate or trust does not receive a distribution deduction.13 b. The estate or trust is not required to recognize gain or loss on the distribution.14 c. The 643(e) election does not apply to a distribution under 663(a)(1). Thus, the fiduciary may not elect to recognize gain or loss on the distribution.15 d. The basis of the property in the hands of the distributee beneficiary is the estate or trusts basis i.e. there is a carryover basis.16 e. The distributee has an automatic long-term holding period.17 Example: Decedents will says, I leave my grand piano to my niece, Mildred. The bequest of the grand piano is a bequest of specific property under 663(a)(1). As a result, Mildred is not required to include the value of the grand piano in her income and the estate does not get a distribution deduction for the value of the grand piano. Since the specific property left to Mildred is, in fact, being distributed to her, the estate does not, and may not elect to, recognize gain or loss on the difference between the fair market value and the estates basis in the piano. Mildred takes the estates basis in the grand piano. Mildred is deemed to have held the piano for the long-term holding period. If the fiduciary distributes property other than that actually bequeathed or devised, there is still no DNI carried out to the beneficiary but the gain or loss results are different. a. Under 663(a)(1) the bequest or devise of specific property does not carry out DNI. The distributee beneficiary does not include the distributed property in his gross income and the estate or trust does not receive a distribution deduction.18 b. The estate or trust must recognize gain if it distributes appreciated property (property with a fair market value greater than its basis) or loss if it distributes depreciated property (property with a fair market value less then its basis).19 The bequest is treated for tax purposes as if the estate or trust distributed the actual property bequeathed and then exchanged it for the other property distributed.20 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. c. The estate or trusts recognition of gain or loss is mandatory, not elective.21 d. The basis of the distributed property in the hands of the distributee beneficiary is its fair market value at the time of distribution.22 Since the gain is required to be recognized as a result of the distribution, the distributed property receives a basis equal to the fair market value on the date of distribution.23 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties.

38-6e. The holding period does not appear to tack. The length of the holding period is governed by 1223(2). 1223(2) states that the period property is held by the transferor is tacked onto the transferees holding period if the property has the same basis in whole or part in [the transferees] hands as it would have in the hands of the [transferor]. If the transferors basis was the starting point in computing the transferees basis, the transferees basis was the same in part as the transferors and the holding period tacks under 1223(2).24 Since the property takes a basis of its fair market value as a result of the trust paying a tax on the gain, a literal reading of 1223(2) would prohibit a tacking of the transferors holding period. In this case the estate or trust is deemed to have sold the property to the beneficiary so it would be logical to treat the beneficiary as a purchaser under the tacking rules. As a result, the beneficiarys basis is not determined, in whole or in part, by the trust or estates basis. Thus, 1223(2) is inapplicable and the beneficiarys holding period begins the day after the distribution. Example: Decedents will says, I leave my grand piano to my niece, Mildred. Instead of distributing the grand piano to Mildred, the executor distributes an antique table of equivalent value. The distribution of the antique table falls under the general rule of 663(a)(1). Thus, Mildred is not required to include the value of the antique table in her income, and the estate does not get a distribution deduction for the value of the antique table. However, unlike the previous example, the estate is required to recognize gain on the difference between the fair market value of the antique table and its basis to the estate due to the fact that the distribution was of property other than the property specifically left to Mildred. Mildred would take a basis in the antique table equal to its fair market value as of the date of distribution. Mildreds holding period in the antique table would commence on the day after the table was distributed to her i.e. the holding period starts anew in Mildreds hands. B. Bequest of Specific Sum of Money Ascertainable at Focal Date. If the fiduciary makes a distribution of cash to satisfy a distribution of a specific sum of money, the amount of which is ascertainable at the focal date (usually the date of death), the income tax results are as follows: a. The bequest of a specific sum of money which is ascertainable at death is not included in the beneficiarys income and the estate or trust does not receive a distribution deduction if the governing instrument does not require payment of the bequest in more than three installments and the governing instrument does not require that the bequest be satisfied out of income.25 If the governing instrument does not specify a time for the payment of the bequest, any payments are treated as required to be paid in a single installment.26 b. The estate or trust is not required to recognize gain or loss.27 c. The 643(e) election doesnt apply to distributions of cash. Thus, the estate or trust cannot elect to recognize gain or loss. d. Cash has a basis equal to its denomination. e. The holding period of cash is not an issue.

