Wills, Trusts, and Estates: Aspen RoadMap Law Course Outline

By Jeffrey N. Pennell and Alan Newman

 

Copyright © 2000 by Jeffrey N. Pennell and Alan Newman

 

All rights reserved.  No part of this material may be reproduced or tranmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage or retrieval system, without permission in writing from the publishers.  Requests for permission to make copies of any part of this material should be mailed to:

Permissions, Aspen Law & Business, A Division of Aspen Publishers, Inc., 1185 Avenue of the Americas, New York, NY 10036

Chapter 20

 

Income Taxation of Estates,

Trusts, and Beneficiaries*/

 

 

A.    Introduction.

 

The income tax provisions that apply to estates and trusts, and their beneficiaries, are found in Subparts A-D of Part I of Subchapter J of the Internal Revenue Code. They present various options and considerations that largely constitute the postmortem estate planning done by many estate and trust attorneys, but they are likely to be ancillary (or totally ignored) in your basic trusts and estates course. So we're going to make this simple and straightforward (as much so as the subject permits) on the assumption that, here at least, less is more.

 

1.     Estates and Trusts Are Separate Tax Paying Entities

 

Although for some purposes fiduciary entities are subject to passthrough taxation similar to S corporations and partnerships, estates and trusts are treated as separate tax paying entities for income tax purposes and therefore must be considered separately.

 

2.     File Returns and Pay Tax

 

Estates and trusts must file annual income tax returns (Form 1041) and may incur income tax on net earnings, capital gains, and other income that is not distributed currently to their beneficiaries.

 

3.     Conduits

 

On the other hand, they are treated as conduits to the extent they pass "distributable net income" (DNI) to their beneficiaries on a current basis and to the extent they distribute accumulated income that was not distributed in the year it was earned.

 

               a.      Character of Distributed Current Income

 

                                    In most respects income that is distributed to beneficiaries currently has the same character (tax exempt, capital versus ordinary, preference items for alternative minimum tax purposes, and such) in the beneficiaries' hands as it would on the fiduciary's return if it was not distributed.

 

               b.      Character of Distributed Accumulated Income

 

But, with only one exception, the character of items accumulated in one year and distributed in another is not preserved under the accumulation distribution rules, so it is not just a matter of timing distributions and comparing the relative tax brackets of the fiduciary entity and of the beneficiaries that informs decisions relating to income accumulation and the proper time for distribution.

 

4.     Unique Rules

 

As just this little introduction shows, therefore, estates and trusts are subject to their own unique set of income tax rules, and any comparison to passthrough entities or "conduit" taxation is a gross generalization. As the following material demonstrates, the operation of Subchapter J in its entirety is complex and excessively technical.

 

B.    Taxable Income

 

The taxable income of an estate or trust is generally the same as it is for an individual taxpayer. See §641(b). The principal differences between the tax treatment of the income of an estate or trust and that of an individual are the income tax deduction allowed to the entity under §§651(a) and 661(a) for distributions made (or required to be made) to beneficiaries, and the unlimited deduction allowable under §642(c) for amounts paid (or, in some circumstances, permanently set aside) for a charitable purpose.

 

1.     Distributions Carry Out DNI

 

With few exceptions, any distribution made from an estate or trust to a beneficiary — whether made from current or accumulated income, or from principal — is treated as a distribution of current income to the extent of the entity's DNI.

 

               a.      Definition of "Beneficiary"

 

Under §643(c) the term "beneficiary" is as you would expect: an heir, a legatee, or a devisee.

 

               b.      Distributable Net Income

 

But under §643(a), DNI — discussed in some detail below — is a term of art, created by the tax law to serve a limited but pivotal role in the income taxation of estates and trusts.

 

                        i.          Primary Function of DNI. Most important, it serves as a yardstick or measure, placing a limit on the amount of the entity's distribution deduction and on both the amount and the character of current income that is attributable to the income beneficiaries for taxation in the current year.

 

                        ii.         Other Purposes. DNI also serves as an element in the definition of "undistributed net income" (UNI) and "accumulation distribution" for taxation under the "throwback" rules in Subpart D of Part I of Subchapter J. We examine the meaning and function of DNI later, but first we need to consider some special aspects of estate and trust taxable income, which is at the core of both DNI.

 

2.     Deduction in Lieu of Personal Exemption

 

Estates and trusts are denied the §151 personal exemption afforded to individuals but substituted in its stead is the §642(b) deduction in lieu of the personal exemption, granted in various amounts, all much less than the amount granted to individuals. For example, the deduction in lieu of an estate's personal exemption is $600, and the amount allowed to a trust is even less: $300 if the trustee is required to distribute all of the trust's income currently, and only $100 otherwise. §642(b).

 

               a.      Definition of "Income"

 

For this and most other purposes, the statutory reference to trust "income" means state law fiduciary accounting income and is to be contrasted with "taxable income," which is determined under the income tax rules. In most states fiduciary accounting income is determined under the Uniform Principal and Income Act or the Revised Uniform Principal and Income Act, under which capital gains and losses are excluded for most purposes from the determination of income for fiduciary accounting purposes.

 

3.     Deductions

 

Because §63(c) does not apply to an estate or trust, there is no standard deduction or zero-bracket amount for fiduciary entities. Thus, every dollar of an estate or trust's net taxable income is subject to tax at the rates found in §1(e), which by far are the most onerous applicable to any taxpayer under the Code. Otherwise, with few exceptions, an estate or trust is permitted the same deductions that are allowed to individuals.

 

               a.      Two Percent Limitation

 

One favorable discrimination in the taxation of fiduciary entities is §67(e), which specifies that the 2% floor on deductibility of miscellaneous itemized deductions for individuals will not apply with respect to "costs which are paid or incurred in connection with the administration of the estate or trust and would not have been incurred if the property were not held in such trust or estate."

