Estate Planning Council of Delaware

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Estate Planning Council of Delaware By Joseph
V. Falanga, CPA, AEP Sharon H. Goodman,
Esq.
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Introduction

• The Uniform Principal and Income Act (and
  relevant state statutes that have adopted the Act
  or the unitrust methodology in some form)
  controls allocations between principal and income
  and who gets what. The Act has absolutely no
  significance where the governing instrument gives
  the fiduciary sufficient discretion to distribute
  principal, allocate between income and principal
  and make tax elections. Then, the governing
  instrument controls.
• This presentation touches on some of the more
  pressing issues and complications resulting from
  certain provisions of the Act and the unitrust
  methodology. These complications and issues
  point to the fact that the controlling documents
  should be well crafted to give the fiduciary the
  ability to act impartially without having to rely
  on the Act or state law.
• In light of the downturn in the economy, where
  expectancies of beneficiaries will be thwarted,
  it is essential that, should the governing
  instrument not provide the flexibility needed to
  insure impartiality, the practitioner understand
  the intricacies of the Act and adjustment and
  unitrust powers under relevant state law.

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Historical Overview of the Revised Uniform
Principal and Income Act (UPIA) and Amendments to
Code Section 643(b)

• The UPIA was revised in 1997 and in 2004,
  amendments were made to
  the Code Section 643(b) definitions of income.
• Factors which played a role in the revisions and
  amendments include
• New forms of investment
• Modern portfolio theory of investing for total
  return replaced the traditional income and
  principal approach
• The traditional approach generally focused on
  investing to produce income
• The total return approach diminished the ordinary
  income available for distribution to the income
  beneficiary
• In 2004, in response to the changes to the UPIA,
  amendments were made to Code Section 643(b) and
  the accompanying Regulations.
• The amendments to Code Section 643(b) changed the
  definition of income to reflect modern investment
  theory.

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• The provisions of the old UPIA historically
  provided rules regarding the determination of
  what constituted a trusts net income.
• Over the past few decades, there have been
  substantial differences between actual versus
  assumed investment returns
• The 1970s and early 1980s produced high
  inflation.
• In more recent years, there has been low to
  negligible inflation, and now there is talk
  of a recession.
• Concurrently, the investment model evolved from
  the prudent man standard to an investment
  philosophy that encompasses the portfolios total
  return.
• Total return looks to capital appreciation as
  well as the annual return on the investments.
• The result of these changes to investment theory
  generally had a negative impact on income
  beneficiaries who saw a reduction in the income
  that could be distributed to them under the
  traditional theory of what constituted net
  income.

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• The revisions to the UPIA and amendments to Code
  Section 643(b) have brought complications and
  confusion in a number of areas.
• Historically, the trusts net income consisted of
  income, dividends and rents, but excluded capital
  gains.
• The total return concept impacted negatively on
  what the income beneficiary could receive from
  the trust in situations where the trustee did not
  have flexibility in distributing principal to the
  income beneficiary.
• While the total return concept of investing might
  have increased the overall value of the trust,
  interest and dividend income was dramatically
  reduced.
• These factors moved the National Commissioners to
  issue the 1997 revisions to the UPIA.
• The UPIA and Code Section 643(b) revisions
  brought some new and innovative concepts,
  including
• Giving the fiduciary the power to adjust between
  principal and income under certain
  circumstances (and vice versa), and
• The unitrust concept.

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Challenges to Fiduciaries What is Net Income?

• Fiduciaries now must confront major challenges in
  dealing with the interaction of
• (1) the power to adjust between principal and
  income,
• (2) the unitrust method of determining income and
  
• (3) the final Treasury Regulations which define
  trust income.
• It is essential to understand that the power to
  adjust controls the income available for
  distribution.
• This is because the Subchapter J definition of
  income, which establishes the tier distribution
  system, provides that income when not modified
  by such terms as gross, distributable net or
  undistributed net is determined under applicable
  state law.

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• The only exception to this rule is if the
  governing instrument provisions depart
  fundamentally from traditional principles of what
  is income versus what is principal in such case,
  IRS will not respect the governing instrument
  definitions of income and principal.
• The UPIA defines income as money or property a
  fiduciary receives as current return from a
  capital asset and it includes a portion of the
  receipts from a sale, exchange or liquidation of
  a principal asset, to the extent provided in
  Article 4. This is in effect gross income.
• Under the UPIA, net income is defined as the
  total receipts allocated to income minus the
  disbursements made from income during the
  accounting period. Significantly, the definition
  provides that receipts and disbursements include
  items transferred to or from income. The comments
  to the UPIA under Section 102 explain that
  transfers to or from income include, among other
  items, the power to adjust under Section 104(a).

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Power to Adjust

• Section 104(a) of the UPIA for the first time
  gives the fiduciary the ability to make transfers
  from principal to income (and vice versa).
• The power to adjust affects various classes of
  trust beneficiaries and also affects the tax
  treatment of distributions and potentially
  impacts the beneficiarys tax liability,
  especially under the rules enacted by Code
  Section 643(b) and Regulation 1.643(b)-1.
• Under modern portfolio theory, an investment that
  is made solely in growth stock under the prudent
  investor standard and which, accordingly,
  produces virtually no dividend income, is the
  subject of the adjustment power.
• In effect, there is a charge to principal and
  credit to income.
• The discussion which follows below is based on
  the UPIA issued by the Uniform Commissioners.
  (Note Many states have adopted the UPIA with
  certain modifications so it is essential to
  review and understand the local controlling law
  before taking any action).
• Under Section 104 of the UPIA, the fiduciary is
  given the power to adjust when the governing
  instrument is silent.
• Note The terms of the governing instrument
  controls and will override the UPIA provisions.