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Example: Decedent leaves $10,000 in her will to her nephew, Thaddeus. Since the bequest is ascertainable at the date of the decedents death, Thaddeus is not required to report any of the $10,000 in his income and the estate does not get a distribution deduction for the $10,000 distribution. Example: Instead of leaving a specific sum of money, the decedent leaves an amount of money equal to the date of death value of her grand piano to her nephew, Thaddeus. The tax results are the same as in the preceding example.28 Example: Decedents will leaves $100,000 to Ozzie. After paying all debts and administration expenses, the estate has only an asset having a FMV of $80,000 and a basis of $50,000. The asset is transferred to Ozzie in satisfaction of the $100,000 bequest. The bequest is still governed by 663(a)(1). Although the full amount of the bequest cannot be satisfied, the bequest is not transformed into a residuary bequest. Thus, satisfying the bequest with the asset does not result in taxable income to the beneficiary or result in a distribution deduction for the estate. However, the estate must recognize gain of $30,000 ($80,000 FMV less $50,000 basis). The basis of the asset to the beneficiary is $80,000, the FMV of the asset. The holding period of the assets appears to begin the day after the acquisition by the beneficiary. If instead of distributing cash, the fiduciary makes a distribution of property in lieu of the specific sum of money bequeathed, there is still no DNI carried out to the beneficiary but the gain or loss results are different. The income tax results are as follows: a. The distributee beneficiary is not required to include the value of the property in his gross income and the estate or trust does not receive a distribution deduction.29 b. The estate or trust must recognize gain or loss on the distribution if the fair market value of the property exceeds or is less than its basis.30 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. c. The estate or trusts recognition of gain or loss is mandatory, not elective.31 d. The basis of the distributed property in the hands of the distributee beneficiary is the propertys fair market value at the date of the distribution.32 Since the gain is required to be recognized as a result of the distribution, the distributed property receives a basis equal to the fair market value on the date of distribution. See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. (e) The holding period does not appear to tack. The length of the holding period is governed by 1223(2). 1223(2) states that the period property is held by the transferor is tacked onto the transferees holding period if the property has the same basis in whole or part in [the transferees] hands as it would have in the hands of the [transferor]. If the transferors basis was the starting point in computing the transferees basis, the transferees basis was the same in part as the transferors and the holding period tacks under 1223(2). Since the property takes a basis of its fair market value as a result of the trust paying a tax on the gain, a literal reading of

38-81223(2) would prohibit a tacking of the transferors holding period. In this case the estate or trust is deemed to have sold the property to the beneficiary so it would be logical to treat the beneficiary as a purchaser under the tacking rules. As a result, the beneficiarys basis is not determined, in whole or in part, by the trust or estates basis. Thus, 1223(2) is inapplicable and the beneficiarys holding period begins the day after the distribution. If a bequest is delayed and the beneficiary is entitled to interest on the bequest pursuant to state law, the payment will be interest paid or incurred by the estate pursuant to 163 and gross income to the beneficiary pursuant to 61(a)(4).33 Pursuant to Rev. Rul. 73-322, 661 and 662 do not apply because the relationship between the parties is that of debtor and creditor rather than of estate or trust and income beneficiary. The final separate share regulations come to the same conclusion. Thus, the payment of interest on the late payment of a pecuniary bequest results in no DNI being carried out from the estate to the beneficiary. The interest payment is taxable income to the beneficiary under the general rule of Section 61. The estate treats the interest payment as personal interest that is not deductible by the estate under Section 163(h).34 Note that this treatment may result in double taxation the beneficiary reports the interest income and the estate receives no deduction for the payment because it is nondeductible personal interest and, in addition, does not qualify for a distribution deduction. C. Bequest of Specific Dollar Amount not Ascertainable at Focal Date. If the fiduciary makes a distribution of a cash to satisfy a distribution of a specific dollar amount, the amount of which is not ascertainable at the focal date (usually the date of death), the income tax results are as follows: a. The distribution carries out DNI. 663(a)(1) does not apply unless the distribution is ascertainable as of the focal date (usually the date of death).35 The beneficiary must include the distribution in his income and the estate or trust may deduct the distribution, subject to the rules of 661 and 662. b. The estate or trust is not required to recognize any gain or loss. c. The 643(e) election doesnt apply to distributions of cash. d. Cash has a basis equal to its denomination. e. The holding period is not an issue. Note that although a bequest of a specific dollar amount includes bequests of a specific sum of money, for DNI purposes there is a distinction between a specific sum of money bequest, the dollar amount of which is ascertainable at death, and all other specific dollar amount bequests, the dollar amount of which is not ascertainable at death. The regulations under 663 state that a distribution is not a bequest of a specific sum of money or of specific property (and thus not governed by 663(a)(1)) if the amount of money or the identity of the property is ...dependent both on the exercise of the executors discretion and on the payment of administration expenses and other charges, neither of which are facts existing on the date of the decedents death.36 The regulation goes on to state that, It is immaterial that the value of the bequest is determinable after the decedents death before the bequest is satisfied...37 The most common example of a bequest of a specific dollar amount that is not a bequest of a specific sum of money is a pecuniary

