For income tax purposes, trusts fall into one of two broad categories: “grantor” trusts, which are treated as if they are another party for income tax purposes (who is generally, but not always, the creator, a/k/a the “grantor”, of the trust), and “non-grantor” trusts. A grantor trust may or may not need to file its own separate income tax returns, depending on a number of factors, none of which are within the scope of this newsletter, and the party treated as the grantor of the trust will pay any income taxes generated by the trust’s income, not the trust itself. However, a non-grantor trust is a taxpayer in its own right, is required to file an annual IRS Form 1041 (the income tax return used by trusts and estates), and may end up paying income taxes on some or all of its own income.
For income tax purposes, non-grantor trusts also fall into one of two subcategories: “Simple” trusts, which are non-grantor trusts that require the trustee to distribute all of the trust’s net income to one or more beneficiaries during each year, and “complex” trusts. In a complex non-grantor trust, the trustee has some ability (the trustee’s “discretion”) to decide whether, when, and how much of the trust’s income (and, in many cases, principal) to distribute to the trust’s beneficiaries in a given year. While a trustee will likely make many of its distribution decisions based on factors unrelated to income taxes, income tax considerations are part of what the trustee should consider.
Some background on trust income taxes: When a non-grantor trust files its IRS Form 1041 for a given tax year, the return first calculates the trust’s net taxable income for the tax year (a non-grantor trust normally uses the calendar year as its tax year for income tax purposes). The 1041 next shows an amount called “distributable net income” or DNI, which generally represents the trust’s accounting income for that tax year. A trust’s accounting income generally includes the trust’s interest, dividends, rents, and royalties. Accounting income may, but does not always, also include part or all of the trust’s capital gains for the year. DNI is used to determine who actually pays tax on the trust’s accounting income. In general, a dollar distributed to a beneficiary carries out a dollar of DNI to the beneficiary. If DNI is carried out to a trust beneficiary, that beneficiary, not the trust, will pay the tax on that income. DNI can be carried out to multiple beneficiaries. Any DNI that is not carried out to a beneficiary is retained by the trust, and the trust will pay the taxes on that income. Because of the differences between the way that individual income taxes are calculated and the way that trust income taxes are calculated, trusts generally end up paying income taxes at the highest possible marginal rate, and individuals generally end up paying income taxes at much lower marginal rates. In other words, for income tax purposes it can be desirable to allow a trust’s DNI to be carried out to the trust’s beneficiaries rather than allowing it to accumulate in the trust.
Towards the end of a complex non-grantor trust’s tax year, at least two important income tax planning questions need to be answered by its trustee: One such question is the extent, if any, to which DNI is likely to remain to be taxed at the trust level. The answer to this first question requires the trustee to determine how much DNI was created during the year, how much of that DNI will be carried out to beneficiaries based on distributions that have already been made during the year, and how much of that DNI will be carried out by additional distributions that are expected to be made by the end of the tax year. If it appears that DNI will remain in the trust after already-made and already-planned distributions are taken into account, the second important question is whether the trustee can and should make additional distributions in order to carry out some or all of the remaining DNI. Answering this second question also requires the trustee to answer another list of questions, including whether the trustee’s discretion allows such distributions, the potential income tax rates that will apply to the trust’s beneficiaries, and whether distributions that will carry out the trust’s DNI are a good idea for reasons unrelated to income taxes (i.e., are the potential income tax benefits offset by the loss of asset protection on distributed assets, the potential problems that might arise if a beneficiary who ideally should not receive funds directly gets a direct distribution, or other potential problems that can be reduced or avoided if assets are retained in the trust).
There is a timing problem that reduces a trustee’s ability to answer the above questions and use distributions for income tax planning purposes: A trustee often cannot know how much DNI the trust will have until after the end of the trust’s tax year, but distributions made after the end of the trust’s income tax year normally do not apply to that tax year. However, in Internal Revenue Code (IRC) Section 663(b), the government gives trustees some relief from this timing issue.
Under IRC Section 663(b), a trustee can elect to treat distributions made during the first 65 days of a given tax year as if those distributions had been made on the last day of the previous tax year. This election effectively allows a trustee 65 days after the end of a given tax year to: (i) figure out the actual amount of DNI for that given tax year; (ii) compare this to the actual trust distributions already made during that given tax year; (iii) consider the likely marginal income tax rates of the trust and its beneficiaries for that tax year; (iv) figure out how much in additional distributions, if any, should be made for income tax planning purposes after considering the trustee’s discretion to make trust distributions and the possible loss of the trust’s asset protection benefits or otherwise; and (v) make any such desired additional distributions to the beneficiaries.
What is the 65th day of the tax year deadline to make additional trust distributions to be treated as made the prior tax year? For most non-grantor trusts, which use a calendar tax year, the 65th day will normally be March 6th, but in leap years the 65th day will be March 5th because of the extra day in February. To be safe, trustees should generally always act as if the deadline is March 5th.
The IRC Section 663(b) 65-day election must be made on a timely filed IRS Form 1041 for the trust for the income tax year to which it is to apply. “Timely filed” normally means filed by April 15th, or as late as September 30th if a valid extension is filed. This election is available each year. However, once made for a given tax year, the election is irrevocable as to that year.
Some trusts, like many of the ones we draft for our clients, allow a trustee to do income tax planning beyond just the planning allowed by the 65-day-election. For example, in some types of non-grantor trust, the trust agreement can include provisions that permit a non-beneficiary trustee or co-trustee or a trust protector to give a beneficiary of the trust the right to withdraw an amount of income from the trust. Under IRC Section 678(a)(1), having a beneficiary hold the power to demand the trust’s income can cause the trust’s DNI for the year to be carried out to the power-holding beneficiary even if the beneficiary does not exercise the power and even if the power only lasts for a very short period of time. In the right situation, the use of this kind of power can help balance the benefits of having assets remain in the trust while still allowing the trust’s income to be taxed at the beneficiary’s lower income tax rates.
Finally, while it was not the topic of this Newsletter, executors and administrators of estates should note that the same IRC Section 663(b) 65-day election option is available and should be considered for estates while they are being administered.
If you would like to discuss these income tax planning issues or other aspects of your estate plan in more detail, please call us at (678) 720-0750 or e-mail us at info@morgandisalvo.com to schedule a consultation. We look forward to speaking with you.
