Source: http://www.pgdc.com/pgdc/analysis-643b-proposed-regulations-part-i
Timestamp: 2017-12-12 21:52:18
Document Index: 280801026

Matched Legal Cases: ['§643', '§1', '§643', '§642', '§643', '§584', '§643', '§643', '§664', '§1', '§1', '§643', '§643', '§643', '§14', '§16045', '§ 5', '§518', '§30', '§ 7', '§501', '§45', '§175', '§18', '§26', '§643', '§643', '§1', '§2523', '§1433', 'arts 1', '§643', '§1', '§104', '§1', '§506', '§15', '§30', '§6112', '§55', '§1', '§1', '§2523', '§20', '§2056', '§20', '§1', 'art 1', '§1', '§643', '§1', '§1', '§1', '§1', '§1', '§104', '§401', '§1', '§1']

Analysis of 643(b) Proposed Regulations - Part I | Planned Giving Design Center
Article posted in Regulations by Marty McKeever on 29 March 2001| comments
Part I of this two-part article details the historical background, state law changes and the nature of the proposed Regulations under Code Section 643(b). Part II of this Article will detail the impact of these new proposed Regulations on charitable gift planning vehicles.
Part I of this two-part article will detail the historical background, state law changes and the nature of the proposed Regulations under Code Section 643(b). Part II of this Article will detail the impact of these new proposed Regulations on charitable gift planning vehicles.
Historical Background. The "times they are a-changing" is an apt description of what has been happening over the past 10 years in the usually staid world of fiduciary investment standards and fiduciary income accounting practices for common non-grantor, split-interest trusts, e.g. charitable remainder trusts ("CRTs"), charitable lead trusts ("CLTs"), pooled income funds ("PIFs"), qualified terminable interest trusts ("QTIPs"), and qualified domestic trusts ("QDOTs").
It used to be that split-interest trusts were required to invest in the most conservative manner possible, adhering slavishly to the common law, "prudent investor standard" with respect to each acquired investment. Some states even prescribed a statutory "legal list" of the permissible (and almost always conservative) types of investments suitable for such trusts. Adherence to these investment limitations was designed to preserve the trust principal and produce a safe, steady (and usually very modest) stream of income for lifetime or trust term "income" beneficiaries. Most trustees strayed from these "prudent" investment rules rarely to avoid personal liability if they invested otherwise and lost money.
The pressure to change the prudent investor rules began to mount in the 80's and became an irresistible force in the 90's as world capital markets matured, the rate of inflation slowed, and the engines of free enterprise and new technologies exponentially increased personal wealth. At the same time, the end of the Cold War and taming of inflation significantly reduced the returns an investor could earn on relatively safe fixed-income investments, such as U.S. government securities and high-grade corporate bonds. The lowering of average equity dividends to around 2%, coupled with a reduction of interest payable on relatively safe, fixed income investments to the 4-6% level came at a time when extraordinary, double-digit gains were being realized by equity investors willing to risk their savings in the "new economy" with its explosion of new information technologies, computers, wireless communications and the Internet.
It did not take long in this robust economic environment for both classes of split-interest trust beneficiaries to protest the conservative investment rules of the past and start to modify them. The legal investment practices of the depression era were producing far too little income for the income beneficiaries and the meager appreciation potential of prudent, income-producing investments was severely short-changing the potential future value of a remaindermen's corpus. In response, new settlors began to change the old paradigm by having their trust documents drafted with more liberal fiduciary investment standards and accounting rules. On the investment side, they sought to permit their trustees to invest for "total return."1 From a fiduciary accounting perspective, they sought to permit realized capital gains to be treated as distributable income so the income beneficiaries could benefit from asset growth as well as from whatever dividends, interest, rents or royalties an investment was producing. The forces for change became so strong that a majority of state legislatures have now responded by replacing their old prudent man investment standard or legal investment lists with some version of the new "Uniform Prudent Investor Act"2 that sanctifies modern concepts of "total return" investing, investment diversification, and prudent asset allocation among a broad spectrum of investment types carrying varying degrees of risk.
On the heals of these changes came new demands to conform fiduciary "income and principal" accounting rules to the new reality of "total return" investing. This demand is causing the states to reevaluate their existing laws with respect to split-interest trust allocations of principal and income and rewrite them to expand their "default" definition of distributable income to include at least some portion of realized capital gains and even principal that historically would have accrued solely to the benefit of remainder beneficiaries.3 The states are taking various tacks to accomplish this objective, all of which attempt to balance the competing interests of the income and remainder beneficiaries and be fair to both. The most common approach is to adopt some version of the 1997 Uniform Principal and Income Act ("1997 UPIA") that is intended to replace both the original and 1962 revision of this Act.