38-9formula marital bequest. The amount of money needed to satisfy the pecuniary formula marital bequest remains unascertained until the administrator of the estate exercises his or her discretion with respect to certain deductions and distributions.38 Example: Decedents will leaves Jasper a sum of money equal to 10% of his adjusted gross estate as defined in 6166(b)(6) (gross estate less deductions allowed under 2053 and 2054). The amount Jasper will receive is not ascertainable as of the decedent's death. This is due to the fact that the executor may elect to claim administration expenses either as an estate tax deduction or a fiduciary income tax deduction. Thus, the base amount of the adjusted gross estate is not ascertainable until that election is made at some point after the decedents death i.e. the base amount is not ascertainable as of the date of the decedents death. The distribution carries out DNI to Jasper and the estate will receive a corresponding income distribution deduction. If instead of distributing cash, the fiduciary makes a distribution of property in lieu of the specific sum of money bequeathed, the income tax results are as follows: a. The distribution carries out DNI equal to the fair market value of the property at the date of distribution. 663(a)(1) doesnt apply. The distributee beneficiary must include the fair market value of the property in his gross income and the estate or trust gets a distribution deduction equal to the fair market value of the property, subject to the distribution rules of 661 and 662. b. The estate or trust must recognize gain if it funds a pecuniary bequest by distributing property with a fair market value in excess of its basis. 39 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties c. The estate or trusts recognition of gain or loss on funding a pecuniary bequest with appreciated property is mandatory, not elective.40 d. The basis of the property to the distributee beneficiary is the propertys fair market value at the date of distribution.41 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. (e) The holding period does not appear to tack. The length of the holding period is governed by 1223(2). 1223(2) states that the period property is held by the transferor is tacked onto the transferees holding period if the property has the same basis in whole or part in [the transferees] hands as it would have in the hands of the [transferor]. If the transferors basis was the starting point in computing the transferees basis, the transferees basis was the same in part as the transferors and the holding period tacks under 1223(2). Since the property takes a basis of its fair market value as a result of the trust paying a tax on the gain, a literal reading of 1223(2) would prohibit a tacking of the transferors holding period. In this case the estate or trust is deemed to have sold the property to the beneficiary so it would be logical to treat the beneficiary as a purchaser under the tacking rules. As a result, the beneficiarys basis is not determined, in whole or in part, by the trust or estates basis. Thus, 1223(2) is inapplicable and the beneficiarys holding period begins the day after the distribution.

38-10Example: The classic example of this situation is a pecuniary formula marital deduction bequest e.g. an amount equal to the smallest amount which will result in the lowest possible federal estate tax. A formula marital deduction bequest does not qualify as a specific bequest under 663(a)(1). The amount of the bequest is not ascertainable at the date of death due to the fact that post-death tax elections are available to the executor that may change the amount of the bequest. Thus, the distribution rules of 661 and 662 apply. Although the marital deduction amount is a specific dollar amount or specific property, the identity of the property and the amount are dependent on the exercise of the fiduciarys discretion and on the payment of administration expenses or other charges, neither of which are ascertainable on the date of the decedents death (as is required for the qualification as a specific bequest by Reg. 1.663(a)-1(b)(1)). Thus, distributions to the surviving spouse or the marital deduction trust will carry out DNI. Satisfaction of a pecuniary marital deduction amount with appreciated or depreciated property will result in recognition of gain or loss (subject to the rules of 267) to the distributing entity, with a corresponding adjustment to the basis of the asset in the hands of the surviving spouse or trust equal to the propertys fair market value. Since the propertys basis in the hands of the distributee is its fair market value, the propertys holding period starts anew as of the day after the date distributed to the beneficiary. D. Residuary Bequest A residuary bequest is a bequest of the value of the assets left over after the payment of all expenses and other distributions. The regulations under 663 state residuary bequests do not qualify as tax-free specific bequests.42 Instead, residuary bequests are subject to the normal distribution applicable to estate and trusts A common form of a residuary bequest is a fractional formula marital deduction clause that essentially leaves to the surviving spouse an amount equal to a fraction of the residue of the estate. The pro rata funding of a fractional marital deduction formula clause will not result in gain or loss to an estate or trust. The fractional share is not a pecuniary amount.43 Residuary distributions funded in kind are more complicated44 and, as a result, give the fiduciary a greater opportunity for planning. The income tax consequences of funding a residuary distribution with property are governed by 643(e). 643(e) was enacted by the Tax Reform Act of 1984 to close a loophole in the law that allowed an estate or trust to fund a residuary bequest with appreciated property without having to recognize any gain. Under the old law, funding a residuary bequest with appreciated property gave the distributee beneficiary a basis in the distributed property equal to the fair market value of the property at the date of distribution so that the distribution would step up the propertys basis without requiring the estate or trust to recognize gain on the distribution of the appreciated property.45 As a result, the Tax Reform Act of 1984 changed the law by adopting 643(e). Under current law, when an estate or trust distributes property in-kind, 643(e)(3) allows the fiduciary to elect to treat the distribution as a sale to the beneficiary and recognize gain or loss on the distribution.46 Because the above loophole affected only residuary bequests, the legislative history of the Tax Reform Act of 1984 indicates that 643(e) apparently applies only to residuary bequests.47 Reg.