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• When a trustee adopts a total return investment
  policy, rather than a policy which expressly
  addresses the income and principal rights of the
  beneficiaries, the trustee is permitted to
  transfer amounts from principal to income (and
  from income to principal).
• The trustees decision must recognize
• What is fair and reasonable to all beneficiaries.
• The trustees duty of impartiality.
• Note Impartiality does not mean equality. It
  means that the trustee must treat the
  beneficiaries equitably in light of the purposes
  and terms of the trust.
• The power to adjust becomes operative when the
  trust instrument
• Fails to contain adequate discretionary
  administrative powers, and
• Does not clearly show an intention that the
  trustee must or may favor a particular
  beneficiary.
• In effect, the power to adjust is a default
  provision
• It gives the trustee the ability to override
  other provisions of the UPIA regarding
  allocations between income and principal.
• It is operative when the power to adjust is
  necessary to allow the trustee to accomplish its
  duties and responsibilities.
• So, if the governing instrument is silent in
  regard to the determination of what is income and
  what is principal, the power to adjust under the
  UPIA applies.
• The power to adjust is not a power to transfer
  capital gains from principal to income. In
  determining the amount to adjust, the amount of
  realized capital gain is irrelevant.
• Code Section 643 and the Regulations sets forth
  the income tax treatment of the adjustment.

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Factors which must be considered under the UPIA
when determining if the Power to Adjust should be
exercised

• Section 104 of the UPIA says that the trustee
  must consider the following factors when
  considering use of the power to adjust
• The nature, purpose and expected duration of the
  trust.
• The intent of the settlor.
• The identity and circumstances of the
  beneficiaries.
• The need for liquidity, regularity of income and
  preservation and appreciation of capital.
• The assets held by the trust, their nature and
  the extent they are used by a beneficiary and
  whether the asset was transferred to the trust by
  the settlor or acquired by the trustee.
• The net amount allocable to income under other
  provisions of the UPIA and the increase or
  decrease in the value of the principal assets.
• Whether and to what extent the trustee is given
  the power to invade principal or accumulate
  income, or is prohibited to do so under the terms
  of the trust agreement and the past history in
  regard to the use of the adjustment power.
• The actual and anticipated effect of economic
  conditions on principal and income and the
  effects of inflation or deflation, and
• The anticipated tax consequences of the
  adjustment.

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When the Trustee cannot exercise a Power to Adjust

• In certain situations, the fiduciary is
  explicitly prohibited from exercising a power to
  adjust.
• The power to adjust may not be exercised when
  such exercise would have a negative tax impact,
  including causing the loss of part or all of
• (1) a federal or state gift tax exclusion,
• (2) an income, gift or state charitable
  deduction, or
• (3) an inheritance deduction otherwise
  available.
• The power to adjust is also precluded when
  exercise of the power would
• diminish an income interest in a marital trust.
• reduce the actuarial value of an income interest
  in a transfer intended to qualify for gift tax
  exclusion.
• change the amount payable to a beneficiary as a
  fixed annuity or a fixed fraction of the value of
  the trusts assets.
• affect any amount permanently set aside for
  charitable purposes.
• cause an individual to be treated as the owner of
  the trust for income tax purposes.
• cause all or part of the trust assets to be
  included in the gross estate of an individual who
  has the power either to remove or appoint a
  trustee.
• allow the trustee to make an adjustment for
  his/her direct or indirect benefit, including the
  satisfaction of a legal obligation.
• Note A disinterested trustee may make an
  adjustment that benefits another trustee.

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• The power to adjust may not be exercised if the
  governing instrument clearly bars the trustee
  from exercising an adjustment power.
• The comments to Section 104 provide certain
  examples of the power to adjust
• Investment advisors convince the trustee to shift
  to a total return investment policy that involves
  solely growth stocks. The change results in a
  reduction of dividend and interest receipts from
  100,000 in the prior year (and the average of
  the past five years) to 10,000. As a result of
  the portfolio change, principal value increased
  by 300,000. These results indicate to the
  trustee that it should exercise its power to
  adjust by transferring 90,000 from principal to
  income. Accordingly, the income beneficiary
  receives 100,000, the determination of trust
  accounting income after the adjustment.
• Adjustments can also be made from income to
  principal where a very high interest return is
  obtained in a period of substantial inflation
  where part of the interest return is a principal
  return in an economic context that represents
  loss of principal value due to inflation. Example
  2 of the Section 104 comments illustrates this
• Inflation returns, and the trustee invests 1
  million in U.S. government bonds with a 14
  coupon. The inflation rate is 8, so the trustee
  decides to adjust by transferring 80,000 from
  income to principal, an amount the trustee
  considers an appropriate adjustment (other
  fiduciaries may choose a larger or smaller
  adjustment) to make up for the loss in value due
  to inflation and 60,000 is distributed to the
  income beneficiary.

