Taxation of a New York Statutory Unitrust

By David Schaengold

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Background

Effective 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.

The IRS Position on Statutory Unitrusts

In 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 methodology.

In 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.

With 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.

At 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 section 643(b)
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.

Treasury Regulations section 1.643(a)-3 states the following:

(a) 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 beneficiary.
(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 local law)—

(1) 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)).

Analysis of Regulation

Thus, 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.

The 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.

In 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)].

NYS Unitrust Examples

Exhibit 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).

Exhibit 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).

When 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.

Implications

The 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.