How do these changes impact the Internal Revenue Code? Whenever state legislatures change the "default" definitions of fiduciary accounting "principal and income" and how to account for it, the changes directly affect the Internal Revenue Code ("Code") definitions of "income" and other Code provisions applicable to trusts that rely on these local law "income" definitions. The "lynchpin" section of the Code most directly affected is §643(b).4 It provides the definition of trust "accounting" (also referred to as "fiduciary") income" as that term is defined for purposes of the income, gift and estate tax rules affecting split-interest trusts, e.g., CRTs, CLTs, and PIFs.5 Corresponding Reg. §1.643(b)-1 provides further that trust provisions that depart fundamentally from the concepts of local law in determining what constitutes income will not be recognized.
Also affected is the definition of distributable net income ("DNI")6 and the extent to which realized capital gains can be so classified under the terms of the governing instrument or local law.7 Additionally, such changes could have an adverse impact on Q-TIP trusts that are required to distribute all of their "income" to the spousal income beneficiary for life8 and certain "grandfathered," generation-skipping trusts9 that could lose their exclusion from the generation-skipping transfer tax if a new state law definition of fiduciary income were to result in shifting a beneficial interest in the trust to a lower generation beneficiary, or increasing the amount of the generation-skipping transfer.10
Given the pervasive nature of the state law changes noted above, Treasury could not help but notice that old rules and regulations, e.g. Code §§643(a) and (b) and §642(c)(3), had become inadequate in a new century when fiduciary "income" is being defined by the states and settlors to include more than just dividends, interest, rents and royalties. Consequently, the proposal of new Regulations11 published in February, 2001 to deal with the issues created by this paradigm shift in the meaning of "income" should come as no surprise. In the remainder of this article we will examine the nature of the state law changes that precipitated the proposed Regulations, the provisions of the Code that they effect and the regulatory solutions Treasury is proposing to rectify the perceived problems -- particularly as these modifications will impact split-interest charitable trust gifts.
What have the States wrought? At the urging of financial institutions, trust companies, charities, trust and estate attorneys, financial planners, accountants, and individual trust settlors and income beneficiaries, state legislatures have moved fairly quickly to liberalize traditional fiduciary investment standards and fiduciary income accounting rules.12 Working together, this new legislation dramatically changes the rules for responsible trust fund investing and how income and principal can be divided between the different classes of split-interest trust beneficiaries. The proposed update to the Code §643(b) regulations and related others affected by it was precipitated specifically by the following types of state law changes to definitions of fiduciary accounting income (either made already, or now in the proposal stages) that permit the trustee of a split-interest trust to:
Make an "equitable adjustment" between income and principal if necessary to ensure that both the income beneficiary and the remainder beneficiary are treated impartially, based on what is fair and reasonable to all of the beneficiaries.13
Pay a "unitrust amount" to the income beneficiary in satisfaction of that beneficiary's right to the income from the trust.14
Treat realized (and in some cases unrealized) "capital gains" as fiduciary income distributable to the income beneficiary in satisfaction of that beneficiary's right to the income from the trust.15
Treat as fiduciary income the increment in value of an obligation for the payment of money payable at a future time in accordance with a fixed, variable, or discretionary schedule of appreciation in excess of the price at which it was issued from the first principal cash available or, when none is available, when realized by sale, redemption, or other disposition of such obligations as deferred annuity contracts before annuitization, life insurance policies before the death of the insured, and interests in bank common trust funds as defined in Code §584.16
What is Treasury's response? Here is an overview. The newly proposed Regulations published in February, 2001 generally:
add more detail to the definition of "income" under Code §643(b);
modify the definition of DNI under Code §643(a) and legitimize certain split-interest trust provisions and practices that allocate certain capital gains to fiduciary income and DNI;
provide a new limitation on the deductibility of net realized, long-term capital gains permanently retained by a PIF in situations where the PIF could allocate unrealized gains to the income recipients or satisfy income interests with unitrust-type distributions;
make it clear that defining fiduciary "income" in terms of a unitrust amount for net income only charitable remainder unitrusts ("NIOCRUTs") or net income with makeup charitable remainder unitrusts ("NIMCRUTs") will not be permitted if such trusts are to be tax-qualified under Code §664; however, it is permissible to allocate to "income" realized capital gains attributable to post-gift or post-purchase asset appreciation, but only if such allocations are non-discretionary and supported by the applicable state law and governing trust document;