 

                        i.          Application Uncertain. Some uncertainty exists with respect to the meaning of this provision in the context of deductible items that are attributable to expenses that would be incurred even if the property were not held in an estate or trust. For example, it seems clear that a fiduciary's costs to prepare a Fiduciary Income Tax Return (Form 1041) are fully deductible, notwithstanding the 2% floor, because this return is necessary only because the property is held in a fiduciary capacity, but what about the fiduciary's own fees for administration of the entity?

 

 

Examples and Analysis

 

            Suppose the grantor of a trust paid for investment advice prior to creation of the trust, but that the trustee of the trust provides investment counsel with respect to trust assets as part of the services it renders. If the trustee does not account or charge separately for this investment function, we don't know whether the full fee will be deductible, or whether the fiduciary must somehow allocate its fees to be able to identify items of expense that might have been incurred were the property not held in the trust. Most fiduciaries are assuming for the present that everything is deductible until the government establishes the contrary, and then clarifies the parameters of that rule.

                       

 

                        ii.         O'Neill Irrevocable Trust v. Commissioner, 98 T.C. 227 (1992), rev'd, 994 F.2d 302 (6th Cir. 1993), involved investment counseling fees paid to an outside advisor by trustees who were individuals and unwilling to serve unless the trust authorized them to hire investment advisors, which the document specifically permitted. The court on appeal held that the 2% haircut did not apply because investment advice might be necessary to help the trustee diversify or choose among prudent investments because the fiduciary is potentially liable for negligence in these activities, unlike individual investors, making these fees unique to fiduciary administration for §67 purposes.

 

                        iii.        Mellon Bank v. United States, 2000-2 U.S. Tax Cas. (CCH) ¶50,642  (Ct. Fed. Cl. 2000), involved fees paid for investment strategy advice, along with accounting, tax preparation, and management services. The opinion discredits the opinion on appeal in O’Neill, saying it is not enough to determine that the expenses were incurred properly in a fiduciary context, nor that they were necessitated by the fiduciary duties involved. Instead, required is a determination on a case by case basis whether the particular costs would have been incurred even if no trust had been involved. “[T]he fact that costs can be characterized as trustee fees in a trust context says nothing about whether those costs would not have been incurred in a nontrust context.”

 

            b.         Charitable Deduction

 

In lieu of the §170 deduction allowed to individuals for charitable contributions, which is subject to certain limitations based on the type of property transferred and character of the recipient, §642(c) allows an unlimited deduction to an estate or trust for any amount of its gross income that is paid for a charitable purpose or use. The deduction is allowed for amounts paid pursuant to a direction in the will or other governing instrument and for amounts paid pursuant to the exercise of fiduciary discretion granted in the instrument, including any current gross income of an estate that is permanently set aside for future charitable distribution. This §642(c)(2) set-aside deduction is not available to most trusts.

 

 

 

 

           

     Examples and Analysis

 

            Under the terms of a trust instrument, $30,000 of income must be distributed currently to A and the balance to Charity. The trust earned $30,000 of taxable income and $10,000 of interest on tax-exempt municipal bonds. Because the charitable distribution of $10,000 consists proportionately of all items of taxable and nontaxable income of the trust, the charitable deduction is limited to $7,500. The $30,000 distribution to A also consists of a proportionate share of each variety of income, $22,500 taxable and $7,500 tax ­exempt. Treas. Reg. §1.662(b)-2 Example (1).

 

 

               c.      Administration Expenses

 

Expenses of administration that are allowable as estate tax deductions under §2053 also may qualify as income tax deductions under §§162, 163, 165, or 212, or as a reduction of the sales price in determining gain on the disposition of assets. Section 642(g) requires that the decedent's personal representative elect whether to take an income tax or an estate tax deduction (or some of each) with respect to these items, the object being to preclude utilization of the same expenditures to work double duty under each of the estate and income taxes.

 

C.    Distributable Net Income

 

Unique to the income taxation of trusts and estates is the concept of "distributable net income."

 

1.     Why We Need DNI

 

We begin our study of DNI by looking at the primary purpose it serves.

 

               a.      Gifts of Corpus Are Income Tax Free

 

If X gave or bequeathed property to Y, §102(a) provides that Y does not recognize gross income from the transfer, but §102(b) specifies that any income subsequently produced by the property is taxable to Y. Similarly, if X gratuitously gave or bequeathed income producing property to a trust for the benefit of Y, neither the transfer into the trust nor any subsequent distribution of the trust corpus to Y would constitute gross income to either Y or the trustee. Section 102 excludes gifts and inheritances from gross income, and it does not matter whether the property is transferred directly to the donee or beneficiary immediately or is held and distributed in the future through the medium of a trust.

 

               b.      Income from Gifted Corpus is Taxable

 

But income produced by the trust property subsequent to X's transfer should not escape income taxation, either to the beneficiary or to the trust (as a separate entity). Moreover, the beneficiaries of a fiduciary entity should be taxed only on their distributive share of any taxable income of the entity, which requires that the tax exempt character of the estate or trust's income must be preserved.

 

            c.         Identifying Distributions

 

The statutory challenge is to determine the extent to which distributions to beneficiaries are tax free distributions of corpus or of tax exempt income, or taxable income produced by corpus that is not yet distributable. This identification of estate or trust distributions is geometrically more complex if distributions are made to multiple beneficiaries, especially if the nature of their beneficial interests vary (e.g., income and remainder beneficiaries). Since 1954, Subchapter J has used the concept of distributable net income as the device to determine the extent to which distributions to beneficiaries are taxable.

 

2.     DNI's Role

 

DNI is a tax term of art that has no meaning or use outside Subchapter J, which probably is appropriate, given its complexity for just this limited function. Even within Subchapter J, the role of DNI is both limiting and limited, so it is best to keep it in proper perspective.

 

               a.      Limits Beneficiaries' Taxable Income

 

DNI limits the amount of estate or trust distributions that may be treated as taxable income to the beneficiaries, even if total distributions are greater. §§652(a), 662(a).

