New Regulations On Definition Of Trust Income And DNI

Summary

This article summarizes the provisions of the new IRC 643 regulations which bring the Code's definition of income into line with the 41 states which have passed some form of total return legislation. The statutes and the new regulations are sure to provide new opportunities, discretion and some pitfalls for fiduciaries around the country.

Our roundup of fourth quarter decisions includes, from California, a conservatorship case which highlights the modern statutory trend of barring donative transfers by dependent adults to their "care custodians." Cases involving alleged gifts made by the elderly and infirm to their caregivers have plagued our court systems for years. California and other states (like Florida) have responded by passing statutes addressing this problem.

Also, a number of Illinois cases including the Estate of Lane, dealing with the technical requirements of filing a claim. Lane is basically a reprise of the Beider case from ten years ago. The holding of both courts may surprise some readers. Another interesting case is Estate of Ramlose, a guardianship matter involving the Public Guardian's recovery citation efforts against an individual accused of wrongly converting the ward's assets. Ramlose deals with due process rights related to freeze orders.

Consistent with this constitutional theme is Estate of Muldrow which examines the equal protection rights of a convicted felon to act as the executor of an estate. Lastly, an update on a case we reported on last year. Estate of Poole discusses a purported biological father's rights and the interplay of the Illinois Probate Act, the Parentage Act and the Wrongful Death Act when a viable fetus is stillborn following an automobile accident.

On December 30, 2003, the IRS issued final regulations that (1) broaden the definition of trust income and (2) expand the circumstances in which capital gains will be included in distributable net income (DNI). TD 9102. The new regulations are intended to take into account the changes in many states of the definition of trust accounting income to allow trustees to invest for total return. Generally speaking, the changes in the definition of income apply only to trusts in states that have adopted a broader definition of income, while the changes in DNI apply to all trusts. These regulations will be effective for all tax years ending after January 2, 2004.

Income

The income regulations apply to trusts where state statutes (1) give the trustee the discretion to adjust between income and principal to treat beneficiaries fairly or, (2) define income as a unitrust amount. A court order could also meet the "state statute" requirement if the order announces a general principal or rule of law. However, a court order applicable only to the trust before the court will not meet this requirement.

The regulations provide that the trustee can use any definition of income that complies with a state statute that provides for reasonable apportionment between the income and remainder beneficiaries of the trust's total return for the year, including ordinary and tax-exempt income, capital gains, and appreciation. If income is defined as a unitrust amount, the amount is reasonable if it is between 3% and 5% of the value of the trust assets. Additionally, the value can be determined annually or by averaging the value of the trust assets over a period of years.

The regulations do not restrict trustees to a single definition of income. In fact, the regulations provide that switching between state approved definitions of income (1) will be respected for federal tax purposes, (2) will not be a recognition event and, (3) will not have gift tax consequences. In addition, if the trust is exempt from the generation-skipping transfer tax, a switch in the method of defining income will not result in a loss of exempt status. This applies even to switches that result from a change in the trust's situs.

Keep in mind that if a...