38-111.661(a)-2(f) continues to apply to funding bequests of specific property and specific dollar amounts with property. Pursuant to Reg. 1.661(a)-2(f) and Reg. 1.1014-4(a)(3) gain or loss will be recognized and the property in the hands of the distributee beneficiary will receive a basis equal to the fair market value of the property as of the date of distribution, subject to the rules denying loss recognition in related party transactions, discussed below. The rules for the distribution of property in kind to fund a residuary bequest under 643(e) may be summarized as follows: i. The distributing estate or trust may elect, but is not required, to recognize gain or loss as if the property had been sold at its fair market value to the distributee.48 ii. The distributed property carries out DNI to the beneficiary but the amount of the DNI depends upon whether the estate or trust elects to recognize gain or loss.49 iii. The basis of the distributed property to the distributee beneficiary is equal to the basis of the property in the hands of the estate or trust plus or minus any gain or loss the estate or trust elects to recognize on the distribution.50 The income tax consequences of funding residuary distributions with cash are relatively straightforward. a. The distribution carries out DNI. 663(a)(1) does not apply to residuary bequests.51 The distributee beneficiary must include the cash in his gross income and the estate or trust gets a distribution deduction, subject to the rules of 661 and 662. b. The estate or trust recognizes no gain or loss on the distribution. c. The estate or trust may not elect to recognize gain or loss since 643(e) does not apply to distributions of cash. d. Cash has a basis equal to its denomination. e. The holding period is not an issue. The distribution of property in kind to fund a residuary bequest under 643(e) has the following tax consequences: a. The distributed property carries out DNI to the beneficiary but the amount of the DNI depends upon whether the estate or trust elects to recognize gain or loss under 643(e). 663(a)(1) doesnt apply to residuary bequests.52 b. The amount the distributee beneficiary must include in his gross income and that the estate or trust may deduct depends upon whether the estate or trust elects under 643(e) to recognize gain or loss.

38-12i. If the estate or trust does not elect to recognize gain or loss, the distribution carries out DNI equal to the lesser of the basis of the property or the propertys fair market value on the date of distribution.53 ii. If the estate or trust elects to recognize gain or loss, the distribution carries out DNI equal to the propertys fair market value.54 c. The estate or trust is not required to recognize gain or loss on the funding of a residuary bequest with appreciated property because a residuary bequest is not a bequest of a specific dollar amount or specific property.55 However, 643(e) permits the estate or trust to elect to recognize gain or loss when satisfying a residuary bequest with appreciated property.56 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. d. The basis of the distributed property to the distributee beneficiary is equal to the basis of the property in the hands of the estate or trust plus or minus any gain or loss the estate or trust elects to recognize on the distribution.57 e. The holding period of the distributed asset should carry over to the distributee and, as such, the holding period should tack under 1223(2). Under 643(e)(1) the basis of the distributed asset appears to be determined with reference to the trust or estates basis. Under 1223(2), if the basis of the distributed asset is determined in whole or in part with reference to the assets basis in the hands of the transferor, the holding period of the transferor tacks to the holding period of the transferee. Thus, the basis of the distributed asset carries over to the distributee and, as such, results in the tacking of the holding period under 1223(2). If the assets was held at the date of death and included in the decedents gross estate for federal estate tax purposes, the holding period of the transferor will be an automatic long-term holding period under 1223(10). Example: A trust has DNI of $50,000. The trustee funds a residuary bequest by transferring stock with a fair market value of $50,000 and a basis of $20,000. The trustee makes a 643(e) election. The distribution of stock carries out $50,000 of DNI (the fair market value of the stock). The 643(e) election causes the trust to recognize gain of $30,000 ($50,000 FMV less $20,000 basis). The beneficiary takes a $50,000 basis in the distributed stock (the trusts $20,000 basis plus the $30,000 of gain recognized by the trust). Since the beneficiarys basis is determined in whole or in part by reference to the trusts basis in the stock, the trusts basis of the stock is tacked onto the beneficiarys holding period for purposes of determining if the gain is long-term or short-term. The 643(e) election gives the fiduciary the opportunity to shift tax consequences between the estate or trust and its beneficiaries. For example, it gives the fiduciary an opportunity to shift capital gains and losses to the beneficiaries in a year before termination. Generally, capital gains and losses are taxed to the estate or trust and get passed out to the beneficiaries only in the year the estate or trust terminates.58 If the fiduciary funds a residuary bequest using appreciated property and does not make the 643(e) election, the beneficiary takes the property with the same basis as it had in the trust or estates hands. The beneficiary can then sell the asset and realize the gain or loss on its own. This allows the beneficiary to time the recognition of gain and losses. The beneficiary may then recognize gains to offset its own losses or to recognize losses to offset

38-13its own gains. Alternatively, the gain will be eliminated if the property is held by the beneficiary until death and the asset receives a step-up in basis. Making the Election. A 643(e) election is made by the estate or trust on its return for the taxable year for which the distribution was made. The election is made by checking a box on the bottom of page 2 of the Form 1041. The election applies to all property distributions made during the year with the exception of 663(a) property distributions.59 Thus, the estate or trust may not make a 643(e) election in a particular year for some property distributions but not for others. Once made, the election may only be revoked with the consent of the Secretary of the Treasury.60 The election is made on a year-by-year basis i.e. it can be made for property distributions in one year but not the next. The revocation of the 643(e) election may be approved through a Reg. 301.9100 relief request.61 Planning with 643(e). 643(e) gives the fiduciary a number of planning options. Perhaps most important, it gives the fiduciary the option of choosing whether the fiduciary or the beneficiary will report the gains and losses on property which is distributed in-kind to the beneficiary. The fiduciary has the following options: i. Make the election to incur gains at the estate or trust level to offset the estate or trusts previously recognized losses. ii. Make the election in order to carry out the maximum amount of DNI to the beneficiary i.e. DNI equal to the fair market value of the distributed property. iii. Make the election to incur a loss at the estate or trust level in order to offset previously realized gains. iv. Dont make the election and distribute low basis/high fair market value property to a beneficiary, thus giving the beneficiary the opportunity to sell the property and realize the gain, either to offset a prior loss or to have the gain taxed at a lower rate than it would have been taxed in the estate or trust. Alternatively, the beneficiary could hold the property until his death and the step-up in basis allowed under 1014 will eliminate the gain. v. Dont make the election when distributing high basis/low fair market value assets enabling the beneficiary to realize a loss on a subsequent sale. vi. Make the election when funding a residuary or fractional bequest with an interest in a passive activity in order to trigger a deduction against nonpassive income for any unused suspended passive activity losses (PALs) applicable to the PALs transferred. The 643(e) election will also affect the amount and the character of the income taxable to the estate or trust and the beneficiaries. Example: Trust has DNI of $3,000 and the trustee distributes appreciated property to the beneficiary. The property has an adjusted basis of $1,000 and a fair market value of $2,500. If the 643(e) election is made, the beneficiary will have a basis of $2,500 in the property and will be required to report $2,500 of ordinary income pursuant to 662(a)(2). If no 643(e) election is made, the beneficiary will have a basis of $1,000 in the property

