Source: http://www.irs.gov/irb/2004-05_IRB/ar08.html
Timestamp: 2014-03-11 14:20:27
Document Index: 180116060

Matched Legal Cases: ['ART 1', 'ART 20', 'ART 25', 'arts 1', '§1', 'art 1', 'art 20', 'art 25', 'art 26', '§1', '§1']

Internal Revenue Bulletin - February 2, 2004 - T.D. 9102 Internal Revenue Bulletin: 2004-5 February 2, 2004 T.D. 9102 Definition of Income for Trust Purposes Table of Contents
Background Summary of Comments and Explanation of Revisions Effective Dates Special Analyses Adoption of Amendments to the Regulations PART 1—INCOME TAXES
PART 20—ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954 PART 25—GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954
DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Parts 1, 20, 25, and 26 AGENCY:
This document contains final regulations revising the definition of income under section 643(b) of the Internal Revenue Code.
The regulations are necessary to reflect changes in the definition of trust accounting income under state laws. The final
regulations also clarify the situations in which capital gains are included in distributable net income under section 643(a)(3).
Conforming amendments are made to regulations affecting ordinary trusts, pooled income funds, charitable remainder trusts,
trusts that qualify for the gift and estate tax marital deduction, and trusts that are exempt from generation-skipping transfer
taxes. The regulations affect the grantors, beneficiaries, and fiduciaries of trusts.
Effective Date: These regulations are effective January 2, 2004.
Applicability Date: Generally, the final regulations are applicable to trusts and estates for taxable years ending after January 2, 2004. See
revised §§1.642(c)-2, 1.642(c)-5, and 1.664-3 for special dates of applicability affecting those sections.
Bradford R. Poston at (202) 622-3060 (not a toll-free number).
Background On February 15, 2001, proposed regulations (REG-106513-00, 2001-1 C.B. 1076 [66 FR 10396]) were published in the Federal Register containing proposed amendments to the Income Tax Regulations [26 CFR part 1], the Estate Tax Regulations [26 CFR part 20],
the Gift Tax Regulations [26 CFR part 25], and the Generation-Skipping Transfer Tax Regulations [26 CFR part 26] relating
to the definition of income for trust purposes. A public hearing was held on the proposed regulations on June 8, 2001. Written
comments were received on the proposed regulations. The proposed regulations, with certain changes in response to the comments,
are adopted as final regulations.
Summary of Comments and Explanation of Revisions Definition of Income The proposed regulations provide that, for purposes of determining what constitutes trust accounting income under section
643(b), trust provisions that depart fundamentally from the traditional concepts of income and principal generally will continue
to be disregarded as they have been under the existing regulations. One commentator suggested that, instead of using traditional
concepts of income and principal, the benchmark should be whether there is a departure from the duty to administer the trust
or estate impartially based upon what is fair and reasonable to all the parties. One commentator suggested eliminating the
distinction between trust accounting income and principal. Another suggested that the regulations clarify the consequences
of a fundamental departure from traditional concepts of income and principal. Income under section 643(b) is the amount of income determined under the terms of the governing instrument and applicable
local law. This concept of income is used as the measure of the amount that must be distributed from a trust in order for
the trust to qualify for certain treatment under various provisions of the Internal Revenue Code. Trusts classified as simple
trusts, pooled income funds, net income charitable remainder unitrusts, and qualified subchapter S trusts (QSSTs) are required
to make distributions measured at least in part by the amount of trust accounting income. A similar concept applies to trusts
that qualify for the gift and estate tax marital deductions. Because section 643(b) requires a determination of trust accounting
income, it is not possible to ignore any distinctions between trust accounting income and principal as suggested by a commentator.
A trust instrument may provide for any amount to be distributed to beneficiaries currently. Trust provisions that measure
the amount of the distribution by reference to income but define income differently from the state statutory definition of
income generally will be recognized for state law purposes. However, Internal Revenue Code provisions that require the current
distribution of income to qualify the trust for certain federal tax treatment are based on the assumption that the income
beneficiary will receive what is traditionally considered to be income. In some situations, such as with QSSTs and marital
deduction trusts for spouses who are U.S. citizens, the income beneficiary is permitted to also receive principal distributions
as long as all the income is currently distributed. In other situations, as with pooled income funds and net income charitable
remainder unitrusts, only the income may be distributed. In all these situations, the determination of income is critical.
Thus, the definit ion of income under the terms of the governing instrument and applicable local law must not depart fundamentally
from traditional concepts of income and principal, if the desired federal tax treatment is to be secured. The IRS and the Treasury Department recognize that state statutes are in the process of changing traditional concepts of income
and principal in response to investment strategies that seek total positive return on trust assets. These statutes are designed
to ensure that, when a trust invests in assets that may generate little traditional income (including dividends, interest,
and rents), the income and remainder beneficiaries are allocated reasonable amounts of the total return of the trust (including
both traditional income and capital appreciation of trust assets) so that both classes of beneficiaries are treated impartially.