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• Applying the adjustment power may be difficult
  and problematic when the governing instrument is
  an old trust document that does not provide the
  flexibility built into more recent documents. The
  comments to Section 104 gives the following
  example (Example 4)
• When the irrevocable trust was formed and funded,
  the state law did not contain the prudent
  investor rule. The trust document required all
  income to be distributed to a named beneficiary.
  The trustee was provided with very narrow
  principal invasion powers for dire emergencies
  only, and over the term of the trust the
  aggregate principal invasion was limited to 6 of
  the trusts initial value. The state of the
  trusts situs then changed its law by adding the
  prudent investor rule. As a result, the trustee
  changed the asset allocation from 50/50
  percentages for stocks and bonds to 90/10
  percentages for stocks and bonds. This change in
  the portfolio reduced the annual income from
  dividends and interest, but it significantly
  increased the total return. This example in the
  UPIA concludes that the trustee may adjust by a
  transfer from principal to income, but only if
  the transfer is exclusively from the capital
  appreciation resulting from the switch in the
  asset allocation. Even so, the adjustment will be
  prohibited if the trustee cannot determine, or
  inadequate records exist to assist the trustee in
  ascertaining, the application of the 6 invasion
  cap.

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• Additional examples of circumstances of when the
  power to adjust can be used
• Trust gives A income for life with the remainder
  going to B. The settlor funded the trust with a
  portfolio consisting of stocks and bonds in a
  20/80 ratio. In accordance with his fiduciary
  duties, the trustee determines that suitable risk
  and investment return objectives indicate that
  the portfolio should be invested 50/50 in stocks
  and bonds. This investment strategy results in a
  decrease in ordinary income. The trustee is
  authorized, after considering the factors listed
  above, to make an adjustment between principal
  and income to the extent it considers it
  necessary to increase the amount payable to the
  income beneficiary.
• Settlor creates a trust that provides income is
  paid to the settlors sister, S, for life, with
  the remainder payable to charity. The trust terms
  allow the trustee to invade principal to provide
  for S health and to support her in her
  accustomed manner of living but does not
  otherwise indicate if the trustee should favor S
  or the charity. S is a retired schoolteacher,
  with no children. Her income from various sources
  is more than enough to provide for her accustomed
  standard of living. In applying prudent investor
  standards, the trustee determines that the
  portfolio should be invested entirely in growth
  stocks which provide virtually no dividend
  income. While it is not necessary to invade
  principal to maintain S accustomed standard of
  living, she is entitled to receive the degree of
  beneficial enjoyment accorded to a person who is
  the only income beneficiary of the trust. The
  trustee has the power to adjust between principal
  and income to provide S with that degree of
  enjoyment.

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The Unitrust Rules

• The UPIA does not preclude a state from adopting
  a unitrust provision.
• The unitrust concept is not part of the UPIA.
• The unitrust concept is a provision that allows
  trust income to be computed by using a fixed
  percentage of the value of the trusts assets
  (the unitrust amount) to compute income.
• The IRS allows the unitrust amount to range from
  3 to 5. Reg.1.643(b)-1.
• The unitrust concept permits an income
  beneficiary to receive a fixed percentage of the
  trusts assets (the valuation base), revalued
  annually.
• The fixed percentage may be applied to the
  valuation base on an annual basis, or as adopted
  by some states in a form that uses a three year
  moving average of the fair market value of the
  assets.
• Use of the unitrust methodology eliminates the
  need for Trustees to wrestle with the
  determination of accounting income and principal.
• If the unitrust concept is elected state law may
  preclude the trustee from using a power to
  adjust.

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• Once elected (unless otherwise directed by the
  Court) state law may provide that the unitrust
  methodology must be used in subsequent years.
• This mandatory rule make the use of the unitrust
  less flexible than the power to adjust.
• It is a separate fiduciary accounting income
  distribution system and is operative only if a
  state independently enacts a unitrust provision.
• If state law adopts a unitrust provision, as a
  general rule, the trustee must obtain court
  approval to use the unitrust methodology if the
  governing instrument does not allow for the use
  of the unitrust methodology.

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The Final Income Tax Regulations Under Code
Section 643(b)

• When the UPIA was revised in 1997 giving the
  trustee the power to adjust or ability to convert
  to a unitrust, there were questions as to whether
  the IRS would allow trustees to exercise such
  powers (and thereby increase or decrease
  accounting income) without, for example
• jeopardizing the marital deduction,
• causing any gift tax ramifications and
• jeopardizing grandfathered generation-skipping
  transfer trusts.
• The Regulations that were effective as of January
  2004 answered these concerns in a positive
  manner.
• If the trustees actions fall within the
  Regulations parameters, using a power to adjust
  or converting the trust to a unitrust will not
• Cause the loss of a federal marital deduction
• Cause a taxable transfer for gift tax purposes
• Cause a taxable sale or exchange
• Undo the grandfathered status of a
  generation-skipping transfer tax trust
• The new Regulations generally will respect the
  trustees determination of income made in
  accordance with the trustees power to
• (1) adjust between principal and income (and
  vice versa) granted under local law,
• (2) convert to a unitrust granted under local
  law and
• (3) allocate capital gain to fiduciary
  accounting income.

