New York State Releases Its Throwback Tax Form (and It Is Unduly Complex)

By:
Kevin Matz, Esq., CPA, LLM
Published Date:
Feb 1, 2016

The New York State Department of Taxation and Finance (NYSDTF) has posted on its website Form IT-205-J, New York State Accumulation Distribution for Exempt Resident Trusts (Schedule J), with accompanying instructions for computing the throwback tax applicable to exempt resident trusts. Given the complexity of this area of tax law, it should not be surprising that this form will be very difficult for practitioners to complete. Moreover, practitioners will be required to track down information pertaining to trusts and their beneficiaries going back to 1969 (the year that man first walked on the moon!) to determine the existence of prior years’ undistributable net income to which certain distributions could be applied. This measure was likely intended to be helpful to taxpayers by excluding from tax certain distributions to New York resident beneficiaries that are matched up against undistributed net income attributable to tax years prior to Jan. 1, 2014. Unfortunately, the NYSDTF has not permitted trusts to use a simplified “default calculation” - similar to that employed by the IRS in Part III of Form 3520 - for throwback purposes. To its credit, the form does also clarify that capital gains will not be subject to throwback except where the capital gains are part of federal distributable net income, such as where the trust is a foreign trust for federal income tax purposes.

Background

On April 1, 2014, Governor Andrew Cuomo signed into law several provisions affecting estate planning and trusts as part of the New York State Executive Budget. Although most attention has focused on New York’s estate tax law changes, the new law also ushered in significant changes in the income taxation of trusts as well. The most far-reaching of these changes is New York’s introduction of a “throwback tax” on certain distributions of prior years’ taxable income to New York resident beneficiaries from trusts qualifying for the “New York Resident Trust Exception.” As New York Tax Law section 605(b)(3)(D) states, the New York Resident Trust Exception applies to nongrantor trusts for which (1) all of the trustees are domiciled outside of New York; (2) all real and tangible trust property is located outside of New York; and (3) all trust income and gains are derived from sources outside New York. Many of the contours of the throwback tax, however, awaited clarification from the NYSDTF.

Why The Throwback Tax Was Enacted and How It Works

The throwback tax was enacted by New York to address a perceived abuse by nongrantor trusts qualifying for the New York Resident Trust Exception, which resulted in those trusts accumulating and then distributing income to resident beneficiaries free of state income tax. The perceived abuse resulted from the following circumstances. First, the starting point for the income taxation of trusts for New York fiduciary income tax purposes is the federal rules governing the income taxation of nongrantor trusts. Under those rules, either the trust or the beneficiary is subject to income tax, but not both. The mechanism to accomplish this is “distributable net income” (DNI). DNI is essentially taxable income subject to certain adjustments, such as the backing out of capital gains – which is the general rule, subject to several exceptions. When DNI is distributed to beneficiaries, the trust gets an offsetting income distribution deduction, and the beneficiaries are liable for the income tax.

Against this federal backdrop are the New York rules governing the income taxation of nongrantor trusts. There are two general categories of nongrantor trusts for New York income tax purposes – resident trusts and nonresident trusts. A resident trust is one created by a person who was a New York resident at the time the trust became irrevocable. If the trust is created while the grantor is living, an “inter vivos trust,” the trust would generally become irrevocable upon its creation. If the trust is created under the grantor’s will, a “testamentary trust,” the trust becomes irrevocable upon the person’s death. If the trust is not a resident trust, then it is a nonresident trust. In general, though subject to a very important exception discussed below, resident trusts are taxed on their worldwide income (although potentially excluding in certain circumstances income from real estate, tangibles, or businesses conducted outside of New York). Nonresident trusts are only taxed on income derived from New York real estate, tangibles, or businesses.

The exception mentioned above applies to trusts that qualify for the New York Resident Trust Exception (exempt resident trusts). The New York Resident Trust Exception applies to nongrantor trusts for which (1) all of the trustees are domiciled outside of New York; (2) all real and tangible trust property is located outside of New York; and (3) all trust income and gains are derived from sources outside of New York.

If an exempt resident trust makes a current year distribution out of DNI to a New York resident beneficiary, then New York will impose income tax on the beneficiary. But a gap exists where the trust accumulates income, and then distributes the accumulated income in a subsequent tax year. Under the previous law, New York could not impose tax on the prior year’s taxable income.

To close this perceived loophole for exempt resident trusts, New York enacted a “throwback tax.”  As stated in New York Tax Law section 612(b)(40), the throwback tax applies to income (1) of an exempt resident trust (2) which is distributed to a New York resident beneficiary (3) that was not previously taxed by New York and (4) that has been accumulated during the taxable years beginning on or after Jan. 1, 2014 for which there was a New York resident beneficiary at least 21 years of age. Section 9 to the budget bill that enacted this statute provides that this provision does not apply to income paid to a beneficiary before June 1, 2014.