38-14and will be required to report $1,000 of ordinary income. Therefore, by not making the election, the beneficiary benefits by having $1,500 of ordinary income converted into potential capital gain i.e. the potential gain is shifted to the beneficiary. On the other hand, if the 643(e) election is not made, the trust suffers by converting $1,500 of capital gain into $1,500 of ordinary income. A fiduciary should be aware of the impact of the 643(e) election when there are multiple beneficiaries and the trustee distributes cash to some and property to others.62 Example: Trust has $3,000 of DNI. Assume the separate share rule does not apply. Trustee distributes $5,000 in cash to beneficiary A and distributes property with a basis of $2,500 and a fair market value of $5,000 to beneficiary B. If no 643(e) election is made, under 662(a)(2) beneficiary B is treated as receiving a distribution equal to the basis of the property ($2,500) and will be taxed on only $1,000 of income ($3,000 DNI x $2,500 distribution/$7,500 total distribution). Beneficiary A will recognize $2,000 of income ($3,000 DNI x $5,000 distribution/$7,500 total distribution). If the 643(e) election is made to recognize gain in the trust, both A and B are treated as receiving equal amounts under 662 and both will be required to report $1,500 of income ($3,000 DNI x $5,000 distribution/$10,000 total distribution). If a fiduciary makes a 643(e) election to recognize capital gain and the capital gain is included in DNI, any distribution to the beneficiary will cause the gain to be carried out and taxable to the beneficiary.63 Example: In the year of termination of a trust, the trustee distributes property with a fair market value of $35,000 and a basis of $20,000. The trustee makes a 643(e) election. The trust recognizes a capital gain of $15,000. The $15,000 becomes part of DNI in the year of termination. Assuming the distribution carries out all of the trusts DNI, the beneficiary is taxed on the gain. Another word of caution for the fiduciary. 1239 will convert any gain recognized by the trustee as a result of the 643(e) election to ordinary income if the appreciated property distributed by the fiduciary to the beneficiary may be depreciated by the beneficiary.64 For tax years beginning after August 5, 1997, the same rule applies to estates except in the case of appreciated property used to satisfy a pecuniary bequest.65 If an executor or trustee distributes property that has a basis in excess of its fair market value (i.e. loss property), the distribution will carry out DNI equal to the fair market value of the property whether or not the trustee makes the 643(e) election.66 The reason for this is that whether or not the 643(e) election is made, gain or loss is recognized as if the property were sold to the beneficiary at its fair market value. If the distribution is made to a related taxpayer, 267 will disallow the loss. In either event, the amount taken into account 661(a)(2) and 662(a)(2) will be the fair market value of the property and the basis of the property in the hands of the beneficiary will be the same as the trusts basis in the property immediately before the distribution. Stated differently, if property has declined in value, the amount taken into account under 661(a)(2) and 662(a)(2) and the propertys basis will be the propertys fair market value, whether or not an election is made. Example: Trustee funds a residuary bequest by transferring stock with a fair market value of $30,000 and a basis of $50,000. The trustee does not make a 643(e) election. The amount taken