Some statutes permit the trustee to pay to the person entitled to the income a unitrust amount based on a fixed percentage
of the fair market value of the trust assets. Other statutes permit the trustee the discretion to make adjustments between
income and principal to treat the beneficiaries impartially. Under the proposed regulations, a trust’s definition of income
i n conformance with applicable state statutes will be respected for federal tax purposes when the state statutes provide
for a reasonable apportionment of the total return of the trust. Some commentators suggested that, even in those states that have not enacted legislation specifically authorizing powers to
adjust or a unitrust definition of income, trust instruments containing such provisions should be respected as defining income
for purposes of section 643(b). Under a unitrust or power to adjust, items traditionally allocable to principal (such as
gains from the sale or exchange of trust assets) may, under certain circumstances, be allocated to income, and items traditionally
allocable to income (such as dividends, interest, and rents) may, under certain circumstances, be allocated to principal.
The proposed regulations already recognize that gains from the sale or exchange of trust assets may, under certain circumstances,
be allocated to income under the terms of the governing instrument. However, §1.643(b)-1 has always provided that the allocation
to principal, under the terms of the governing instrument, of items that traditionally would be allocable to income will not
b e respected for purposes of section 643(b), and this position is maintained in the final regulations. Accordingly, the
IRS and the Treasury Department believe that an allocation to principal of traditional income items should be respected for
Federal tax purposes only if applicable state law has specifically authorized such an allocation in certain limited circumstances,
such as when necessary to ensure impartiality regarding a trust investing for total return. Under the regulations, a state
statute specifically authorizing certain unitrust payments in satisfaction of an income interest or certain powers to adjust
would satisfy that requirement. Further, the IRS and the Treasury Department acknowledge that other actions may constitute
applicable state law, such as a decision by the highest court of the state announcing a general principle or rule of law that
would apply to all trusts administered under the laws of that state. However, a court order applicable only to the trust
before the court would not con stitute applicable state law for this purpose.	Two commentators suggested that the permissible range of unitrust percentages should include any percentage permitted by state
statutes. The IRS and the Treasury Department believe that when establishing a unitrust percentage that attempts to yield
the equivalent of income over a long period of time that may encompass wide variations in economic conditions, a range of
3% to 5% will be considered a reasonable apportionment of a trust’s total return. In response to one comment, the range of
unitrust percentages has been adjusted in the final regulations to include, rather than exclude, unitrust percentages of 3%
and 5%. Also in response to comments, the final regulations state that the periodic redetermination of the fair market value
of the trust assets may be done as of a particular date each year or as an average determined on a multiple year basis. The proposed regulations state that traditionally ordinary income is allocated to income and capital gains are allocated to
principal. One commentator pointed out that ordinary income and capital gains are tax concepts and not concepts that have
any meaning for purposes of trust accounting income. The final regulations have been revised to state that traditionally
items such as dividends, interest, and rents are allocated to income and the proceeds from the sale or exchange of trust assets
are allocated to principal. The proposed regulations refer to a power to make equitable adjustments between income and principal and describe the circumstances
under which these adjustments currently are permitted under state law and will be respected for Federal tax purposes. Specifically,
state statutes permit adjustments when trust assets are invested under the state’s prudent investor standard, the trust instrument
refers to income in describing the amount that may or must be paid to a beneficiary, and the trustee, after applying the state
statutory rules regarding the allocation of receipts and disbursements between income and principal, is unable to administer
the trust impartially. One commentator requested clarification of the requirements a trustee must satisfy to make an adjustment
that will be respected for Federal tax purposes. Those requirements are a matter of local law and may differ from state to
state; the trustee must meet whatever requirements are imposed by applicable local law on the exercise of this power. One
commentator pointed out that state statutes do not include the term equitable in referring to this power and suggested deleting
that term. One commentator suggested adding “generally” to the statement concerning the circumstances in which these adjustments
are permitted because some states may permit these adjustments without enacting a prudent investor standard. These two suggestions
are adopted in the final regulations. One commentator suggested clarifying that the definition of income in the regulations also applies to spray and sprinkle trusts.
The final regulations provide that allocations apportioning the total return of the trust pursuant to the state statute will
be respected regardless of whether the trust has one or more income beneficiaries and irrespective of whether income must
or may be paid out each year. The commentator also suggested that allocations pursuant to one apportionment method should
be respected even if a different apportionment method was used in prior years. The final regulations provide that, as long
as the trust complies with the requirements of state statutes for switching between methods authorized by the statute, then,
when the trust switches between permitted methods: (i) the method used in any year will be respected for Federal tax purposes;
(ii) the switch will not constitute a recognition event under section 1001; and (iii) neither the grantor nor any beneficiary
will have any g ift tax consequences. This provision does not apply to switches between methods not specifically authorized
by state statute.
It has been questioned whether the changes to §1.643(b)-1 affect the amount of income required to be distributed by QSSTs.
Section 1.1361-1(j) provides that QSSTs are required to distribute income as