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• The Regulations allow for the conversion of an
  existing trust into a unitrust and the use of a
  power to adjust when such powers are granted
  under state law.
• Generally, federal tax law follows local state
  law with respect to the definition of income.
  State law definitions of income which provide for
  a reasonable apportionment between the income and
  principal beneficiaries of the total return of
  the trust for the year will be respected.
• The final Regulations define income as the
  amount of income of an estate or trust for the
  taxable year determined under the terms of the
  governing instrument and controlling local law.
• The final Regulations retain the previously
  existing rule that trust provisions that depart
  from traditional principles in regard to the
  characterization of income and principal will
  generally not be recognized for federal tax
  purposes.

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• The Regulations say that allocations between
  principal and income pursuant to local law will
  be respected if the local law provides for a
  reasonable apportionment between the income and
  principal beneficiaries of the trusts total
  return for the year.
• Total return includes ordinary and tax-exempt
  income, capital gains and appreciation.
• For the allocations to be respected, the
  Regulations mandate that the controlling state
  law specifically authorize the power to equitably
  adjust and/or provide a unitrust definition of
  income.
• For the unitrust provision to be respected for
  federal purposes, the state statute must define
  the unitrust amount as being between 3 to 5 of
  the trusts fair market value.
• The preamble to the Regulations clarifies that if
  no statutory law exists, other actions, such as a
  decision by the states highest court enunciating
  a general principle of law applicable to all
  trusts administered in the state may constitute
  applicable state law.
• A court order applicable only to the specified
  trust does not constitute applicable state law
  for such purposes.

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• In regard to the power to adjust, the Regulations
  require that such adjustment power be expressly
  allowed under state law and that such law
  describe the circumstances under which the power
  to adjust may be used.
• Generally, adjustments are allowed when the
  trustee invests under the prudent investor model,
  the trust describes the amounts that can be
  distributed to the beneficiary by referring to
  trust income and the trustee, after applying the
  local state rules in regard to the allocation of
  principal and income, is not able to administer
  the trust impartially.
• In certain situations the trustee is expressly
  prohibited from using the power to adjust.
• IRS will generally recognize an allocation of all
  or part of a capital gain to income if the
  allocation is made pursuant to
• the terms of the governing instrument and local
  law, or
• a reasonable and impartial exercise of a
  discretionary power granted to the fiduciary
  under the governing instrument or pursuant to
  local law, if not prohibited by applicable law.
• The final Regulations dramatically changed the
  rules concerning the inclusion of capital gains
  in distributable net income (DNI).
• The old rule was that generally capital gains
  were not included in DNI.
• The premise under the new Regulation is that
  capital gains are included in DNI. Reg. Section
  1.643(a)-3(b).

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• Capital gains are included in DNI to the extent
  they are
• required to be included under the terms of the
  governing instrument and local law, or
• allowed to be allocated to DNI pursuant to a
  reasonable and impartial exercise of the
  fiduciarys discretion in accordance with a power
  granted to the fiduciary by the governing
  instrument or local law if not prohibited by
  local law
• allocated to income (but if income under the
  state statute is defined as, or consists of, a
  unitrust amount a discretionary power to allocate
  gains to income must also be exercised
  consistently and the amount so allocated may not
  be greater than the excess of the unitust amount
  over the amount of DNI)
• allocated to corpus but treated consistently by
  the fiduciary on the trusts books, records and
  tax returns as part of the distribution to the
  beneficiary or
• 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 the beneficiary.
• The Preamble to the Regulations says that the
  power to adjust does not have to be exercised
  consistently as long as it is exercised
  reasonably and in an impartial manner. If however
  the unitrust provisions are used, the power must
  be exercised on a consistent basis.

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What does all of this mean and when can Capital
Gain be Included in DNI?

• The Regulations contain some useful illustrations
  showing when capital gains are included in DNI.
• They show that a pattern is established with the
  first act or the first failure of the trustee to
  act where the governing instrument gives the
  trustee discretionary power.
• Two of the illustrations showing the tax
  treatment when the fiduciary has discretionary
  power are
• Example 1 Under the terms of Trusts governing
  instrument, all income is to be paid to A for
  life. Trustee is given discretionary powers to
  invade principal for As benefit and to deem
  discretionary distributions to be made from
  capital gains realized during the year. During
  Trusts first taxable year, Trust has 5,000 of
  dividend income and 10,000 of capital gain from
  the sale of securities. Pursuant to the terms of
  the governing instrument and applicable local
  law, Trustee allocates the 10,000 capital gain
  to principal. During the year, Trustee
  distributes to A 5,000, representing As right
  to trust income. In addition, Trustee
  distributes to A 12,000, pursuant to the
  discretionary power to distribute principal.
  Trustee does not exercise the discretionary power
  to deem the discretionary distributions of
  principal as being paid from capital gains
  realized during the year. Therefore, the capital
  gains realized during the year are not included
  in distributable net income and the 10,000 of
  capital gain is taxed to the trust. In future
  years, Trustee must treat all discretionary
  distributions as not being made from any realized
  capital gains.