 

               b.      Allocation of Kinds of Income Among Beneficiaries

 

DNI also provides the basis for allocating various classes of income among the beneficiaries. §§652(b), 661(b), 662(b), and Treas. Reg. §§1.652(b)-2, 1.662(b)-2.

 

                        i.          Tax-Free Income. Known as the character rules, this aspect of DNI's job is important because a distribution that is treated as income to a beneficiary is not necessarily taxable to the beneficiary, depending on the tax character of the item distributed (for example, interest from a state or municipal bond that is exempt from tax under §103, as opposed to taxable corporate bond interest).

 

                        ii.         Conduit Effect. The character rule has the effect of treating the entity as a conduit through which income flows from its original source to the beneficiaries. This treatment requires an allocation of various classes of income ratably among beneficiaries according to the amount of DNI deemed received by each (although the governing instrument specifically may allocate different classes of income to different beneficiaries, provided that the allocation has an economic effect independent of the income tax consequences of the allocation). See Treas. Reg. §1.652(b)-2(b).

 

               c.      Limits Entity's Distribution Deduction

 

DNI has a third function, limiting the maximum amount of income tax deduction allowed to an estate or trust under §§651(a) and 661(a) for distributions made to its beneficiaries.

 

3.     Determining DNI

 

DNI is defined in §643(a) as the taxable income of the estate or trust for the tax year, with a number of adjustments.

 

               a.      Deduction in Lieu of Personal Exemption

 

The first is to perform the §643(a)(2) "add back" of the amount of the deduction in lieu of the personal exemption, allowed under §642(b) in computing taxable income. By this increase, distributable net income is larger than taxable income, meaning that a larger distribution deduction is available to the entity for current income distributions and a larger amount is subject to inclusion in the taxable income of the beneficiaries of the estate or trust who received distributions, in each case because distributable net income is a cap on each.

 

               b.      Tax Exempt Income

 

The second adjustment is an additional add back, with a similar effect on DNI, dictated under §643(a)(5) for §103 tax exempt income. By increasing DNI, and thus increasing both the distribution deduction and the amount subject to inclusion at the beneficiary level, this add back serves to permit this form of tax favored income to pass through to the beneficiaries.

 

                                    i.          Effect on Beneficiaries. If distributed currently, the character pass through rules of the conduit system of taxation under §§652(b) and 662(b), discussed below, permit the beneficiaries to enjoy the special status of income items that trigger this adjustment. However, because §§652(b) and 662(b) dictate a pro rata allocation of the character of all items included in DNI, distributions that generate deductions for the entity are also pro rated to various items of taxable and tax favored or exempt income, under Treas. Reg. §§1.643(a)-5(b), 1.652(c)-4, 1.661(b)-2 and 1.661(c)-2(d).

 

                        ii.         Deductions Attributable to Taxable or Tax Exempt Income. Thus, care must be exercised to assure proper allocation of these items to the proper beneficiaries. Otherwise the government may attempt to allocate deductions to tax exempt income, which essentially wastes the deduction (the income and deductions balancing out) while the taxpayer attempts to allocate deductibles to receipt of taxable income to maximize their utility.

 

               c.      Distribution Deduction

 

In addition to adding back the deduction in lieu of the personal exemption and tax exempt income in computing DNI, three items normally considered in the determination of taxable income are ignored for purposes of computing DNI. Thus, a third adjustment, dictated by §643(a)(1), is to ignore the distribution deduction allowed by §§651(a) and 661(a). Because that deduction is limited to the taxable portion of DNI, an unavoidable circularity otherwise would develop if DNI were equal to taxable income after allowance of the distribution deduction: the deduction would be limited by DNI and DNI would be dependent for computation on the amount of the deduction.

 

               d.      Capital Gains

 

The fourth and fifth adjustments relate to items of taxable income that are allocated to principal and not currently distributed. Thus, for example, under §643(a)(3) and Treas. Reg. §1.643(a)-3, capital gains that are allocated to corpus (either under the terms of the document or under a local law such as §3(b)(8) of both Uniform Principal and Income Acts) and not distributed or set aside for charity, along with capital losses used in computing taxable income, are ignored for purposes of computing DNI. The effect is to reduce DNI and, correspondingly, to reduce the maximum distribution deduction, thereby causing these gains to be taxed to the entity in years when not distributed to the beneficiaries.

 

 

               e.      Taxable Extraordinary and Stock Dividends

 

Similarly, but applicable only to simple trusts (defined below) under §643(a)(4), taxable extraordinary or stock-on-stock dividends that are allocated to principal under the instrument or local law (see the Uniform Acts §§3(b)(4) and (6)) and that are not currently distributed are excluded from DNI, again reducing the maximum distribution deduction and causing the tax thereon to fall on the entity. This is more complexity than you need to know.

 

 

     Examples and Analysis

 

            The following example illustrates the foregoing adjustments in computing DNI. Assume a simple trust in which receipts and disbursements for the year include:

 

1. Taxable Dividends, allocable to income                          $25,000

2. Taxable Dividends, allocable to principal                         12,000

3. Taxable Interest                                                                  15,000

4. Tax Exempt Interest                                                          10,000

5. Long Term Capital Gain                                                      7,000

6. Long Term Capital Loss                                                     (2,000)

7. Fiduciary Fees, charged to income                                    (5,000)

8. Fiduciary Fees, charged to principal                                  (5,000)

 

Fiduciary Accounting Income reflects the following items:

 

1. Taxable Dividends                                                            $25,000

3. Taxable Interest                                                                  15,000

4. Tax Exempt Interest                                                           10,000

7. Fiduciary Fees                                                                      (5,000)

                                                                          FAI =           $45,000

 

Taxable Income reflects the following items:

 

1. Taxable Dividends, allocable to income                          $25,000

2. Taxable Dividends, allocable to principal                         12,000

3. Taxable Interest                                                                  15,000

5. Long Term Capital Gain                                                      7,000

6. Long Term Capital Loss                                                      (2,000)

7. 80% of Fiduciary Fees,[1]/ charged to income                      (4,000)

8. 80% of Fiduciary Fees, charged to principal                      (4,000)

