Trust distributions to beneficiary

[hntrust]

Trust language allows the trustee to allocate capital gains as income to the beneficiary. When this is done and the income is reported on the K-1 so that the tax is paid at the beneficiary tax rate, does the trustee actually have to make the distribution?

[ScruffyCurmudgeon]

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: 

1. Allocated to income;
2. Allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary; or 
3. Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount distributed or required to be distributed to the beneficiary.
4. 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.
5. 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.

[hntrust]

So if the conditions you outline are met then I can allocate capital gains to DNI without actually distributing to the beneficiary, correct?

[ScruffyCurmudgeon]

Not what is said. please see following answer

[ScruffyCurmudgeon]

No matter what you try to do, the Trust will have to pay tax on the gain if retained. - see discussion.

Capital Gains can under certain conditions be included in the DNI calculation if any of the following apply:

1. The gain is allocated to income in the accounts of the estate or by notice to the beneficiaries under the terms of the will or by local law.
2. The gain is allocated to the corpus or principal of the estate and is actually distributed to the beneficiaries during the tax year.
3. The gain is used, under either the terms of the will to determine the amount that is distributed or must be distributed.

So, provision 1 would allocate gain to DNI and therefore would be taxable to the beneficiary.  Provision 2 would allocate gain to the Trust (and the Trust would pay the C/G tax) and gain proceeds are distributed. Provision 3 relates to when a fixed distribution is required and the income received is insufficient.  

To reiterate, many states that tax Trusts (indeed, those that also tax live persons) require that the gain be a taxable event within the trust irrespective of the proceeds being distributed.

All that said, if state law allows capital gain to be allocated to DNI and if the Trust document also provides, the Trustee can allocate and distribute the gain.

HOWEVER:

1. The distribution deduction of the Trust is limited to the lesser of trust income (IRC §651) or DNI for simple trusts, or the lesser of distributions or DNI for complex trusts (IRC §661) 
2. DNI is the maximum amount of taxable income of the trust that is taxed to a beneficiary of a trust as the result of a distribution to the beneficiary as determined under IRC §643(a)

So no matter what you try to do, the Trust will have to pay tax on the gain if retained.

[ScruffyCurmudgeon]

What would be the possible reason to have the beneficiary report on their Form 1040 a capital gain for proceeds withheld?

[hntrust]

The beneficiary is in the lowest tax bracket. However in light of the rules you outlined as trustee I will just distribute the gain using the 65 day rule so it applies to 2018 taxes.

[ScruffyCurmudgeon]

Yes, best to take advantage of the lower tax bracket.  Note the following:
In order to use the 65-Day Rule, the trustee must make the §663(b) election by checking the box on Box 6 under Other Information on bottom of page two of Form 1041, the trust’s fiduciary income tax return. To be valid, the election must be made by filing form 1041 by its due date, including extensions. Once made, the election is irrevocable.

[hntrust]

To follow up, in TurboTax do I input any capital gains that I allocate to income as a first tier distribution? Will that then get reported on the K-1?

[ScruffyCurmudgeon]

Yes.  But, again, be careful to verify that what you entered in the interview shows up on Schedule B line 10 of 1041 because that determines if it successfully gets on the Distribution Worksheet for K-1 and the  K-1

[eli46]

All rental income went to one beneficiary of a family trust. The K-1 form does not show that, so tax on the rental income is paid by the trust, rather than being passed along to this one beneficiary. The K-1 does have a place for rental income to be listed. How do I enter this information?

[VictoriaD75]

The K-1 is generated as a result of the trust return. If the rental income was a part of the trust, the trust return may need to be amended to reflect the income. How things are allocated by the trust on the K-1 issued to each beneficiary depends on the terms/conditions of the trust and will be reflected on each individual's Schedule K-1. You cannot just add information to the K-1 without making changes to the trust return on Form 1041.

[CorrectInfo]

The following contradicts your statement that "No matter what you try to do, the Trust will have to pay tax on the gain if retained."

Exception No. 2: Allocated to Corpus but Consistently Treated as Part of a Distribution

Capital gains 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 may be included in DNI (Regs. Sec. 1.643(a)-3(b)(2)). In the A Trust example, the trustee has discretionary power to distribute principal to B for health, maintenance, and support. After calculating FAI of $10,000 per Example 1, the trustee distributes $10,000 of income plus, at his or her discretion, an additional $25,000 of principal to B . Assuming the trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains realized by A Trust during the year, the trustee can treat the $25,000 principal distribution as consisting of the capital gains and include it in DNI (see Regs. Sec. 1.643(a)-3(e), Example (2)). However, the trustee must continue to treat principal distributions as coming from realized capital gains for all future years.

The consistent practice is adopted during the trust's initial tax year (id., Example (1)). For new trusts, this is not an issue, since the capital gains could be included in DNI under this exception, with the limitation that the fiduciary must continue to do so going forward. (Given the uncertainty of future tax rates for both the trust and beneficiaries, this decision should not be taken lightly.) However, will older trusts be allowed to adopt a new consistent practice, particularly following new tax legislation? A commentator on the IRS's proposed net investment income tax regulations asked this question, and the IRS indicated that the final net investment income tax regulations do not allow a fiduciary to adopt a new consistent practice going forward (preamble to T.D. 9644). Existing trusts for which the statute of limitation has expired on prior tax returns will likely be unable to adopt a new methodology despite the subsequent creation of tax rules that were not contemplated when the initial tax return was prepared.

The source of this excerpt is taken from: https://www.thetaxadviser.com/issues/2014/aug/tax-clinic-03.html

My question is, provided the above is correct and applies to NY, can the beneficiary offset the capital gains allocated but not distributed to him, with capital loss carryovers that he has from his own accounts?

[Mike9241]

The point seems to be that an actual timely distribution has to be made to the beneficiary to distribute capital gains. 

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if you distribute corpus you have a complex trust and under IRC 663(b)(2) REG 1.663(b)-1(a) only distributions during the year and the first 65 days of the next tax year can be treated as current tax year distributions

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"Assuming the trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains"

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"can the beneficiary offset the capital gains allocated but not distributed to him". so the answer would seem to be no. 

[CorrectInfo]

Spoke to two CPA's today who specialize in Trusts. Both said that Capital Gains can absolutely be allocated to Corpus, but treated by the fiduciary as part of the distribution to a beneficiary, WITHOUT ACTUALLY BEING DISTRIBUTED to the beneficiary. 

Which is also what is written in the Exception 2 in the excerpt that I posted. 

Now, if this is correct, and you are not correct, but continue to state that you are, don't you think you are misleading many people who are looking for this information and find this thread?