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• Example 2 The facts are the same as in Example
  1, except that Trustee intends to follow a
  regular practice of treating discretionary
  distributions of principal as being paid first
  from any net capital gains realized by Trust
  during the year. Trustee evidences this
  treatment by including the 10,000 capital gain
  in distributable net income on Trusts federal
  income tax return so that it is taxed to A. This
  treatment of the capital gains is a reasonable
  exercise of Trustees discretion. In future
  years Trustee must treat all discretionary
  distributions as being made first from any
  realized capital gains.
• The Regulations also provide illustrations in the
  unitrust context
• Example 11 The applicable state statute
  provides that a trustee may make an election to
  pay an income beneficiary an amount equal to four
  percent of the fair market value of the trust
  assets, as determined at the beginning of each
  taxable year, in full satisfaction of that
  beneficiarys right to income. State statute
  also provides that this unitrust amount shall be
  considered paid first from ordinary and
  tax-exempt income, then from net short-term
  capital gain, then from net-long term capital
  gain, and finally from return of principal.
  Trusts governing instrument provides that A is
  to receive each year income as defined under
  state statute. Trustee makes the unitrust
  election under state statute. At the beginning
  of the taxable year, Trust assets are valued at
  500,000. During the year, Trust receives 5,000
  of dividend income and realizes 80,000 of net
  long-term gain from the sale of capital assets.
  Trustee distributes to A 20,000 (4 of 500,000)
  in satisfaction of As right to income. Net
  long-term capital gain in the amount of 15,000
  is allocated to income pursuant to the ordering
  rule of the state statute and is included in
  distributable net income for the taxable year.

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• Example 12 The facts are the same as in Example
  11, except that neither state statutes nor
  Trusts governing instrument has an ordering rule
  for the character of the unitrust amount, but
  leaves such a decision to the discretion of
  Trustee. Trustee intends to follow a regular
  practice of treating principal, other than
  capital gain, as distributed to the beneficiary
  to the extent that the unitrust amount exceeds
  Trusts ordinary and tax-exempt income. Trustee
  evidences this treatment by not including any
  capital gains in distributable net income on
  Trusts Federal income tax return so that the
  entire 80,000 capital gain is taxed to Trust.
  This treatment of the capital gains is a
  reasonable exercise of Trustees discretion. In
  future years Trustee must consistently follow
  this treatment of not allocating realized capital
  gains to income.
• Example 13 The facts are the same as in
  Example 11, except that neither state statutes
  nor Trusts governing instrument has an ordering
  rule for the character of the unitrust amount,
  but leaves such a decision to the discretion of
  Trustee. Trustee intends to follow a regular
  practice of treating net capital gains as
  distributed to the beneficiary to the extent the
  unitrust amount exceeds Trusts ordinary and
  tax-exempt income. Trustee evidences this
  treatment by including 15,000 of the capital
  gain in distributable net income on Trusts
  Federal income tax return. This treatment of the
  capital gains is a reasonable exercise of
  Trustees discretion. In future years Trustee
  must consistently treat realized capital gain, if
  any, as distributed to the beneficiary to the
  extent that the unitrust amount exceeds ordinary
  and tax-exempt income.

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• The illustrations show that the controlling
  factor is if there is a defined ordering rule,
  either under the applicable state law or
  governing instrument, which determines the
  character of the unitrust amount.
• In the absence of an ordering rule, the trustees
  discretion is considered. If the trustee has a
  discretionary power over the decision, capital
  gains can be included in DNI, but the discretion
  must be exercised consistently. This means that
  the way the return is filed in year 1 is the way
  future returns must be filed.
• Note In all cases, capital gains cannot be
  included in DNI to the extent that they exceed
  the unitrust amount. For example, if the total
  net income of the trust was 100,000, including
  25,000 of capital gains, then capital gains
  could not be included in DNI if the unitrust
  amount was less than or equal to 75,000. If
  the unitrust amount was 100,000 all of the
  capital gains could be included in DNI.
• If there is not an ordering rule and the trustee
  has no discretion over the decision, capital
  gains cannot be included in DNI.

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• The Regulations do have a major shortcoming
  they do not include examples that illustrate the
  inclusion of capital gains in DNI when the
  trustee exercises a power to adjust.
• Treasury refused to provide examples and
  maintained that there were too many potential
  variations in the circumstances and ramifications
  of exercising the power to adjust under the
  applicable state laws.
• While the regulations do not provide guidance in
  the context of a power to adjust, some
  commentators believe that the unitrust examples
  provide analogies for guidance and suggest that
  the exercise of a power to adjust will result in
  the inclusionof capital gains in DNI when 1)
  state law ordering rules allow (or are silent
  regarding) inclusion of such gains in DNI, 2)
  the trustee determines that inclusion is
  appropriate and equitable, 3) Form 1041 reflects
  this tax approach and 4) the tax treatment is
  followed consistently in subsequent years. If
  state law precludes an ordering that includes
  capital gains, and the trust document is silent
  or it precludes ordering as well, then capital
  gains cannot be included in DNI.
• Some commentators maintain that since the
  Regulations provide no guidance regarding the
  inclusion of capital gains in the power to adjust
  context, the best course is to obtain a private
  letter ruling.

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Application to Ownership Interests in
Flow-Through Entities

• Trusts often own interests in flow-through
  entities such as partnerships, LLCs and S
  corporations.
• More often than not these entities show K-1
  income reportable by the trust which differs from
  the amount of cash or other property distributed
  to the trust.
• There are many situations where the cash
  distribution made from the flow-through entity to
  the trust as owner of an interest in the entity
  is less than the taxable income allocated to the
  fiduciary.
• If applicable state law gives the trustee the
  power to adjust, the trustee may decide to
  transfer from principal to income an appropriate
  amount to be reflected as net income and thus
  become distributable.