make it taboo to grant NIMCRUT and NIOCRUT trustees total discretion with respect to whether, when, how and how often realized capital gains can be treated as fiduciary income;
require distributions of property "in kind"17 to the income recipients of certain split-interest trusts18 to be treated by the trustee for tax purposes as a constructive sale of the distributed property for its fair market value on the date of distribution;
clarify that the interest of the spousal beneficiary of a Q-TIP19 or life estate with general power of appointment arrangement20 who is entitled to income pursuant to a state statute that provides for a reasonable apportionment of the total return of the trust between the income and remainder beneficiaries will satisfy the respective "income for life" requirement,21 even where state law defines "income" as a unitrust amount, or permits the trustee to adjust the composition of distributions to income recipients between principal and income to fulfill the trustee's duty of impartiality to both the income and principal beneficiaries;
clarify that the payments made to the spousal income beneficiary of a QDOT22 will be considered distributions of trust income,23 if the applicable state statute meets the requirements of Reg. §1.643(b)-1 and provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust, e.g. where it defines "income" as a unitrust amount or permits the trustee to adjust between principal and income to fulfill the trustee's duty of impartiality between income and principal beneficiaries; and
preserve the Generation-Skipping Transfer Tax ("GSTT") exemption of grand-fathered, generation-skipping trusts24 in situations where such a trust comes to be administered in accordance with a new state law that defines income as a unitrust amount, or permits equitable adjustments between income and principal to ensure impartiality in accordance with the new requirements of Reg. §1.643(b)-1(a).
The Service acknowledges that these new regulations have been promulgated specifically to take into account the recent state law modifications to the definition of trust accounting income and what is now considered to be prudent fiduciary investing. However, while the IRS wishes to reasonably accommodate these changes, it intends to make sure that Code sections relying on the Code §643(b) definition of income are not "undermined by an unlimited ability of the trustee to allocate between income and principal."
How has the Code §643(b) definition of "income" been modified, specifically? The proposed regulations25 do not change the current rule that permits the IRS to disregard trust provisions that "depart fundamentally from traditional concepts of income and principal" in administering the Tax Code. However, amounts allocated between income and principal pursuant to applicable state law will be respected under the proposed regulations if state law provides for a "reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year," taking into account ordinary income, capital gains, and, in some situations, unrealized appreciation.
For this purpose, an allocation of capital gains to income will be respected if the allocation is made either pursuant to the terms of the governing instrument and local law, or pursuant to a "reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law." Similarly acceptable as a reasonable apportionment of the total return of the trust would be a state law that permits the trustee to make "equitable adjustments" between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries.26 The official comments to the proposed regulations site as an example of such a reasonable apportionment of the total return of the trust, a state law that provides for the income beneficiary to receive each year a unitrust amount of between 3% and 5% of the annual fair market value of the trust assets.
How has the Code §643(a) definition of DNI been modified, specifically? Under the proposed new rules,27 capital gains are to be included in DNI to the extent they are, pursuant to the terms of the governing instrument or local law, or pursuant to a reasonable and consistent exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by the governing instrument or local law): (i) allocated to income; (ii) allocated to corpus but treated by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary; or (iii) allocated to corpus but utilized by the fiduciary in determining the amount which is distributed or required to be distributed to a beneficiary. These principles are illustrated in a series of revised examples that clarify the following:
Until a trustee who has discretion to treat capital gains as fiduciary income exercises this discretion, he is free to make discretionary distributions in excess of traditional income from principal (assuming this is allowed by the trust instrument and local law). However, once he exercises this discretion, he apparently must treat all future discretionary distributions to income beneficiaries in excess of traditional income as coming first from any capital gains realized in the tax year of the distributions and such gains will be included in DNI.28