 

                                          Taxable Income =                    $49,000[2]/

 

Distributable Net Income is computed as:

 

Taxable Income                                                                     $49,000

Less net long term capital gain[3]/                                            (5,000)

Less dividends allocable to principal[4]/                                 (12,000)

Plus tax exempt income, reduced by allocable fees[5]/            8,000

 

                                                           DNI =                         $40,000

 

        As illustrated, fiduciary accounting income, taxable income, and distributable net income each may differ during any given year: fiduciary accounting income could exceed taxable income if deductible expenses were paid from principal or due to the deduction in lieu of the personal exemption; fiduciary accounting income could be less than taxable income if taxable items, such as capital gains or certain dividends, were allocable to principal; taxable income could exceed DNI because the distribution deduction is ignored or because capital gains or taxable dividends are allocated to principal and thus excluded in computing DNI; taxable income could be less than DNI due to tax exempt income or the deduction in lieu of the personal exemption (all considered in computing taxable income but not in determining DNI); and there need be no correlation between fiduciary accounting income and DNI. Consequently, using short-cuts to determine the tax treatment of an estate or trust, by assuming a correlation between any of these three concepts, could be hazardous.

 

 

4.     Separate Share Rule

 

Section 663(c) provides that, in determining the amount of DNI of an estate or trust that is allocable to its beneficiaries, substantially independent and separately administered shares of a single trust or estate will be treated as separate trusts for their respective beneficiaries. Consequently, activity such as accumulations or distributions in one separate share will not affect application of the tax rules or the tax consequences of activity in other shares, regardless of how many beneficiaries there are of any separate share or whether separate books of account are maintained for the separate shares. Treas. Reg. §§1.663(c)-3. Prior to 1997 the separate share rule applied only to trusts; now it applies to estates as well.

 

5.     Differing Tax Years of Entity and Beneficiaries

 

A final function of DNI is not very important for trust administration purposes, but it is relevant for estates, which are the only fiduciary entities with individuals as beneficiaries that routinely may have a tax year that is not a calendar year. Under §§652(c) and 662(c), if an estate or trust has a tax year that is different from that of its beneficiary, the amount of income potentially attributable to the beneficiary and the time of its inclusion in the beneficiary's gross income is based on the entity's income for the entity's tax year that ends during the beneficiary's tax year.

 

 

     Examples and Analysis

 

           If the beneficiary is on a calendar year (most individuals are) and the estate is on a fiscal year that ends on January 31, income distributed by the estate to the beneficiary on February 1 of year 1 is treated as the beneficiary's income in year 2 (the beneficiary's tax year in which the estate's tax year 1 ends — January 31 of year 2), meaning it will not be returned or tax paid on it until April 15 of year 3 at the earliest (unless estimated tax is being reported by the beneficiary on a quarterly basis). This deferral opportunity has its downside, however, at the end of administration, in which case a "bunching" of two years' worth of income may occur in a single year of the beneficiary. For example, in this illustration the prior year's income would be reported in the year of estate termination, plus the income of the year beginning February 1 and ending when the administration terminates in the same year. It also may occur at a beneficiary's death, because there is no tax year of the beneficiary with which or within which the distributing entity's tax year ends (unless the beneficiary happens to die on the last day of the distributing entity's tax year, the entity's tax year will end after the beneficiary's death, which marks the close of the beneficiary's last tax year). Income paid to a beneficiary's estate or successors in interest after the beneficiary's death is taxable to those recipients as income in respect of a decedent under §691(a), which we study beginning at page 26.

 

      

               a.      Selection of Estate's Fiscal Year

 

Because fiscal years are still allowed for estates, careful attention is required to coordinate the tax year of the estate with the years of its beneficiaries. Selection of tax year is one item of postmortem tax planning customarily considered by the personal representative, and administration of even a simple, no frills estate can entail time consuming and often difficult details of this type that many planners and most beneficiaries do not recognize or appreciate.

 

               b.      Last Tax Year for Estate or Trust

Similarly, for both estates and trusts, some discretion exists in selecting when the last year of the entity will end for tax purposes. In this respect, both estates and trusts are deemed to continue to exist for a reasonable period necessary to perform the ordinary duties of administration and thereafter to distribute all but a reasonable reserve for contingent claims. Any attempt to unduly prolong administration (for example to force termination into a later tax year of the beneficiaries) will be disallowed and the entity will be deemed terminated when that reasonable time for administration has expired. Treas. Reg. §§1.641(b)-3(a), 1.641(b)- 3(b).

 

D.   Simple Trusts

 

For income tax purposes, trusts commonly are divided into two groups: simple trusts and complex trusts. The terms "simple trust" and "complex trust" are not used in the Code, but they are common in tax parlance because they are used in the Regulations. See, e.g., Treas. Reg. §§1.651(a)-1, -2, -3; 1.651(b)-1; 1.652(a)-1; 1.661(a)-1.

 

 

 

1.     Simple and Complex Trusts Treated Similarly

 

Curiously enough, although most tax lawyers who are familiar with this area of tax law routinely speak in terms of simple and complex trusts, the reality is that the distinction between them is of little significance. With no exceptions of real merit a simple trust and its beneficiaries would be taxed in an identical manner if the tax rules applicable to complex trusts (§§661-664) were applied. But the statutory provisions for simple trusts (§§651 and 652) are more concise, because much of the legislation needed for complex trusts need not apply to simple trusts.

 

2.     Simple Trust Requirements

 

In essence, then, the simple trust rules are the Reader's Digest version of the complex trust rules, stripped down to the bare essentials needed to deal with the form of trust that meets the requirements of §651(a) that the trust:

 

               a.      Distribute Income

 

Must distribute all current income annually.

 

               b.      No Corpus Distributions

 

Must make no distributions for the year in excess of the amount of current income.

 

               c.      No Charities

 

May make no charitable distributions or set asides.