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Distributions from Flow Through EntitiesTrust
Accounting and Tax TreatmentUPIA Section 505

• For accounting purposes, the trustee must keep an
  income account and a separate principal account
  to reflect the interest of the two classes of
  beneficiaries.
• For income tax purposes, no distinction is made
  between receipts and disbursements that the
  trustee allocates to principal and income.
• All taxable receipts, and all deductible
  expenses, in both the income and principal
  accounts, are combined to determine the trusts
  taxable income for the year.
• Distributions to beneficiaries generally will
  reduce the trusts taxable income. Caveat Under
  traditional concepts, capital gains are not
  included in distributable income for tax
  purposes.
• To the extent tax is paid by the Trustee, it is
  allocated to the income and principal accounts
  under Section 505 of the UPIA.
• Trust income, taxable income and distributable
  net income are usually different.

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• Example
• A Trust that receives dividends of 25,000 and
  pays a trustee commission of 3,000, 1,000 of
  which is allocated to income under state law has
  trust accounting income of 24,000 (25,000 less
  1,000) but taxable income of 22,000 (25,000 -
  3,000).
• Unless the governing instrument provides
  otherwise, trust accountings are made on a cash
  receipt and disbursement basis. A trusts share
  of a partnerships taxable income may be more or
  less than the partnerships distribution to the
  Trust. The accounting income only includes the
  amount received from partnership income. The
  trusts share of the partnerships taxable income
  is irrelevant for trust accounting purposes.
• Distributable Net Income (DNI)
• Places a ceiling on the income distribution
  deduction
• Determines the amount includable in the
  beneficiarys income
• Determines the character of the distribution to
  the beneficiary
• The distribution deduction, and the amount
  taxable to the beneficiary, is never larger than
  DNI.
• If the trusts DNI for the year is less than the
  trust income that is distributed or required to
  be distributed the portion of the income that
  exceeds DNI is not taxable to the income
  beneficiary.

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How is the trusts income tax obligation
calculated when the trust owns a partnership
interest?

• UPIA Rules
• A cash distribution from the partnership is
  allocated to income under Section 401(b) if the
  distribution is not a partial liquidation
• Section 401 (d) of the UPIA allocates money
  received in a partial liquidation to principal.
• Among other definitions, the UPIA provides that
  money is received in partial liquidation if the
  total amount of property and money is received in
  a distribution or series of related distributions
  is greater than 20 of the entitys gross assets
  as shown by the entitys year-end financial
  statements immediately preceding the initial
  receipt. UPIA Section 401 (d) (2).
• Comments made by various professional
  organizations including the ABA, the AICPA, and
  ACTEC suggest that the 20 rule contained in
  Section 410 (d)(2) be eliminated. The belief is
  that such section as written allows a change in
  the character of the return on an investment
  simply by placing the investment in a single
  member LLC. For example, a trustee could
  transfer an investment portfolio into a single
  member LLC in order to dispose of certain highly
  appreciated assets followed by a distribution of
  the proceeds, not in excess of 20 of the
  entitys gross assets, and change the character
  of the proceeds from principal to income through
  the use of the entity.
• Net income means total receipts allocated to
  income during an accounting period minus
  disbursements from income during the period, plus
  or minus transfers under the UPIA to or from
  income during the period. UPIA Section 102(8)

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• Income taxes a trustee must pay on the trusts
  share of the partnerships taxable income are
  paid from income or principal under the rules of
  UPIA Section 505(c)
• Section 505(c) provides A tax required to be
  paid by a trustee on the trusts share of an
  entitys taxable income must be paid
  proportionately
• From income to the extent the receipts from the
  entity are allocated to income and
• From principal to the extent that (A) receipts
  from the entity are allocated to principal and
  (B) the trusts share of the entitys taxable
  income exceeds the total receipts described in
  paragraph (1) and (2)(A)
• If the amount distributed from the partnership
  exceeds the trusts share of partnership taxable
  income, and if all of the distribution must be
  paid to the income beneficiary, the trust will
  not bear any tax.
• If the amount distributed from the partnership is
  less than the trusts share of partnership
  taxable income, the trust must bear some or all
  of the amount allocated to the trusts income and
  perhaps from principal.

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• UPIA Sections 505 (c) and (d) pertain to how the
  trustee should allocate income tax on the trusts
  share of a flow-through entitys taxable income.
• The interplay between Sections 505 (c) and (d)
  produces different tax results depending upon the
  order in which the provisions of such sections
  are applied.
• The AICPAs comments regarding certain proposed
  changes to various sections of the UPIA
  illustrates this dynamic.
• As pointed out in the AICPAs comments, it is not
  clear if Section 505(c) is applied first or if
  505(d) is applied first.
• James Gamble, co-reporter of the UPIA, apparently
  believes that Section 505(c) is applied first.
• Under Gambles interpretation, the trusts tax on
  its share of the entitys taxable income is
  calculated and then the tax is subtracted from
  income receipts from the entity. To the extent
  the trust receives an income distribution
  deduction for paying cash received from the
  entity to the beneficiary, the trustee in turn
  increases its payment to the income beneficiary
  to the extent of its tax savings under UPIA
  Section 505(d).

