This article first appeared on State of Estates, which can be found at https://griffinbridgers.substack.com, and is being reposted here with permission.
Background and Example
Quincey Harker, III, is an attorney who is representing his client and friend Victor in the administration of a long-term dynasty trust. The trust holds numerous income-producing assets, resulting in taxable income each year. However, it is difficult to determine the precise amount of the taxable income in time for it to be distributed to the beneficiaries before the end of the year. In prior years, passive loss carryforwards have wiped out this income, so the timing was not an issue. However, the losses have finally been used up, and Victor is concerned that the trust will have a high income tax bill.
This is a valid concern. The tax brackets for trusts are the same as those for individuals, but a trust reaches the highest tax rate of 37% once it exceeds just $15,650 of income in 2025. In contrast, for a married filing jointly couple, that number is $751,600. Obviously, the trust has the potential of paying the highest tax rate on a significantly higher amount of income.
However, Quincey explains to Victor that all hope is not lost, even though the trust is a complex trust. Under this type of trust agreement, Victor as trustee has the authority to decide how much income to distribute to the beneficiaries. This contrasts with a simple trust, which requires all the income to be passed out, or a grantor trust, which simply provides a report to the grantor of the trust, who then includes all the items of income and expense on his or her return. The distinction is important, because it means that for a complex trust, a distribution to the beneficiaries is necessary to carry out non-capital gain income to the beneficiaries of the trust. As seen above, the beneficiaries are more likely to be taxed at a favorable tax rate than the trust.
Victor is happy that Quincey seems to have an idea on how to solve the problem – distributing the income of the trust to the beneficiaries – but it seems like an incomplete solution. He could estimate how much money to distribute, but without knowing the exact amount of the income until after year end, he won’t be sure how much to distribute to the beneficiaries. Fortunately, Quincey is aware of this issue and has an answer for it too: the 65-day rule.
The 65-Day Rule
The 65-day rule is an election provided for by Internal Revenue Code Section 663(b). Under this election, any distributions made within the first 65 days of the year from a nongrantor trust can be treated as paid or credited to the beneficiary on the last day of the preceding tax year. (Note that any trust income subject to the grantor trust rules is taxed to the deemed owner, even if distributed to beneficiaries.) Importantly, this election can apply to all, or part, of the distributions made during this period. So, if for some reason it is necessary to distribute more than the amount of trust income needed to carry out the prior year’s income, the applicable amounts can be applied to the most beneficial year. This way, the beneficiaries will report the income on their personal returns at a lower rate than the trust would have.
Applied to the current situation, Quincey and Victor can wait until after December 31st and then perform a calculation of the trust’s income. They can make distributions to the beneficiaries based on this calculation. As long as the distributions are made on or about March 5 (depending on the year, that day may fall on the weekend, in which case the deadline would be extended to the following Monday), then the election can be made so that they are treated as having taken place in the prior year. He notes that Section 663(b) says that the distribution must be “properly paid or credited” to the beneficiary. He wonders what that might mean exactly and decides that a court must have fleshed that out at some point. Research reveals that his instinct was right. In Commissioner v Stearns (1933), the noted jurist Learned Hand set forth that the phrase means that the income has to be definitively allocated to the beneficiary such that it can’t be called back. Just noting it on the books of the trustee would not be enough, unless there was some way to make that irrevocable.
One wrinkle that Quincey notices is that it is important to pay attention to the timing of the income. In two old Tax Court cases, interpreting Section 162(d)(3), a predecessor to Section 663(b) with substantially the same language, the court held that in neither case could the income be treated as income distributed in the prior year, because the income itself was not available until the subsequent year. In both of Trust of John Walker v Commissioner (1958) and Pauline Sturm Nalle v Commissioner (1960), the income became available (because of court decisions releasing previous restraints on it) at the beginning of the year, and the executors attempted to treat it as taxable in the prior year. However, the Tax Court held that the distribution within 65 days of the beginning of the year would not make income that was received in one year taxable in the prior year. Although it is not applicable in his situation, Quincey notes this as a potential trap for the unwary.
Mechanics of Election
Then, the election itself just needs to be made on the trust’s 1041, whether it is filed on time at the April 15th deadline or at the extended September 30th deadline. It is possible to do an election even later than that under Treas. Reg. 1.9100-1, but reasonable cause would have to be established by means of a request in a separate application. Additionally, affidavits would have to be supplied to support the assertion of reasonable cause. Further, there are fees similar in amount to the ones paid for a private letter ruling. Obviously, this is not desirable from the tax preparer’s perspective, and therefore it is definitely Quincey’s plan to make a timely election.
There are other intricacies of the election. First, the election once made is irrevocable after the deadline (or extended deadline) of the return on which it is made. In addition, the election is only applicable for the year it is made. That means it needs to be considered on a year-to-year basis. Because of this, careful record-keeping will be important to know which years and which amounts prior elections apply to.
The actual how-to of making the election is simple. Here is the relevant line of the tax return:
To make the election, just check the box. In addition, the amounts being treated to distributed to the beneficiaries will need to be input in the tax software as well so that the correct income flows out to the beneficiaries. This election is a case where the background calculations to project income and the amount necessary to be distributed are where the real work lie. The making of the election is simply the final piece.
Limitations of Trust, Applicable Law, and Capital Gains
Central to this point is that trust (fiduciary accounting) income is not the same as taxable income. Treas. Reg. 1.663(b)-1(a)(2) expressly limits this election to the greater of trust income or distributable net income – each of which is a subject for another time, but which can be explored starting in IRC Section 643. As a preview, note that Treas. Reg. 1.643(a)-3 calls for a review of the trust document and applicable local law to determine whether capital gains are allocated to corpus or income. If capital gains may be allocated to income, further elections on Form 1041 may be required to make this allocation for purposes of the (separate) 663(b) election.
Once this research is done, Quincey realizes that there is an additional consideration and precaution to take before simply distributing out the income. What does the trust document say about distributions of income? Often a dynasty trust will discourage distributions except for specific reasons because the goal is for the corpus to grow for future generations. Making a distribution that is not explicitly permitted by the document, or, even worse, is prohibited by it could expose Victor to potential legal liability. Quincey would not want to have Victor become the defendant in a lawsuit because Quincey advised him to make distributions to save money on taxes. In addition, even if permitted, distributions might not be prudent. As an example, distributing $100,000 cash for the discretionary spending of a three-year-old would most likely not be the best exercise of the trustee’s discretion. Finally, it is important to note what is allowed under the document, because that might affect the amount allowed under the election. Quincey discovered this in Private Letter Ruling 8728001 from 1986 that says that amounts distributed to beneficiaries that are more than allowed under the trust document are not eligible for the election under 663(b).
Upon analysis of the document, they conclude that it would not violate the grantor’s intent in the creation of the trust to make the distributions, but for peace of mind’s sake, Quincey is glad he knew to look. Wary of all of the above but comfortable in their thoroughness, they decide to move forward with the plan.
No comments found.