 

3.     All Income

 

The trust must require distribution of all income currently, but not all income actually must be distributed to qualify. That is, even if income is not currently distributed, the fact that distribution is required will suffice to satisfy the all income requirement. Treas. Reg. §1.651(a)-1(b).

 

               a.      Delay in Distributing Income

 

A trust might require distribution of income but not actually distribute it in a variety of circumstances.

 

                        i.         Routine Administration. Often a trust's tax year ends with income on hand that is not distributable until the next periodic income distribution date (monthly, quarterly, semi-annually or whatever). This is proper administration of a trust and the Code recognizes it.

 

                        ii.        Beneficiary's Desire. Occasionally the beneficiary requests or authorizes a delay in the current distribution of income.

 

                        iii.       Beneficiary Uncertain. The trustee may be unsure of the identity of the proper beneficiary and seek instructions while withholding trust income pending a judicial determination.

 

               b.      Actual Distribution Not Required

 

To avoid disqualification as a simple trust in any of these events, the tax rule intentionally does not require actual distribution of all income annually.

 

               c.      Fixed Income Not Required

 

It also does not require that the entitlement of any given beneficiary be specified. For example, a trust that requires distribution of all income annually among a group of beneficiaries, in whatever proportions the trustee selects, would be a simple trust even though no single beneficiary has a guaranteed entitlement.

 

4.     No Other Distributions

 

As to the second requirement for qualification as a simple trust — that there be no distributions in excess of current income — the trustee need not be prohibited from distributing amounts in excess of current income. Rather, the trustee simply must insure that only income is distributed in a given year, thus allowing the trust to be taxed as a simple trust for that year. This imposes a burden on the trustee to carefully monitor distributions, because expected tax consequences may be lost due to inadvertent excess distributions.

 

               a.      "Income"

 

"Inadvertent" might seem to be an inappropriate term because you might think that even the most inexperienced trustee ought be able to tell whether a distribution exceeds income. Here, however, the difference between trust accounting income and income in a tax sense becomes important.

 

                        i.         Fiduciary Accounting Income. For tax purposes, distributions made by a trust are income under §643(b) to the extent they are not in excess of the amount of the current year's fiduciary accounting income. Whether extent exceed DNI or match taxable income is irrelevant. That is, "income" means fiduciary accounting income, as determined by the fiduciary in good faith under the governing instrument and applicable local law. Thus, Treas. Reg. §1.651(a)-2(a) recognizes the validity of reserves to which income may be allocated without constituting a failure to distribute all current income annually.

 

                        ii.        Form of Distribution. The amount of current income, rather than the actual identity of items received as income, is determinative for simple trust qualification purposes, regardless of the source of that distribution for trust accounting purposes. See §651(a) (last sentence, referring to "amounts of income" described in §651(a)(1)). Thus, distributions not in excess of the current year's fiduciary accounting income are "income" for purposes of applying the simple trust rules, and it is the amount of fiduciary accounting income, not the actual source of the distribution, that the trustee must monitor to insure qualification as a simple trust.

 

 

     Examples and Analysis

 

           A trust has income of $1,000 for the current year and is required to distribute all income currently. A distribution of stock held in the trust with a fair market value of $1,000 would be regarded as a distribution of income, even though the stock was held as a part of trust corpus on the trust accounting ledger.

 

 

                        iii.       Distributions May Exceed Taxable Income or DNI. Because fiduciary accounting income may exceed either taxable income or DNI, it is possible to distribute amounts of fiduciary accounting income in excess of what otherwise would be taxable to the trust, without losing the status of a simple trust.

 

5.     Tax Treatment of Simple Trusts

 

If a trust qualifies as a simple trust, the tax consequence is "conduit" treatment. Effected under §§651(a) and 651(b) through a "distribution deduction," resulting in a tax wash to the trust, distributions of fiduciary accounting income from the trust "carry out" DNI to the recipients thereof under §652(a) and Treas. Reg. §1.652(a)-1, and those recipients thereby acquire the liability to pay tax thereon.

 

               a.      Distribution Deduction

 

In computing its income tax liability for the year, a qualifying simple trust may deduct the amount of income it was required to distribute.

 

                        i.         Limitation on Deduction. However, to prevent a deduction larger than the trust's taxable income, which would put the trust in a loss position for tax purposes, under §651(b) the distribution deduction may not exceed distributable net income, computed without inclusion of the net amount of tax exempt income.

 

                        ii.        Treatment of Tax Exempt Income. Thus, Treas. Reg. §1.651(b)-1 requires reduction of DNI by the amount of tax exempt interest income specified in §643(a)(5) (as adjusted by any deductions allocable thereto). The effect of this adjustment is to limit the distribution deduction to the taxable portion of DNI so as not to put the trust in a loss position in computing its taxes for the year. The tax exempt quality of the income is not lost, however, because it carries over to the recipients by virtue of the character rule in §652(b).

 

               b.      Beneficiaries' Taxation

 

The tax consequence of qualification as a simple trust to beneficiaries entitled to receive required distributions of income is §652(a) inclusion in income of the amount allowed as a deduction to the trust, whether the income actually was distributed or only required to be distributed.

 

                        i.         Excess Distributions. If distributions exceed the allowable deduction, because fiduciary accounting income is greater than the taxable portion of DNI, each recipient includes a pro rata portion of the amount of the deduction, based on the total distributions made by the trust. So complete is the pass through of tax liability to the beneficiaries that, under §652(b) and Treas. Reg. §1.652(b)-1, amounts originally received by the trust retain their tax character (tax exempt income, capital gains, tax preference items, and so forth) when distributed to the beneficiaries.

 

                        ii.        Allocation Among Beneficiaries. Moreover, unless specifically altered by a provision of the governing instrument mandating non pro rata distribution of various classes of income, the character of all amounts included in DNI, both income (including tax exempt income) and deductions, effectively is allocated pro rata to the recipients by §652(b) and Treas. Reg. §1.652(b)-2. Discretionary non pro rata distributions of various classes of income do not alter this allocation. Treas. Reg. §1.652(b)-2(b)(1).

