A First point: The ability to allocate, and pay, capital gains to beneficiaries is not only a matter of whether or not it is provided in the Trust document but also whether or not the resident state (that is, the state of residence for the trust, which is the state of residence for the trustee) in fact taxes gains at the Trust level and not at the beneficiary level. You must determine that. To repeat, some states will tax the Trust irrespective of whether or not the gain was distributed under the provisions cited following herein.
Under the traditional definition of fiduciary accounting income (FAI), capital gains are typically excluded from distributable net income (DNI) and, thus, are taxed at the trust level.
What you are seeking to do, possibly, is to violate the conventional and accepted practice. Note that tax rates at the Trust level are almost always higher than at the individual level, so allocating but not distributing would result in a higher tax cost.
The implementation of the Uniform Principal and Income Act of 1997 (UPAIA) and the 2004 revisions to the regulations under Sec. 643 [15 U.S. Code §?634] have provided fiduciaries with some flexibility in making distributions of capital gains to beneficiaries. Tax advisers should understand the options available under state law, including the "power to adjust" and "unitrust" provisions, and how those provisions intersect with Treasury Regs. Sec. 1.643(a)-3.
The fiduciary can pass the capital gains through to the income
beneficiary only if the capital gain income can be included in DNI as
described in Treas. Regs. §1.643(a)-(3), effective for tax years ending after January 2, 2004.
The regulations state that capital gains are properly included in DNI to the extent that
the governing instrument and applicable law, or by a reasonable and impartial exercise of
discretion by the fiduciary, are:
- Allocated to income;
- Allocated to corpus but treated consistently by the fiduciary on the trust’s books, records,
and tax returns as part of a distribution to a beneficiary; or
- Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in
determining the amount distributed or required to be distributed to the beneficiary.
- Most practitioners assume (properly) that in a plain vanilla trust and under most state laws,
capital gains usually are not included in fiduciary accounting income or DNI, so it is unlikely
in a plain vanilla trust for capital gains to be included in income or DNI for item 1.
- The best
bet for including capital gains in DNI is either to find specific fiduciary discretion in the trust or
to work with items 2 or 3.
The question becomes, does the trust allow the fiduciary to allocate capital gains to trust
income for either accounting or tax purposes? Because most state laws are derived from the
Uniform Principal and Income Act (UPIA) and most states have adopted the Prudent Investors
Act, any discretion provided by the trust or state law require the fiduciary to make impartial
decisions, not ones based solely on the tax implications.
If this posted response is useful to you, please click on the upraised hand in the lower left of this post. Thank you. Scruffy Curmudgeon--PFFM/ IAFF, retired FireFighter/Paramedic - Locals 718/30, Veteran USAR O3 AIS/ASA '65-'67
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