38-15into account under 661(a)(1) and 662(a)(2) is the fair market value of the stock (lower of FMV and trusts basis) and the trusts basis in the stock carries over to the beneficiary (no gain or loss is recognized so trusts basis carries over to beneficiary). If the trustee made a 643(e) election, 267 would disallow recognition of the loss. The amount taken into account under 661(a)(1) and 662(a)(2) is the fair market value of the stock (FMV pursuant to 643(e)(3)(A)(iii)) and the trusts basis in the stock carries over to the beneficiary (no gain or loss is recognized so trusts basis carries over to beneficiary pursuant to 643(e)(1)). Thus, where a fiduciary distributes property that has a basis in excess of its fair market value, the tax results are the same whether or not the trustee makes the 643(e) election. VI. NONRECOGNITION OF LOSS - 267 In the context of funding bequests, 267 can result in the denial of loss recognition if (1) the fiduciary funds a pecuniary bequest with an asset with a basis in excess of its fair market value or (2) the fiduciary incurs a loss as the result of making a 643(e) election. However, the recognition of the loss is not permanent. The related party rules of 267 prohibit the recognition of losses that arise from transactions between related parties. The term related party is defined in 267(b) to include: (1) a fiduciary of a trust and a fiduciary of another trust, if the same person is the grantor of both trusts - 267(b)(5); (2) a fiduciary of a trust and a beneficiary of the same trust - 267(b)(6); (3) a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts - 267(b)(7); and (4) for taxable years beginning after August 5, 1997, an estate and a beneficiary of that estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest 267(b)(13). Thus, a loss incurred by an estate in funding a pecuniary bequest is recognized. If the trusts loss is disallowed by 267, it is not lost forever, Instead, on the beneficiarys subsequent sale or exchange of the distributed property gain is not recognized to the extent of the previously disallowed loss.67 Example: Trust distributes property having a fair market value of $20,000 and a basis of $26,000 to a marital trust to fund a pecuniary formula bequest. Although the funding of a pecuniary bequest with appreciated or depreciated assets is normally a recognition event, the loss on the distribution is disallowed by 267 because the funding trust and the marital trust are related parties under 267(b)(5). If the marital trust later sells the property for more than $20,000, up to $6,000 of the gain is not included in gross income. However, if the marital trust sells the property for $20,000 or less, the basis for computing loss is only $20,000.68 As noted above, the 1997 legislation added an estate and its beneficiaries to the list of related parties for taxable years after August 5, 1997. However, that rule is subject to an exception. If an estate funds a pecuniary bequest with assets whose basis exceeds their fair market value, the estate may recognize the loss.69 If, on the other hand, the funding were between a trust and its beneficiary, 267 would disallow the loss. Thus, funding a pecuniary bequest with loss assets

38-16results in an estate, but not a trust, being able to recognize the loss. The trustee of an eligible trust who would like to recognize the loss on funding could make a 645 election to be treated as an estate. The trust would then be eligible to deduct the loss on funding. Instead of using assets with a built-in loss to fund a pecuniary bequest, the trustee should consider selling the asset and recognize the loss at the trust level. The trustee can then use the loss at the trust level and distribute the cash proceeds to the beneficiary to fund the bequest. Alternatively, the trustee could make an in-kind distribution and not make the 643(e) election. In that case, the timing and recognition of the loss is up to the beneficiary. VIII. FUNDING A BEQUEST WITH INCOME IN RESPECT OF A DECEDENT (IRD)

A.

Allocation of IRD and the 691(c) Deduction When IRD is Payable to an Estate or Trust

If an item of IRD is payable to an estate or trust and is not distributed in the year of receipt, the IRD will be taxed to the estate or trust and the 691(c) deduction will be deductible by the estate or trust. In other words, if the IRD is allocated to principal of the estate or trust and is distributed to a beneficiary in a subsequent year, the 691(c) deduction is allocable only to the estate or trust.70 If an item of IRD is payable to an estate or trust and is distributed in its entirety to an estate or trust beneficiary in the year of its receipt, the IRD enters into the calculation of distributable net income (DNI) (unless it is capital gain income) and is passed out to the beneficiary. In addition, the 691(c) is also passed out to the beneficiary.71 If an item of IRD is payable to an estate or trust and is partially distributed to an estate or trust beneficiary, the IRD enters into the calculation of DNI (unless it is capital gain income) and a portion of the IRD and the 691(c) deduction will be passed out to the beneficiary based on the distribution rules of 651, 652, 661 and 662.72 Example: The executor of an estate receives taxable interest of $5,500 and IRD of $4,500 during the taxable year. The 691(c) deduction is $1,500. The executor makes a discretionary distribution of $2,000 to the sole beneficiary during the year. The DNI of the estate is $10,000 consisting of taxable interest of $5,500 and IRD of $4,500. The amount of the distribution deduction allowed to the estate under 661(a) and the amount taxable to the beneficiary under 662(a) is $2,000 as DNI exceeds the amount of the distribution. The balance of the DNI of $8,000 is taxable to the estate. IRD makes up 45% of the DNI ($4,500/$10,000). Thus, of the $2,000 distributed to the beneficiary, $900 (45% x $2,000) is IRD and the $1,100 balance is taxable interest. In addition, $300 ($900/$4,500 x $1,500) of the 691(c) deduction is allocated to and may be deduced by the beneficiary and the $1,200 balance of the 691(c) attributable to the estate ($3,600/$4,500 x $1,500) is allocated to and may be deducted by the estate. The estates taxable income of $6,200 is calculated as follows: $10,000 gross income less $2,000 distribution deduction less $1,200 691(c) deduction less $600 exemption. Notice that the executor can control who gets taxed on the IRD. If the executor retains the IRD, the estate pays the tax on the IRD and gets the 691(c) deduction. On the other hand, if the executor distributes the IRD to a beneficiary who then collects the IRD, the beneficiary pays the tax on the IRD.