If the terms of the governing instrument (in a provision not inconsistent with applicable local law), require the trustee to treat realized gains as fiduciary income, such gains must be included in the trust's DNI in the taxable year of receipt.29
Once a trustee who has the power to make discretionary distributions to income beneficiaries from either principal or realized capital gains decides that he will make such distributions only from and to the extent he has realized capital gains, he will be obliged to continue this practice. Such realized capital gains will be included in the trust's DNI in the taxable year of receipt in which a discretionary distribution is made.30
If the applicable state law and the trust's governing instrument give the trustee the authority to pay an income beneficiary an amount equal to a reasonable fixed percentage, e.g. four percent, of the annual fair market value of the trust assets (i.e., a unitrust amount) in full satisfaction of that beneficiary's right to income (on the condition this distribution will be considered paid first from ordinary income, then from net short-term capital gain, and then from net long-term capital gain, and finally from return of principal) and the trustee adopts this method of payment, any realized capital gains will be included in the trust's DNI for the year of receipt.31
If the applicable state law and the trust's governing instrument permit an income interest to be satisfied fully with a reasonable unitrust amount, e.g. 4% of the annual fair market value of the trust assets, and no ordering rules are provided for classifying the unitrust distributions as ordinary income, short term capital gains, long-term capital gains, etc., the trustee must establish such ordering rules and stick with them without variation. Thus, if in the first tax year of the trust, capital gains were realized but the trustee chose to characterize the unitrust distribution solely as a combination of ordinary income and trust principal, thereafter he must consistently treat all distributions in excess of ordinary income as principal distributions -- and the trust will be liable for any taxes on its "locked in," realized capital gains.32
Commenting on these examples earlier this year,33 Professor Jerry A Kasner questioned how many existing split-interest trusts contain expressed provisions giving the trustee discretion to treat realized capital gains as distributable fiduciary income. In the absence of such a provision in the trust document, Kasner does not believe the trustee would be free to so allocate "capital gains" under existing and proposed "total return equitable apportionment" or "unitrust-type" distribution statutes. Why? This conclusion is warranted because the statutory authority, e.g. the 1997 UPIA, neither mentions capital gains nor expressly sanctions the practice of allocating capital gains as a component of either unitrust-type or equitable apportionment of total return-type distributions to income recipients.34
Consequently, capital gains of any type should not be allocated to unitrust-type or total return equitable apportionment-type distributions unless the trust document specifically authorizes this practice and carefully describes any limitations that must apply.35 Whenever trustees have the expressed authority to allocate capital gains to income, they should carefully document such allocations when they are made.
Conclusions. These proposed regulations are intended to apply to trusts and estates for taxable years that begin on or after the date that final regulations are published in the Federal Register. They will not be adopted as final regulations until the public has had an opportunity to comment. For readers who are interested in participating in the debate over these proposed new rules, a public hearing has been scheduled for this purpose on June 8, 2001, in the IRS Auditorium, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington.
Also, the IRS is currently accepting written comments and concerns about this subject via the Internet or regular mail.36 If you wish to respond via the latter, you should send to the Service a signed original plus 8 copies of your original. All written comments will be made available at the public hearing and must be submitted before then if they are to be considered.
Part II of this Article will detail the impact of these new proposed Regulations on charitable gift planning vehicles.
Investing for "total return" calls for maximizing trust value by allocating trust capital among diverse investments with varying degrees of risk producing both income and growth. Balancing the total return of the whole portfolio with a reasonable amount of total portfolio risk becomes the Trustee's focus, rather than the return and safety of each individual investment, standing alone.back