 

               c.      Conduit Taxation

 

In short, the overall effect of both the distribution deduction and the inclusion rules is conduit taxation that taxes the beneficiaries generally as if the trust did not exist as an intermediary. The exception to this conclusion is the treatment of capital gains that are not treated under the instrument or local law as fiduciary accounting income: they are retained by and taxed to the simple trust.

 

E.    Estates and Complex Trusts

 

All estates, any trust that is not a simple trust for the year (because it either may accumulate income, provides for charity, or actually made distributions exceeding current income), and all trusts in the year of termination (because principal necessarily is distributed), are governed by the complex trust rules of Subpart C (§§661-664) of Part I of Subchapter J.

 

1.     Income (Required to be) Distributed

 

To the extent income of an estate or complex trust is currently distributed — or is required to be distributed — the tax consequences to the entity and beneficiary essentially are the same as the conduit tax treatment of a simple trust: the entity is entitled to a distribution deduction under §661(a), the beneficiaries include the deducted amounts under §662(a), and the character of each item in DNI carries through to the beneficiaries pro rata under §§661(b) and 662(b) (unless the governing instrument specifically dictates otherwise).

 

2.     Distribution Deduction

 

One notable difference between the distribution deduction for a complex trust and that for a simple trust is that, although both deductions cannot exceed the amount of DNI (see §651(b) and the last sentence of §661(a)) as reduced by tax exempt income (see the last sentence of §§651(b) and 661(c)), the amount of DNI will differ by virtue of application only to simple trusts of §643(a)(4) (exclusion from DNI of taxable dividends allocable to principal).

 

 

               a.      Distributions Exceeding Fiduciary Accounting Income

 

In addition, unlike a simple trust, a complex trust or an estate may make distributions of amounts in excess of the dollar amount of fiduciary accounting income (whether the distributed asset comes from fiduciary accounting income or principal), and these distributions also are deemed to carry out income, to the extent of current DNI or prior years' accumulations of income (known as undistributed net income (UNI) and defined at page 21), thus generating additional distribution deductions for the estate or trust and requiring inclusion by the recipients thereof under §§662(a)(2).

 

 

     Examples and Analysis

 

           To illustrate the difference between simple and complex trusts, assume a trust has $33,000 of fiduciary accounting income for the year, consisting of $24,000 of ordinary income and $9,000 of tax exempt income. The trustee is required to distribute all the income annually to B. If the trustee actually distributes more than $33,000 for the year the trust would be a complex trust for that year. The distribution would carry out the $33,000 of DNI, of which $9,000 would be tax exempt to B and the trust would be entitled to a $24,000 distribution deduction (the taxable portion of DNI). In addition, the trust would have made either an accumulation distribution of UNI or a tax free distribution of corpus (or some of each) of the amount in excess of $33,000 that was distributed to B, making the trust complex. No additional distribution deduction would be available to the trust for this excess distribution, and the tax consequence to B would depend on the extent to which the distribution carried out UNI (which largely is irrelevant today). By way of comparison, if the trustee properly had distributed only $22,000 for the year, in this example the amounts distributed would be 24/33 x $22,000 of taxable income items and 9/33 x $22,000 of tax exempt income and the trust would be complex by virtue of accumulating the income that was not currently distributed. B would include taxable income of 24/33 x $22,000 ($16,000) and report tax exempt income of 9/33 x $22,000 ($6,000), and the trust would deduct the full 24/33 x $22,000 ($16,000) of taxable income that was distributed.

 

 

3.     In-Kind Distributions and Specific Bequests

 

Under §643(e) distributions in kind from a complex trust carry out income (either DNI, UNI, or a combination of both) only to the extent of the lesser of the distributed assets' adjusted basis or their fair market value. In addition, by §663(a)(1), excepted entirely from the income carryout rules applicable to complex trusts are transfers in satisfaction of a specific bequest, devise, or legacy payable in less than four installments, if not required to be satisfied only out of income. To constitute a "specific" disposition, the identity of the property conveyed, or the dollar amount of a pecuniary gift, must be ascertainable as of inception of the estate or trust.

 

               a.      "Formula" Bequests

 

(for example, a marital deduction distribution that is tied to a concept such as a decedent's gross estate for Federal estate tax purposes) do not qualify as specific bequests the satisfaction of which will not carry out DNI because they are dependent on variables (such as valuation and tax elections) that make them unascertainable until some later time. Treas. Reg. §1.663(a)-1(b).

 

               b.      Installment Payments

 

In determining whether payment is to be made in less than four installments, the terms of the governing instrument, not actual administration, are determinative. Treas. Reg. §1.663(a)-1(c)(1).

 

4.     Accumulated Income

 

The principal difference between the taxation of simple trusts under Subpart B and the taxation of estates or complex trusts under Subpart C is attributable to accumulations of income in the latter. Only capital gains or other income properly allocable to corpus are taxed to a simple trust. All other income is offset completely by the distribution deduction and is thereby taxed through to the beneficiaries. In a complex trust or an estate, income that is accumulated rather than distributed will be taxed to the estate or trust because the distribution deduction is less than the total taxable income and, thus, does not wash out the full amount of income for the year.

 

               a.      Estate or Trust as a Separate Tax Paying Entity

 

By virtue of this essential difference, the complex trust or estate as a separate taxpayer permits fragmentation of income between the beneficiaries and the entity. At one time this made it possible to reduce the tax paid by all. Now, however, the current rate schedule taxes trusts and estates with modest amounts of taxable income at the maximum income tax rate, so only a very modest potential reduction in tax is available by taxing some income to the entity and some to the beneficiary. Nevertheless, when the tax rates were more favorable it was recognized that this income fragmentation opportunity necessitated several concepts that are not applicable to simple trusts and that remain in the law.