It should be noted that prior versions of the budget bill that enacted this statute would have applied the throwback tax to undistributed net income going back to trust inception and, moreover, would have applied it to nonresident trusts as well. Fortunately, the enacted statute limited its application to the form described above – specifically, to income accumulated in taxable years beginning on or after Jan. 1, 2014, and to exempt resident trusts. The statute imposes no interest charge even though the throwback tax applies to distributions of prior years’ taxable income.

The Throwback Tax Generally Does Not Apply to Capital Gains

One of the issues left open by the New York throwback tax legislation concerned the extent to which throwback applies to capital gains in addition to ordinary income. This uncertainty arose because the statute was enacted via an extensive incorporation by reference of IRC provisions that have been effectively repealed by Congress (except in the case of foreign nongrantor trusts and certain trusts created prior to March 1, 1984). 

The throwback tax form has resolved this question in a manner that is generally favorable to taxpayers. The starting point for determining the applicability of the throwback tax is DNI as reported on Form 1041, the federal fiduciary income tax return. Under IRC section 643(a), capital gains will usually be excluded from DNI unless the trust is a foreign trust for federal income tax purposes. Accordingly, unless the governing instrument provides otherwise or the trustee has exercised discretion to include capital gains in DNI (such as for minimizing trust exposure to the 3.8% tax on net investment income under IRC section 1411), capital gains generally will not be subject to the New York throwback tax.

The Form’s Mechanics and Its Accompanying Instructions

The instructions to Schedule J provide that every exempt resident trust must file Schedule J for any tax year in which it makes an accumulation distribution to a beneficiary who is a New York resident. A resident beneficiary receiving an accumulation distribution from an exempt resident trust (other than an incomplete gift nongrantor trust) must include the accumulation distribution in his or her New York adjusted gross income, unless:

-- the accumulation distribution is thrown back to a tax year for which the trust was subject to New York tax, or a tax year starting before Jan. 1, 2014;

-- the accumulation distribution is thrown back to a tax year prior to when the beneficiary first became a New York resident, or a tax year before the beneficiary was born or reached age 21; or

-- the income was already included in the beneficiary’s gross income.

A resident beneficiary includes the accumulation distribution in his or her New York adjusted gross income by using Part 4 of Schedule J. The trust must provide the resident beneficiary with a copy of Part 4 of Schedule J.

Part 1 of this form determines the amount of the accumulation distribution for the current taxable year. The instructions to Schedule J, at page 1, define an “accumulation distribution” as “the excess of amounts properly paid, credited, or required to be distributed (other than income required to be distributed currently) over the distributable net income of the trust reduced by the income required to be distributed currently. To have an accumulation distribution, the distribution must exceed the accounting income of the trust.”

Part 2 of the form is a nightmare that requires the trust to potentially go back as far as 1969 to determine how much of the undistributed net income (UNI) attributable to prior tax years is available to absorb the current year’s accumulation distribution on a year-by-year basis, starting with the earliest preceding year in which the trust had UNI. This is the so-called “throwback.” As the form illustrates, the UNI for a given year is the DNI for a given throwback year reduced by the trust’s distributions to beneficiaries in that throwback year, and then further reduced by the taxes imposed on the trust for that throwback year (which, per Part 3 of the form, is computed  solely on the trust’s ordinary income for that throwback year, with both short-term and long-term capital gains excluded from this computation). The instructions for line 13 then provide as follows:

Allocate the amount on line 5 that is an accumulation distribution to the earliest applicable year first, but do not allocate more than the amount on line 12 for any throwback year.  An accumulation distribution is thrown back first to the earliest preceding tax year in which there is UNI. Then, it is thrown back beginning with the next earliest year to any remaining preceding tax years of the trust. The portion of the accumulation distribution allocated to the earliest preceding tax year is the amount of the UNI for that year. The portion of the accumulation distribution allocated to any remaining preceding tax year is the amount by which the accumulation distribution is larger than the total of the UNI for all earlier preceding tax years.

The instructions contain an exception for “simple trusts,” which is defined by IRC section 651 and Treasury Regulations section 1.651(a)-1 as: a trust that (1) is required to distribute all of its income currently for the taxable year, whether or not distributions of current income are in fact made; (2) does not allow any amount to be paid or set aside for charitable contributions; and (3) does not in fact make any distributions other than of current income for such taxable year. The instructions elaborate:

A tax year of a trust during which the trust was a simple trust for the entire year is not a preceding tax year unless (a) during that year the trust received outside income, or (b) the trustee did not distribute all of the trust’s income that was required to be distributed currently for that year. In this case, UNI for that year must not be more than the greater of the outside income or income not distributed during that year.