The Uniform Prudent Investor Act was approved by the National Conference of Commissioners on Uniform State Laws in 1994. The Act abrogates all categorical restrictions on types of investments and permits trustees to invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust and otherwise meets the other requirements of prudent investing. It is based heavily on the Restatement of Trusts 3d. Thirty-seven states have now adopted some version of this Act. Representative statutes include: Arizona (A.R.S. §§14-7601 to 14-7611); California (Cal. Prob. Code, §§16045 to 16054); Colorado (C.R.S.A. §§ 5-1.1-101 to 15-1.1-115); Florida (F.S.A. §§518.11, 518.112); Illinois (760 ILCS 5/5, 5/5.1); Indiana (I.C. §30-4-3.5); Maine (18- A MRSA §§ 7-302, 7-302 note); Minnesota (M.S.A. §§501B.151, 501B.152); New York (McKinney's EPTL 11-2.3); New Mexico (NMSA 1978 §§45-7-601 to 45-7-612); Oklahoma (60 Okla. St. Ann §§175.60 to 175.72); Oregon (ORS 128.192 to 128.218); Rhode Island (Gen. Laws 1956, §§18-15-1 to 18-15-13); Utah (U.C.A. 1953, 75-7-302); Virginia (Code 1950, §26-45.1); Washington (RCWA 11.100.010 et. seq.); West Virginia Code, 44-6b-1 to 44-6b-15). Other adopting states include: Alaska, Arkansas, Connecticut, District of Columbia, Hawaii, Idaho, Iowa, Kansas, Massachusetts, Maryland, Michigan, Missouri, Nebraska, New Hampshire, New Jersey, North Carolina, North Dakota, Ohio, Pennsylvania, Vermont, and Wyoming.back
In 1997, the National Conference of Commissioners on Uniform State Laws published in final form their suggested restatement of the Uniform Principle and Income Act, some prior version of which is in effect in all but three or four states. One primary purpose for restating the Act was described by the Commissioners as follows: "The law of trust investment has been modernized. See Uniform Prudent Investor Act (1994); Restatement (Third) of Trusts: Prudent Investor Rule (1992) (hereinafter Restatement of Trusts 3d: Prudent Investor Rule). Now it is time to update the principal and income allocation rules so the two bodies of doctrine can work well together. This revision deals conservatively with the tension between modern investment theory and traditional income allocation. The starting point is to use the traditional system. If prudent investing of all the assets in a trust viewed as a portfolio and traditional allocation effectuate the intent of the settlor, then nothing need be done. The Act, however, helps the trustee who has made a prudent, modern portfolio-based investment decision that has the initial effect of skewing return from all the assets under management, viewed as a portfolio, as between income and principal beneficiaries. The Act gives that trustee a power to reallocate the portfolio return suitably. To leave a trustee constrained by the traditional system would inhibit the trustee's ability to fully implement modern portfolio theory."back
Code §643(b) INCOME.-- For purposes of this subpart and subparts B, C, and D, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.back
Subparts A through D of part I of subchapter J of the Code.back
Code §643(a). DNI essentially determines the extent to which the income of a trust passes through and is taxed by its income beneficiaries.back
See Reg. §1.643(a)-3(a). This Code section generally does not apply to tax-exempt charitable remainder trusts that stay away from generating an unrelated business taxable income.back
See Code §§2523(f) and 2056(b)(7).back
Generation-skipping trusts that became irrevocable before 9-25-85 are exempt from the generation-skipping transfer tax sections of the Code unless they make a GST transfer out of corpus added to the trust after that date.back
See §1433(b)(2)(A) of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085, 2731), 1986-3 (Vol. 1) C.B. 1, 634.back
See 26 CFR Parts 1, 20, 25, and 26 [REG-106513-00] RIN 1545-AX96.back
According to the website of the Commission on Uniform State Laws and other sources, the 1997 revision of the Uniform Principal and Income Act has been adopted in Alabama, Arkansas, California, Colorado, Connecticut, District of Columbia, Hawaii, Iowa, Kansas, Maryland, North Dakota, Oklahoma, Tennessee, Virginia, West Virginia, and, Wyoming. It has been introduced in 2001 in the following state legislatures: Arizona, Idaho, Indiana, Minnesota, Nebraska, New Mexico, Rhode Island and Vermont. All but a handful of states have already adopted an earlier version of this Uniform Act, e.g. the 1931 or 1962 "revised" version.back
For example, a receipt of capital gains that previously would have been allocated to principal may be allocated by the trustee to income if necessary to treat both parties impartially; or, conversely, a receipt of dividends or interest that previously would have been allocated to income may be allocated by the trustee to principal if necessary to treat both parties impartially. See Code §§643(a), Prop. Reg. §§1.643(a)-3 and cf. 1997 UPIA, §104, Trustee's Power to Adjust.back
Such a unitrust amount would be a fixed percentage, sometimes required to be within a range set by state statute, of the fair market value of the trust assets determined annually.back
See Prop. Reg. §§1.643(a)-3 and cf. 1997 UPIA, §506(a), Adjustments Between Principal and Income Because of Taxes.back
E.g. see the Uniform Principal and Income Acts of: Maryland (MCA §15-514(d)); Indiana (I.C. §30-4-5-5); Delaware (DCA 12, §6112); and S. Dakota (SDCLA §55-13-7).back
That is, with trust assets other than cash or cash equivalents.back
See prop. Reg. §§1.651(a)-2(d). This amendment appears to apply only to split interest trusts that are required to distribute all of their annual net income to the trust's income recipient, e.g. marital deduction trusts. CRTs have been subject to such a requirement for quite some time. See. Reg. §1.664-1(d)(5).back
See Code §§2523(e) and 2056(b)(5).back
See Regs. §§20.2056(b)-5(f) and 25.2523(e)-1(f).back