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• On the other hand, as reported in the AICPAs
  comments, the AICPAs Fiduciary Accounting Income
  Task Force takes the opposite approach. The Task
  Force believes Section 505(d) should be applied
  first.
• Under the Task Forces interpretation, receipts
  from the entity would be reduced by the amount
  for which the trust receives an income
  distribution deduction. Then, the trustee would
  apply 505(c) by calculating the trusts tax on
  taxable income from the entity reduced by the
  deductible payments to the beneficiary and
  allocating the tax proportionately between a) the
  reduced income receipts and b) reduced principal
  receipts plus the trusts share of the entitys
  undistributable taxable income.
• Under the above interpretation, as pointed out in
  the AICPAs comments, no taxes would be allocated
  to the income beneficiary if all income receipts
  from the entity would be deductible by the trust
  because income receipts would be zero.
• The rule supported by Gamble that requires that
  the tax be computed first involves a circular
  calculation. The is because the trust's tax
  depends on the amount paid to the beneficiary for
  which the trust receive an income distribution
  deduction. But the amount paid to the income
  beneficiary depends on the trusts tax liability
  attributable to those receipts. The computation
  can be solved by using an algebraic formula to
  determine the net amount due to the income
  beneficiary.

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• The formula is
• D(C - R K) / (1 R)
• D Distribution to Income Beneficiary
• C Cash Paid by the Entity to the Trust
• R Tax Rate on Income
• K Entitys K-1 Taxable Income
• AICPAs comments provide the following
  illustrations concerning the above concepts
• ABC Trust receives an IRS Schedule K-1 from the
  Partnership reflecting taxable income of 1
  million. Partnership distributes 500,000 to the
  trust. The Partnership represents that the
  distribution is income and so the trustee
  initially allocates the entire 500,000 to
  income. The trust is in the 35 percent tax
  bracket.
• Note The above formula and solution would
  become more complicated if the state also had an
  income tax.
• In the above example, the partnership
  distribution exceeds the trusts 350,000 ( i.e.,
  1 million x 35 tax rate) tax liability on the
  IRS Schedule K-1 income by 150,000). The excess
  is income that the trustee is required to
  distribute and for which it receives a
  distribution deduction. But the distribution
  deduction reduces the trustees tax, which
  increases the beneficiarys income and so on.

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• As illustrated below, the trustee must pay
  230,769 to the income beneficiary so that after
  deducting the payment, the trust has exactly
  enough to pay its tax on the remaining taxable
  income from the entity.
• Taxable Income per K-1 1,000,000
• Payment to Beneficiary 230,769
• Trust Taxable Income 769,231
• (35 Tax 269,231)
• Partnership Distribution 500,000
• Tax Allocated to Income (269,231)
• Payable to Beneficiary 230,769
• D(C - R K) / (1 R) (500,000) Cash
• Paid by Entity to the Trust 350,000
• Tax on 1,000,000 K-1 Income at 35 Rate /
  (1-.35) 1- tax rate 230,769 Payable to
  Beneficiary

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• The above circular calculation occurs ONLY when
  the entity distributes an amount that is more
  than enough to pay the tax on the trusts taxable
  income but which is less than its total taxable
  income.
• When the entity distributes less than a
  sufficient amount to pay the tax on the trusts
  share of the entitys taxable income, the trust
  has to retain the entire distribution to pay the
  tax. In this situation, the income beneficiary
  gets nothing.
• When the distributions from the entity to the
  trust are equal to or exceed the K-1 taxable
  income, the tax treatment is simple and straight
  forward.
• When the entity distributes more than its taxable
  income, the trusts tax liability attributable to
  its share of the entitys taxable income is zero.
  This is because the trustee can pay enough to
  the income beneficiary to get a full income
  distribution deduction which reduces the trusts
  tax to zero.
• As shown in the AICPAs comments, the result is
  much different if Section 505(d) is applied
  first. The amount payable to the income
  beneficiary would increase to 500,000.
• If Section 505(d) is applied first, the trustee
  would allocate taxes on the entitys taxable
  income between income and principal based on
  receipts, reduced by payments to the beneficiary
  for which the trustee is entitled to a deduction.
  Thus, receipts in the allocation formula are
  first reduced by amounts that the trustee can
  deduct when paid to the beneficiary. So, the
  trustee would first reduce income receipts by
  amounts for which the trust receives an income
  tax deduction. To the extent this reduce income
  receipts to zero, no tax would be allocated to
  income receipts.

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• Illustration (Assume same facts as above
  Taxable Income 1,000,000 Distribution to Trust
  500,000)
• Taxable Income per K-1 1,000,000
• Payment to Income Beneficiary
  500,000
• Trust Taxable Income
  500,000
• (35 Tax 175,000)
• Partnership Distribution 500,000
• Tax Allocated to Income
  (0)
• Payable to Beneficiary
  500,000
• The above alternate construct could leave the
  trustee in the position of not having sufficient
  cash to pay the tax on the entitys
  undistributable income.
• Another situation which could prove troublesome
  is where the entity makes a distribution
  precisely for the amount of federal income tax
  that is payable on income reflected on Form K-1.
  Suppose the trust has a mandatory distribution
  requirement. Unless the fiduciary takes further
  action, the tax reimbursement is distributable
  to the income beneficiary, depriving trust
  principal of the ability to discharge the tax
  liability from funds received in the
  distribution. Here, the fiduciary could use the
  power to adjust and allocate the distribution to
  principal.