 

               b.      Accumulation Distributions and Throwback

 

Although the beneficiaries of complex trusts and estates still are taxed on income actually distributed, and the fiduciary receives a corresponding deduction therefor, it is accumulated income, taxed to the entity, that presents the potential for tax minimization. To deal with this factor, Subchapter J creates the concept of UNI and imposes seemingly complex rules known as the accumulation distribution and throwback rules. We will not demonstrate this but hope you will take our word for the fact that the rules are hard to decipher (this is one of those cases in which you really need to know what the Code is telling you before you can read it and figure out what it says) and their application requires a good bit of tax related information about both the entity and the beneficiary for prior years, but the actual operation of a throwback computation itself is not as convoluted as many would have you believe.

 

               c.      Effective Repeal of Throwback

 

Much more importantly, in 1997 Congress effectively repealed the accumulation distribution and throwback rules for 99% of all trusts. Although the provisions remain in the Code, they apply only to certain pre-1984 abusive multiple trusts, and foreign trusts, so for our purposes the story of throwback is a dead letter and we won’t bother you with any further details. Suffice it to say that, with this complexity gone, simple and complex trusts are taxed virtually identically.

 

5.     Multiple Trust Rule

 

A second rule applicable to complex trusts exists to minimize their use to fragment income into multiple separate taxpaying entities, each with its own separate rates and deduction in lieu of the personal exemption. By the "multiple trust" rule of §643(f), separate trusts created by substantially the same grantor or grantors, with substantially the same beneficiary or beneficiaries, and with a principal purpose to avoid taxes, are regarded as a single tax paying entity.

 

6.     Sixty-Five Day Rule

 

A third special rule originally limited to complex trusts (but now also applicable to estates) is a reflection of the fact that it may not be possible to know, as of year end, how much income must be distributed to avoid a trust accumulation. Thus, the "sixty-five day" rule of §663(b) permitted complex trusts to elect to treat distributions made within 65 days after year-end as distributions of DNI during the year just ended. The rule was applicable only to complex trusts because the object was to avoid accumulations that subsequently may be subject to the accumulation distribution and throwback rules, which applied only to complex trusts and not to estates or simple trusts. With the repeal of throwback for most trusts, and the equivalence treatment of estates and trusts, this rule now applies to both complex trusts and to estates.

 

7.     The Tier Rules

 

A fourth concept, the "tier" rules, is made necessary in complex trusts by the ability to accumulate income for later distribution. The term "tier," which is not utilized in the Code or Regulations, refers to the distinction drawn in §§661(a)(1) and 661(a)(2) between amounts of income required to be distributed currently ("Tier 1" distributions) and other amounts properly paid, credited, or required to be distributed ("Tier 2" distributions).

 

      

     Examples and Analysis

 

           To illustrate the importance of this concept, assume that a complex trust has $50,000 of fiduciary accounting income for the year but DNI of only $40,000 (due to an income tax deduction for expenses that were charged to principal for fiduciary accounting purposes), that the trustee must currently distribute all income in equal shares to beneficiaries A and B, and that the trustee also makes a discretionary distribution of $50,000 to B. Without the tier rules it would appear that, because A has received $25,000 while B has received $75,000, the $40,000 of DNI ought to be pro rated between them in proportions of $10,000 and $30,000 respectively. However, by virtue of the terms of the trust, it is apparent that A received half the current income, not just one-fourth, and should be taxed on half the DNI. The tier rules provide the mechanism for distinguishing between the various distributions to A and B to effect this treatment.

      

 

               a.      Tier 1 Distributions

 

The technical definitions under the tier rules relate to distributions made by the trust. Under §661(a)(1), Tier 1 distributions are required current distributions of income (not in excess of DNI). So pervasive is the "required" distribution notion that, under §662(a)(1), a Tier 1 distribution is treated as having been made as required, resulting in DNI inclusion to the beneficiary, even if the distribution is not made in fact.

 

               b.      Tier 2 Distributions

Under §661(a)(2) and Treas. Reg. §1.661(a)-2(c), Tier 2 distributions are all other distributions, whether required or discretionary and whether made from current income, from accumulated income, or from corpus.

 

 

     Examples and Analysis

 

           In the preceding example, A and B are equal Tier 1 beneficiaries because the trustee must make current distribution of all income to them. Consequently, the $40,000 of DNI is pro rated equally between them under §662(a)(1) and Treas. Reg. §1.662(a)-2(b), rather than apportioned $10,000 to A and $30,000 to B.

 

          

                        i.         Prorate Remaining DNI Among Tier 2 Beneficiaries. Any DNI remaining after satisfaction of all Tier 1 required current distributions of income similarly would be pro rated under §662(a)(2)(B) and Treas. Reg. §1.662(a)-3(c) among the Tier 2 beneficiaries on the basis of their Tier 2 distributions.

 

                        ii.        Tier 2 Distributions Exceeding DNI. Only the amount of the Tier 2 distributions in excess of any DNI remaining after Tier 1 distributions would qualify as either a §665(b) accumulation distribution of prior years' UNI or a §102 tax-free distribution of principal.

 

 

     Examples and Analysis

 

           In the prior example, the $50,000 distributed to B is a Tier 2 distribution and may be taxable as UNI — if the trust has any (and if throwback applies) — or as corpus.

 

 

8.     Separate Share Rule

 

A final relevant concept under Subpart C is the separate share rule, mentioned at page 12, applicable under §663(c) to trusts (and, only since 1997 to estates alike). By providing that substantially independent and separately administered shares of a single trust or estate will be treated as separate trusts for DNI allocation purposes, activity such as accumulations or distributions in one separate share do not affect application of the tier rules or the tax consequences of activity in other shares.

 

9.     Summary

 

To summarize, DNI in both simple and complex trusts is carried out to trust beneficiaries by required current income distributions. Any remaining DNI is carried out by any other distributions made. DNI is shared pro rata by the recipients within any class or tier of distribution, and each item of income in DNI is shared pro rata within each class or tier (unless the governing instrument provides otherwise).

 

f.     Distributions In-Kind

 

Distributions from an estate or trust carry out income (first DNI, then UNI, to the extent either is available in the year of distribution), regardless of whether the distribution constitutes fiduciary accounting income or corpus and regardless of whether the fiduciary distributes cash or property in-kind.