The term outside income means amounts that are included in the DNI of the trust for that year but not income of the trust as defined in IRC Treasury Regulations section 1.643(b)-1. Some examples of outside income are:  (a) income taxable to the trust under IRC section 691; (b) unrealized accounts receivable that were assigned to the trust; and (c) distributions from another trust that include the DNI or UNI of the other trust.

Significantly, the instructions do not address what happens if the trustee lacks the records necessary to complete this form, which can be expected to occur with tremendous frequency given that the throwback year might be as long ago as 1969. Although it appears that this measure was intended to be helpful to taxpayers, the recordkeeping aspect of this is totally unworkable.  This problem could be ameliorated to some extent if the NYSDTF were to follow the approach taken by the IRS in Part III of Form 3520 and adopt an alternate “default calculation,” which generally limits the throwback amount to distributions for a given year that exceed 125% of the average of the amounts distributed by the trust during the three preceding tax years. 

The form instructs at the bottom of Part 2 that if the throwback year is a tax year in which the trust was subject to New York tax, or a tax year starting before Jan. 1, 2014, then there is no New York State modification required for that year and, as a result, Part 4 of the form should not be completed for that year. The bottom portion of Part 2 further provides that Part 4 should not be completed for the beneficiary if the throwback year is a tax year prior to when the beneficiary first became a resident of New York or a tax year before the beneficiary was born or reached age 21, or if the income was already included in the beneficiary’s gross income.

Part 3 of the form, as noted above, computes the amount of federal taxes imposed on the ordinary income portion of each throwback year’s UNI for purposes of reflecting that information on line 9 in Part 2 of the form.

Finally, Part 4 of the form reports allocations to the New York resident beneficiary for whom Part 4 must be completed, and specifies that the beneficiary should enter the line 49 amount on Form IT-225 as addition modification “A-116.” If the beneficiary received separate Schedule J allocations from multiple trusts, then the sum of the line 49 amounts from all Schedule Js are entered on Form IT-225. The instructions require that the New York resident beneficiary be provided with a copy of Part 4.

Planning to Avoid the New York Throwback Tax

Finally, given the complexity of the New York throwback tax, some discussion about how to avoid it is warranted. Through careful planning, a trustee can use the following techniques:

-- Distribute all DNI each year to beneficiaries, including to New York resident beneficiaries.

-- Minimize DNI (and thereby minimize UNI) by having the trust invest in low-income, high-growth investments.

-- In any year in which there would otherwise be a throwback, do not distribute to any New York beneficiaries who were over age 21 and New York residents during the year of accumulation. Instead, consider “stripping out” UNI - for example, in December of “Year 1” - by making distributions of UNI to non-New York beneficiaries and then distributing the “untainted income” to the New York resident beneficiaries in January of “Year 2.”

-- Strip out DNI each year that is not needed for distributions to a separate “subtrust” that can be used in subsequent years to make distributions to beneficiaries other than those who were New York residents over age 21 in the year of accumulation.

-- Extend the trust as long as possible (via decanting or otherwise) to avoid making mandatory distributions in accordance with the terms of the trust’s governing instrument.

-- Increase trust accounting income in the year of distribution. Under the last sentence in the flush language of IRC § 665(b), if the total distributions from the trust do not exceed accounting income for that year, then the distributions will not be deemed to include UNI even if the distributions exceed DNI. It may be possible to increase trust accounting income by interposing an entity between the portfolio assets and the trust: Section 11-A-4.1 of the New York Estates, Powers and Trusts Law generally allocates distributions from an entity to income (as opposed to principal), unless the distributions are in excess of  20% of the entity’s gross assets.

 


Kevin Matz, JD, LLM, CPAKevin Matz, Esq., CPA, LLM, is the managing attorney of the law firm of Kevin Matz & Associates PLLC, with offices in New York City and White Plains, New York. Mr. Matz is a certified public accountant (in which connection he is a past chairman of the Estate Planning Committee of the NYSSCPA), and writes and lectures frequently on estate and tax planning topics. His practice is devoted principally to domestic and international estate and tax planning and he is a Fellow of the American College of Trust and Estate Counsel. He can be reached by email at kmatz@kmatzlaw.com, or by phone at 914-682-6884.

The author wishes to thank Jonathan Blattmachr and Professor Mitchell Gans for their thoughtful comments to the initial manuscript of this article.

 
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