38-17As discussed below, the distribution of the right to IRD (as opposed to the actual receipt of IRD) is not a distribution for purposes of Subpart C of Part 1 of Subchapter J. This means that an estate or trust that distributes the right to IRD is not entitled to an income tax distribution deduction and the amount is not included in the income of the recipient beneficiary. In other words, the distribution rules of 651, 652, 661 and 662 do not apply to the right to IRD.73 For example, the distribution of an installment note to a beneficiary of the estate is not subject to the distribution rules. Instead, the beneficiary reports the deferred gain upon receipt. B. Transfer of Right to IRD - 691(a)(2).

To prevent a high-bracket taxpayer from transferring IRD to a low-bracket taxpayer, 691(a)(2) treats the disposition of an item of IRD from the person who received or had the right to receive an item of IRD as a taxable transaction to the transferor as if the IRD had been collected. The term transfer includes a sale, exchange or other disposition, or the satisfaction of an installment obligation at other than face value. Under this definition, even a gift of the right to receive IRD will accelerate the recognition of the income.74 The general rule is that IRD is taxable to the recipient in the taxable year when received. 691(a)(2) is an exception to the general rule. It says that where the holder of a right to receive an item of IRD transfers it to another, nonexempt person, the transferor must include in gross income for the year of transfer the greater of: a. The fair market value of the rights transferred or b. The consideration received in exchanged therefore. Example: Widow has the right to receive a $5,000 salary claim that was owed to her cash basis husband at the date of his death. Widow sells the salary claim for $4,000 (it had a FMV of $5,000). The widow would include $5,000 in her income. This acceleration rule applies both to sales of IRD rights to non-beneficiaries and to transfers of IRD rights to beneficiaries who are not entitled to receive them under the terms of the governing will or trust instrument.75 The transfer to a person entitled to receive the IRD by reason of the death of the decedent or by bequest, devise or inheritance from the decedent is not a transfer that causes acceleration of the taxation of the IRD. Notice that those exempt from the transfer rule are those who would otherwise be responsible for reporting IRD under of 691(a)(1). Thus, the term "transfer" as used in 691(a)(2) does not include these 3 situations i.e. there are 3 exceptions to the rule of 691(a)(2): c. Estate transfers the right to receive IRD to a beneficiary of the estate e.g. a specific or residuary legatee. d. Trust is bequeathed IRD and trust terminates and distributes IRD to beneficiary. e. Income in respect of a prior decedent.76

38-18Example: Decedent dies with a $5,000 salary owed to him at the time of his death and so now it is owed to his estate. His estate terminates and transfers his salary to the Decedent's widow. This is the first exception to 691(a)(2) so it is not a "transfer." The widow dies before she gets the $5,000 IRD. The widow's son is the beneficiary of her estate and now the son gets the $5,000 salary claim transferred from his mother's estate to him. This is not a transfer. This is the 3rd exception i.e. income in respect of a prior decedent. The son reports the income when he actually receives it. In addition, the transfer of the IRD to the estate of the decedent is also an exempt transfer. Notice that the transfer exception applies to successive recipients of the item of IRD as long as all of the recipients qualify for the transfer exemption.77 Thus, an estate can transfer the item of IRD to a trust which can then transfer it to a beneficiary of trust who can transfer it to his own trust at his death and all of the transfers would be considered exempt transfers i.e. transfers that do not accelerate the taxation of the item of IRD. The item of IRD would be taxable when it is ultimately collected or when it is transferred in a taxable transfer i.e. to a nonexempt beneficiary. C. Coordination with the Separate Share Rule

If a single trust has more than one beneficiary and if different beneficiaries have substantially separate and independent shares, their shares are treated separately for the sole purpose of determining the amount of DNI allocable to the beneficiaries under 661 and 662.78 663(c) states that for the sole purpose of computing DNI, substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts. Thus, the effect of the separate share rule is to treat multiple beneficiaries of a single trust or estate as if each were the sole beneficiary of a single trust for the purposes of determining how much DNI each distribution carries out. The separate share rule prevents one trust or estate beneficiary who receives a distribution from receiving more than his pro-rata share of DNI. Without the separate share rule, disproportionate distributions to beneficiaries from a trust or estate can lead to disproportionate tax treatment for the beneficiaries. If separate shares exist, DNI is computed separately for each share.79 Traditionally, the separate share rule applied only to trusts. Effective for decedents dying after August 5, 1997, the separate share rule now applies to estates as well. After the fiduciary has identified the separate shares, the fiduciary must allocate the items of income and deductions among those shares to compute the DNI for each share. In computing DNI for each separate share, the portion of gross income that is income under Section 643(b) must be allocated among the separate shares in accordance with the amount of income each share is entitled to under the terms of the governing instrument or applicable local law.80 An important exception to the allocation rules applies to income in respect of a decedent (IRD). The final regulations provide that IRD is allocated among the separate shares that could potentially be funded with these amounts irrespective of whether the share is entitled to receive any income under the terms of the governing instrument or applicable local law. The amount of gross income allocated to each share is based on the relative value of each share that could potentially be funded with such amounts.81