Gifts in trust to a non-U.S. citizen spouse generally do not qualify for an estate tax marital deduction in the estate of the deceased citizen-spouse. However, a Qualified Domestic Relations Trust or "Q-Dot" provides a special exception to this general rule. Such a trust is a special form of marital deduction trust that can be established for the benefit of a surviving spouse who is not a U.S. citizen. See Code §§2056(d) and 2056A.back
As required by Reg. §20.2056A-5(c)(2) to qualify for the estate tax exemption for distributions of income to the surviving spouse.back
That is, unmodified, generations-skipping trusts that became irrevocable before September 26, 1985 and have not subsequently made any generation-skipping transfers with trust corpus added after that date.back
Proposed Reg. §1.643(b)-1: Definition of income. For purposes of subparts A through D, part 1, subchapter J, chapter 1 of the Internal Revenue Code, income, when not preceded by the words "taxable," "distributable net," "undistributed net," or "gross," means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Trust provisions that depart fundamentally from traditional principles of income and principal, that is, allocating ordinary income to income and capital gains to principal, will generally not be recognized. However, amounts allocated between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary income, capital gains, and appreciation. For example, a state law that provides for the income beneficiary to receive each year a unitrust amount of between 3% and 5% of the annual fair market value of the trust assets is a reasonable apportionment of the total return of the trust. Similarly, a state law that permits the trustee to make equitable adjustments between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust. These adjustments are permitted when the trustee invests and manages the trust assets under the state's prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust's income, and the trustee after applying the state statutory rules regarding allocation of income and principal is unable to administer the trust impartially. In addition, an allocation of capital gains to income will be respected if the allocation is made either pursuant to the terms of the governing instrument and local law, or pursuant to a reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law.back
Note that this concession comes with the caveat that such adjustments are permitted only when "the trustee invests and manages the trust assets under the state's prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust's income, and the trustee after applying the state statutory rules regarding allocation of income and principal is unable to administer the trust impartially."back
Prop. Reg. §§1.643(a)-3. Capital gains and losses. Note: Code §643(a) and these corresponding regulations generally do not apply to tax-exempt CRTs.back
Prop. Reg. §§1.643(a)-3(e), Examples 1 and 2. Example 2 appears to create a presumption that the trustee who exercises the discretion to treat realized capital gains as fiduciary income intends to do so on a regular basis, in which case he cannot turn back and selectively decide not to exercise the discretion in the future.back
Prop. Reg. §§1.643(a)-3(e), Example 3.back
Prop. Reg. §§1.643(a)-3(e), Example 4. It is neither clear what happens if the trustee who makes such a decision fails to stick with it consistently in future years nor obvious how the IRS will determine what the trustee's original intent was. By negative implication, if the trustee does not pursue his original decision consistently in future years, the IRS is likely to argue that any future discretionary distributions characterized by the trustee as principal were improperly characterized and should have been reported as capital gain distributions taxable to the recipients.back
Prop. Reg. §§1.643(a)-3(e), Example 9.back
Prop. Reg. §§1.643(a)-3(e), Example 10.back
See 2001 TNT 45-33, 5 Mar 2001.back
Cf. 1997 Uniform Principal and Income Act, §104(d). The only references in the text of this Act to "capital gain" appears in §401(c)(4) thereof, where it is stated that money received from an entity that is a regulated investment company or a real estate investment trust is to be considered "principal" if the money distributed is a capital gain dividend for federal income tax purposes.back
For example, if the trust is a NIMCRUT or NIOCRUT, only post-contribution or post- investment purchase, realized, capital gains are so distributable under the Code and this limitation must be noted expressly in the trust document. If the trust is a PIF, the provision should be drafted to preserve the Reg. §1.642(c)-2 charitable deduction as discussed below. QDOTs are expressly prohibited from distributing any form of capital gains to their income recipients. See discussion below. For other types of split interest trusts, the examples in proposed Reg. §1.643(a)-3 should be consulted, and trust provisions drafted to incorporate the optimal choice of ordering rules regarding when and in what order realized capital gains may be included in income interest distributions.back
Send submissions to: CC:M & SP:RU (REG-106513-00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:M & SP:RU (REG-106513-00), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the "Tax Regs" option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at: http://www.irs.ustreas.gov/tax_regs/regslist.html.back