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Funding a Marital Trust with an IRAor Defined
Contribution PlanNote All such plans will be
referred to for simplicity as an IRA.

• Relying on UPIA provisions will not secure the
  marital deduction.
• IRAs are unique
• Income is taxable to the beneficiary when
  distributed
• Upon the account owners death, the account is a
  principal asset to the fiduciary
• Nature of IRA has caused concern among
  practitioners in regard to securing marital
  deduction when funding a marital trust with an
  IRA
• Securing marital deduction is complicated by
  Codes minimum distribution requirement (RMD)

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• UPIA Provisions
• UPIA includes models of how marital deduction
  could be secured
• Section 409 (c)
• 10 Rule If no part of payment from an IRA is
  characterized as interest, dividend or an
  equivalent payment, and all or part of the
  payment is required to be distributed currently,
  the trustee must allocate 10 of the payment to
  income and 90 to principal
• If no part of the payment is required to be paid
  currently, the entire payment must be allocated
  to principal
• UPIA recognized that above provisions could
  jeopardize the marital deduction
• Q-TIP provisions require payment of net income to
  surviving spouse to secure deduction
• Section 409 (c) mandated classifications bear no
  relationship to IRAs actual income
• In an attempt to insure the marital deduction,
  UPIA requires an additional allocation to income
  if necessary to secure the marital deduction
  (Section 409 (d))

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• Even with Section 409 (d) savings clause,
  practitioner's were concerned that UPIA
  retirement plan allocation rules were problematic
  in marital deduction situations they were
  right!
• Revenue Ruling 2006-26
• Answers question of how adoption of UPIA affects
  the determination of what is IRA income in
  marital deduction situations
• The Revenue Ruling is of critical importance in
  obtaining the marital deduction for amounts held
  in an IRA when the beneficiary is a Q-TIP Trust
  and the applicable state law is the UPIA with
  power to adjust and/or power to define income as
  unitrust amount
• Ruling provides three illustrations showing how
  IRA income should be computed to satisfy marital
  deduction requirements
• The three illustrations address the requirement
  for income distributions in the context of states
  which
• have adopted the UPIAs power to adjust and UPIA
  Sections 409 (c) and (d)
• Have a unitrust definition of income, or
• Have not adopted the UPIAs power to adjust nor a
  unitrust definition

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• The Ruling acknowledges that each of the below
  three methods could produce a sufficient amount
  of income to secure the marital deduction
• Power to Adjust under UPIA section 104 (c),
  (Caution Reliance on UPIA Sections 409 (c) and
  (d) will not secure the marital deduction)
• Determination on unitrust basis
• Determination under traditional state law
  principles
• All three illustrations are based on the same
  basic facts
• The Q-TIP Trust gives the spouse power to require
  the trustee to make withdrawals from the IRA in
  an amount equal to all income and to distribute
  such income to spouse.
• The trustee elects to take distributions over the
  spouses life expectancy.
• The spouse has the right to require that the IRA
  be invested in productive assets.
• The remaindermen are the account owners
  children.
• No person other than the spouse and children have
  a beneficial interest in the trust.
• Illustration 1
• Applies where state laws allows adjustments
  between principal and income and the power to
  adjust is exercised to administer the trust
  fairly
• State law also has adopted Section 409 (c) 10
  rule and 409 (d) savings clause
• Trustee determines total return for all trust
  assets other than the retirement plan and
  allocates between principal and income in
  accordance with UPIA Section 104 (a)
• Trustee separately determines the total return
  for the plan assets and allocates in accordance
  with Section 104 (a)

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• This latter allocation is made without regard
  to, and independent of, the trustees
  determination with respect to trust income and
  principal
• In other words, the allocation of a payment from
  the IRA to trust income or principal under UPIA
  Section 409 (c) is irrelevant to the
  determination of trust income from non-plan
  assets and to the determination of trust income
  from the IRA
• In summary, the Trustee determines income from
• Non IRA assets
• IRA assets
• The above two components together constitute the
  income which must be distributed to the spouse,
  or in the case of IRA income, subject to the
  spouses power to force distribution
• It is critical to note that the method of
  computing income sanctioned by IRS entirely
  ignores the UPIA rules for allocation of IRA
  distributions to income and principal
• The ruling explicitly states that the 10
  allocation rules of Section 409 (c) does not
  satisfy the Q-TIP rules. The 10 rule
• Does not reflect a reasonable apportionment of
  the total return between the income and remainder
  beneficiaries
• Does not represent IRA income under applicable
  state law without regard to a power to adjust

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• The ruling adds that the savings clause of
  Section 409 (d) might not save the marital
  deduction
• Note that even if Section 409 (d) effectively
  requires that the entire distribution be
  allocated to income this still does not insure
  that the surviving spouse will actually receive
  all of the IRAs annual income
• The RMD in any year is unrelated and is not equal
  to the IRAs income
• So, the annual income requirement of Code Section
  2056 is just not met under Sections 409 (c) and
  (d)
• Illustration 2
• Applies where income is defined as a unitrust
  amount in accordance with state law
• The Trust is govern