38-19

This potential allocation of IRD could shift income tax liabilities to trusts that are protected from estate tax or GST tax by the decedents exemptions. Practitioners may want to draft to limit or eliminate the potential recipients of IRD. Although the final regulations do not address the issue directly, expenses that are directly attributable to items of IRD presumably should be allocated in the same manner as the IRD itself i.e. those expenses would be allocated among the separate shares that could potentially be funded with the IRD in proportion to the relative values of those shares. Example: Ds will directs the executor to divide the residue of the estate equally between Ds two children, A and B. The will directs the executor to fund As share first with the proceeds of Ds IRA. The FMV of the estate is $9,000,000. During the year, the $900,000 balance in Ds IRA is distributed to the estate that is allocable to corpus under local law. The estate has 2 separate shares: one for A and one for B. If any distributions are made to either A or B during the year, then for purposes of determining the DNI for each separate share, the $900,000 of IRD must be allocated to As share. If the will did not direct the executor to fund As share with the IRA proceeds (and assuming state law was silent on the allocation issue), a distribution to either A or B would carry our IRD to either share regardless of which share actually received the IRD. Thus, specific direction in the governing instrument about allocating IRD will be recognized as overriding the regulations requirement of allocating IRD among all the potential recipients.82 Thus, if the separate share rule applies to a beneficiary and the trust instrument does not otherwise specify the allocation of the IRD, a fiduciary is no longer able to control the recipient of IRD by making disproportionate distributions during the year the trust or estate recognizes IRD. However, it is still possible to control the recipient of IRD if the right to IRD (as opposed to the IRD itself) is distributed. In other words, if an executor or trustee assigns IRD to a share, the entire IRD will be recognized by that particular share as the IRD is collected.83 This assumes, of course, that the transfer of the right to the IRD does not accelerate the recognition of the IRD to the transferor under 691(a)(2). The final separate share regulations require the practitioner pay careful attention to the income tax aspects of IRD. The issues that can arise are illustrated by Examples 9 and 10 of Reg. 1.663(c)-5. As illustrated above, Example 9 indicates that a specific direction in the governing instrument allocating IRD will be recognized as overriding the regulations requirement of allocation among potential recipients. In Example 9 the estate received a distribution from an IRA. The will provided for distribution of the residue in equal shares to the decedents two children. The will also directed that one childs share be funded first with the IRA proceeds. The results in Example 9 confirm that the IRA income will be allocated to that childs share, instead of being allocated equally to each child as would have been required absent the direction in the will to allocate the IRD to one particular child. Often practitioners intentionally fund gifts or bequests of IRD to the surviving spouse, especially if this can be done without triggering an income tax. This is usually accomplished by making a specific bequest of the IRD to the spouse. Leaving IRD to a surviving spouse allows the estate of the surviving spouse to be reduced by the income tax that will have to be paid on the IRD thereby decreasing the potential future estate tax on the spouses death. This also avoids wasting the decedents unified credit or GST exemption on amounts that will be paid to the government as income tax. Thus, a specific bequest of IRD or a specific direction

38-20about using IRD in funding is now necessary to avoid the final regulations requirement mandating a proportionate allocation of IRD among all potential recipients. This is especially important in the case of an estate or trust that would like to transfer IRD to a charity and qualify for the fiduciary income tax charitable deduction under 642(c). Distributions from an estate or trust to charity do not qualify for the income distribution deduction under 661. The only way to obtain a fiduciary income tax charitable deduction is under 642(c).84 Example: Decedent dies leaving $1,000,000 in stock and a $1,000,000 IRA to his trust. The trust terminates at Decedents death leaving 50% of his estate to charity and 50% to his son. The trust receives the proceeds of the IRA in 2005 (causing the full $1,000,000 to be included in the trusts taxable income for 2005) and transfers $1,000,000 to charity. The estate wants the $1,000,000 transferred to the charity to qualify for the fiduciary income tax charitable deduction under 642(c). The trust instrument does not direct which share gets the IRA. Thus, each share could potentially be funded with the IRA proceeds. Assuming the final separate share rule regulations apply for purposes of calculating the 642(c) deduction, only $500,000 of the amount would qualify for the 642(c) deduction as that is all that is deemed paid to charity. On the other hand, if the trust directed that the trustee fund the charitys share with the IRA proceeds (e.g. a specific allocation of IRD), the full $1,000,000 distribution would qualify for the 642(c) deduction. Alternatively, if the trustee did not cash out the IRA and receive the IRA proceeds in the trust, he could have assigned the right to receive the IRA proceeds to the charity assuming the trustee had the right to do so under the governing instrument or state law. In that case, the proceeds of the IRA would be distributed directly from the IRA to the charity where they would avoid income taxation due to the charitys exemption from income tax.85 Note that since the bequest to charity is specified in the trust instrument and is in the form of a fraction, the transfer of the IRD from the trust to the charity is not considered a transfer that would accelerate the recognition of the IRA income at the trust level under 691(a)(2). If the intent is to qualify for the fiduciary income tax charitable deduction under 642(c), the trust document should specify that IRD be used to fund any charitable bequest. Alternatively, the trustee may want to assign IRD to the charity. D. Funding a Pecuniary Bequest with IRD

If an estate or trust funds a pecuniary bequest with the right to IRD, the traditional view is that the funding accelerates the recognition of the IRD at the estate or trust level. This conclusion is reached in one of two ways: (1) under Reg. 1.661(a)-2(f) (which pro

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