of a New York Statutory Unitrust
to convert a trust to a unitrust under New York’s revised
Prudent Investor Act is a difficult question. One issue is
how the unitrust will be taxed for income tax purposes and
what the tax implications are for income beneficiaries. Recently
finalized regulations for IRC section 643 revise the definition
of income for trust purposes and provide guidance with respect
to unitrust issues.
January 1, 2002, New York Estates, Powers, and Trusts Law
(EPTL) section 11-2.4 allows a trustee to elect to redefine
trust income as a 4% unitrust amount instead of the amount
determined under traditional principal and income rules.
For trusts in administration as of January 1, 2002, the
election must be made on or before December 31, 2005. For
trusts established after January 1, 2002, the election must
be made by the end of the second full year of the trust.
For both old and new trusts, the election to adopt the unitrust
methodology for determining income may be made by the trustee,
either with the consent of all interested persons or at
the trustee’s own discretion.
IRS Position on Statutory Unitrusts
the late 1990s, the IRS began considering questions raised
by states that were planning to allow trustees to elect
the unitrust methodology for determining income. The existing
IRC section 643 regulations dated back to the 1950s and
were too confusing to apply to unitrust situations, perhaps
unnecessarily deterring trustees from electing the unitrust
proposing new regulations, the IRS stated that it made amendments
in order to “permit trustees to implement a total
return investment strategy and to follow the applicable
state statutes designed to treat the income and remainder
beneficiaries impartially” [Proposed Regulations section
1.643(b); IRB. 2001-16]. Many states have incorporated “elective
statutory unitrust” and “trustee’s power
to adjust” provisions in their prudent investor and
principal and income statutes. The new regulations are designed
to conform to these statutes.
respect to state statutory unitrusts, the new regulation
honors a definition of accounting income that is determined
under a state law unitrust if the payout is between 3% and
5% of the annual fair market value of the trust.
the end of 2003, the IRS published the regulations as final
effective January 2, 2004 (IRB 2004-5; T.D. 9102). The regulations
revise the definition of trust accounting income under IRC
and clarify the inclusion of capital gains in distributable
net income under section 643(a)-3. The regulations provide
guidance for the inclusion of capital gains in the taxable
income of beneficiaries in certain unitrust situations.
Regulations section 1.643(a)-3 states the following:
In general. Except as provided in section1.643(a)-6
and paragraph (b) of this section, gains from the sale or
exchange of capital assets are ordinarily excluded from
distributable net income and are not ordinarily considered
as paid, credited, or required to be distributed to any
(b) Capital gains included in distributable net income.
Gains from the sale or exchange of capital assets are
included in distributable net income to the extent they
are, pursuant to the terms of the governing instrument and
applicable local law, or pursuant to a reasonable and impartial
exercise of discretion by the fiduciary (in accordance with
a power granted to the fiduciary by applicable local law
or by the governing instrument if not prohibited by applicable
Allocated to income (but if income under the state statute
is defined as, or consists of, a unitrust amount, a discretionary
power to allocate gains to income must also be exercised
consistently and the amount so allocated may not be greater
than the excess of the unitrust amount over the amount
of distributable net income determined without regard
to this subparagraph section 1.643(a)-3(b)).
a New York trustee is permitted to include capital gains
in the distributable net income of a unitrust beneficiary,
depending on three factors. First, whether net capital gains
are included in the total net income of the trust and whether
the income without the capital gains is less than the unitrust
amount. For example, if the total net income of a trust
was $100,000, including $25,000 of capital gains, then capital
gains would not be included in distributable net income
if the unitrust amount was equal to or less than $75,000
($100,000 – $25,000). But if the unitrust amount exceeded
$75,000, then the excess, up to $25,000, could possibly
be included in distributable net income, depending on the
other two factors.
second factor is whether there is a defined ordering rule,
either by statute or by governing instrument, for determining
the character of the unitrust amount that specifies the
inclusion in distributable net income of capital gain when
the sum of the ordinary and the tax-exempt income of the
trust is less than the unitrust amount to be paid to the
beneficiary. The New York EPTL does not contain an ordering
rule for determining the character of the unitrust amount.
Nonetheless, the IRS regulations provide that if the terms
of the trust instrument require the trustee to follow an
ordering rule, then, in the example described above, capital
gain would be included in distributable net income when
the unitrust amount paid exceeds the sum of the ordinary
and the tax-exempt income of the trust.
the absence of a specified ordering rule, the third factor
is whether the trustee is granted a discretionary power
over this decision. If such a discretionary power is granted
to the trustee, then the regulation allows the inclusion
of capital gains in distributable net income, but only on
the condition that it be “exercised consistently”
[Treasury Regulations section 1.643(a)-3(b)(1)].
1 shows how the regulation operates when there is no
ordering rule specified by statute or governing instrument
and the trustee does not have discretion to allocate gains.
The result is that only ordinary income (and tax-exempt
income, if any) is included in the beneficiary’s K-1.
No capital gain is included in the K-1, even though the
total unitrust distribution to the beneficiary ($120,000)
exceeds the net ordinary income ($80,000). The trust ends
up paying the tax on the entire capital gain ($125,000).
2 shows how the regulation operates when neither statute
nor governing instrument has an ordering rule for the character
of the unitrust amount, but leaves such a decision to the
discretion of the trustee. In this example, the trustee
intends to follow a regular practice of treating net capital
gains as distributed to the beneficiary to the extent that
the unitrust amount exceeds the trust’s ordinary and
tax-exempt income. The result is that the beneficiary must
pay tax on the total amount distributed ($120,000), because
a portion ($40,000) of the trust’s realized capital
gains is included in the K-1 in addition to the net ordinary
income of the trust. The trust must pay tax on the balance
of the capital gain ($85,000).
the trustee has discretion, as in Exhibit 2, the regulation
asserts that the decision is automatically made in the first
year by the manner in which the return is filed, as evidenced
by whether captital gain has been included in distributable
net income on the trust’s federal tax return. Consequently,
trustees should be aware that a decision is effectively
made the first year of the unitrust with the filing of the
fiduciary income tax return. The way the return is filed
in the first year is the way future returns must be filed.
new regulations clearly guide fiduciaries through the complexities
of the income taxation of unitrusts. There is a certain
amount of flexibility, but it is coupled with consistency,
to prevent manipulation. Because the New York EPTL does
not have an ordering rule for the character of the unitrust
amount, the determination relies upon the provisions of
the governing instrument: Does it have an ordering rule,
or does it grant the trustee discretion over the decision?
If there is an ordering rule, then the trustee is bound
by it. If it grants the trustee discretion over the decision,
then the trustee must be aware that a decision made in the
first year of the unitrust, when the fiduciary income tax
return is filed, affects subsequent years.
Schaengold, CPA, practices in New York City, and
specializes in estate and trust matters. He served as the
AICPA Observer to the Drafting Committee to revise the Uniform
Principal and Income Act. He is a member of the NYSSCPA’s
Income of Estates and Trusts Committee.