what type of trust?. with certain trusts the capital gains can not be distributed and then with others only if permitted by the trust document. . even if the trust allows the distribution of capital gains, the allocation ratio can be differnt from the ordinary income allocation.
Generally, capital gains are excluded from DNI to the extent they are allocated to corpus and are not paid, credited, or required to be distributed to any beneficiary during the tax year (Sec. 643(a)(3)). However, Regs. Sec. 1.643(a)-3(b) allows capital gains to be included in DNI to the extent authorized by the governing instrument and local law or pursuant to a reasonable and impartial exercise of discretion by the fiduciary if one of three exceptions applies.
Exception 1: Allocated to Income
Capital gains actually allocated to income per the governing instrument or a reasonable and impartial exercise of discretion by the fiduciary may be included in DNI (Regs. Sec. 1.643(a)-3(b)(1)). In this exception, either through the governing instrument or through a power provided under state law, capital gains are allocated to Financial Accounting Income and, thus, are available for distribution to a beneficiary. Clearly, if the governing instrument allows for capital gains to be allocated to income, then the fiduciary has the power to do so.
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)). 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 principal distribution as consisting of the capital gains and include it in DNI (see Regs. Sec. 1.643(a)-3(e). 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. 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. 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 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.
Exception No. 3: Allocated to Corpus but Actually Distributed
Capital gains may also be included in DNI when they are allocated to corpus but actually distributed to the beneficiary or used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary (Regs. Sec. 1.643(a)-3(b)(3)). A fiduciary could distribute capital gains to a beneficiary when relying on this regulation in a couple of different scenarios.
First, the trust can actually distribute the capital gains to the beneficiary. This exception is valuable in situations such as an age-attainment trust, where specific proportions of the trust are distributed at certain ages of a beneficiary. For example, a trust whose governing instrument provides for distribution of one-half of the principal at age 35 with the remainder distributed at age 45 sells one-half of its assets and distributes the proceeds to the beneficiary at age 35. All or a portion of the capital gain distributed to the beneficiary is included in DNI since it is actually distributed (Regs. Sec. 1.643(a)-3(e), Examples (9) and (10)).
This approach has limited utility, as the regulation examples focus solely on mandatory principal distributions and situations when the proceeds of a specific asset are to be distributed to a beneficiary. The IRS has noted that in this circumstance, "the inclusion of capital gains in [DNI] applies only where there is a distribution required by the terms of the governing instrument upon the happening of a specified event" (Rev. Rul. 68-392). Furthermore, the exception in the regulation does not seem to apply when the trust has sufficient cash to fund its required principal distribution.
Second, the trust can use the amount of capital gains in determining the amount distributed to the beneficiary. the trustee could elect to make discretionary distributions to the beneficiary based on the trust's realized capital gains. If the trustee of a Trust decides that discretionary distributions will be made to the extent the trust has realized capital gains, see Regs. Sec. 1.643(a)-3(e), Example (5)). However, the IRS commentary on the regulations (preamble to T.D. 9102) notes that it is rare for a trust to consider recognized capital gains in determining the amount to be distributed, suggesting that Example (5) of the regulations has limited applicability.
Typically, the amount distributable to the beneficiary is determined without regard to the amount of capital gains realized during the year. Furthermore, money is fungible, and it may be difficult to determine the source of the funds actually distributed to the beneficiary. For trusts with discretionary power to distribute principal, unless the trustee consistently uses realized capital gains in determining the amount distributable to the beneficiary, it is hard to see how the third exception differs from the other two exceptions in requiring a consistent methodology adopted in the first year of the trust. The regulations do not specifically state that consistency is required; however, the key seems to hinge on whether the trustee has discretion over allocating capital gains to DNI. Any discretionary power to include capital gains in DNI seems to require a consistent exercise.
Another consideration when applying exception No. 3 is the ordering rule for capital losses. Generally, any capital losses will first be netted against capital gains at the trust level (Regs. Sec. 1.643(a)-3(d)). Any net remaining capital gains are available for inclusion in DNI. However, netting does not apply when capital gains are distributed under the third exception; rather, the distributed capital gains are taxed to the beneficiary prior to netting. Trusts with capital losses must consider this rule when planning capital gain distributions.
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