 

1.     Tier 2 Distributions

 

Section 643(e), discussed further below, limits the amount of income deemed distributed by a complex trust or an estate on a Tier 2 in-kind transfer of property, and establishes the basis of distributed property. Notice, however, that §643(e) establishes these special rules for distributions and basis only for purposes of §§661(a)(2) and 662(a)(2) (Tier 2 distributions) and has no application to simple trusts that are governed by §§651 and 652, nor to Tier 1 distributions that are governed by §§661(a)(1) and 662(a)(1).

 

2.     Tier 1 and Simple Trust Distributions

 

If §643(e) does not apply, income equal to the fair market value of a distributed asset is carried out by distribution of an asset in-kind (to the extent there is sufficient DNI) unless the distribution qualifies as a specific bequest under §663(a)(1).

 

3.     Effect of §643(e)

 

To the extent it does apply, however, §643(e)(2) limits the income carryout on an in-kind distribution to the lesser of (1) the asset's fair market value or (2) the adjusted basis of the asset (plus or minus any gain or loss realized on the distribution), with an election granted to the fiduciary under §643(e)(3) to intentionally incur gain or loss on the distribution. Further, adjusted basis to the distributee is a carryover of the distributing entity's basis (again, as adjusted for gain or loss realized on the distribution).

 

 

 

 

     Examples and Analysis

 

           Consider an asset with a fair market value of $100 and an adjusted basis of $40. Distribution as a Tier 2 in-kind transfer would carry out income of $40, and basis to the distributee would be $40, being a carryover of the distributing entity's basis (with no adjustment for gain or loss because none was incurred on the distribution). The effect of §643(e) is that less income is carried out by a Tier 2 distribution of an appreciated asset in-kind.

 

      

4.     Rationale of §643(e)

 

If a trustee wants to distribute $70 to a beneficiary, it could do so by distributing (1) an asset with a fair market value of $70 and a basis of any amount, (2) cash of $70, or (3) any combination of the two. Under §643(e) a Tier 2 distribution of cash will carry out up to $70 of DNI but a Tier 2 distribution in-kind will carry out no more DNI than the basis of the distributed asset. The justification for this limited DNI carry out is a feeling that it is inequitable to saddle a distributee with income equal to fair market value plus any unrealized appreciation represented by a basis that is lower than fair market value. That being the case, §643(e) need not apply to Tier 1 distributions governed by §§661(a)(1) and 662(a)(1) and to distributions from simple trusts governed by §§651 and 652 because those in-kind distributions are gain or loss realization events, as discussed next below, with the result that fair market value and adjusted basis will be equal in the beneficiary's hands and DNI carryout will be that same amount (at least to the extent of DNI available for carryout).

 

5.     Realization Events 

 

The carryover of basis and DNI carry out limitation of §643(e) is affected by distributions that otherwise generate a new basis. Gain or loss may be realized under Treas. Reg. §1.661(a)-2(f)(1) by distribution of an asset in-kind, with a concomitant adjustment to basis (to fair market value) if:

 

               a.      Satisfaction of Specific Bequest of Devise

 

The distribution is in satisfaction of the distributee's right to receive some other asset (for example, if Blackacre were distributed instead of a specific bequest of stock), or

 

               b.      Satisfaction of Specific Legacy

 

The distribution is in satisfaction of the distributee's right to receive cash (for example, if Blackacre were distributed to satisfy a debt owed to a creditor or to satisfy a beneficiary's right to receive a specific legacy).

 

               c.      Income Tax Treatment

 

In either case, the income tax treatment is as if the proper asset or cash were distributed and then used to purchase the actual asset distributed, with gain or loss generated on that sale if the asset had unrealized appreciation or depreciation (and nonrecognition under the Code did not otherwise apply).

 

G.   Income and Deductions in Respect of a Decedent

 

Neither income in respect of a decedent (IRD) nor deductions in respect of a decedent (DRD) is a concept unique to the income taxation or administration of estates and trusts or the taxation of beneficiaries. Nevertheless, because each applies to any taxpayer receiving income to which a decedent was entitled, or paying specified deductible expenses on the decedent's behalf, IRD and DRD are common to fiduciary administration and the income taxation of trusts, estates, and beneficiaries.

 

1.     Objective of IRD and DRD Concepts

 

With respect to all taxpayers, the fundamental tax objective of both the IRD and DRD concepts is to maintain the same character of the income and deductions as if received or incurred by the decedent while alive and, for fiduciary income tax purposes, any IRD received or DRD incurred by an entity enters into the computation of its taxable income, and thus into the amount of DNI.

 

2.     IRD and DRD Defined

 

Broadly speaking, IRD is income earned by a decedent prior to death but not recognized for income tax purposes until after the decedent's death. Similarly, DRD consists of expenses or obligations incurred by the decedent prior to death that would have been deductible by the decedent if they had been paid or accrued prior to death.

 

3.     Examples of IRD

Although there is no statutory definition of IRD, we know from Treas. Reg. §1.691(a)-2 that the government regards the following items as IRD:

 

               a.      Compensation for the Decedent's Services, including a bonus voted after the decedent's death that the employer had no obligation to pay.

 

               b.      Renewal Commissions of a deceased life insurance agent.

 

               c.      Accrued but Unreported Interest on Series EE United States Treasury Bonds.

 

               d.      Dividends on stock owned by the decedent that were payable to shareholders of record on a date prior to the decedent's death.

 

               e.      Alimony Arrearages.

 

               f.       Deferred Compensation Death Payments made to beneficiaries under a qualified retirement plan.

 

               g.      Capital Gain on a sale made during the decedent's life and reported on an installment basis is income in respect of the decedent, and the recipient of the right to receive those payments will continue to report them on the same basis as did the decedent.

 

               h.      Distributive Share of Partnership Income paid to a deceased partner for the partnership's taxable year in which death occurs, attributable to the period ending with the partner's death, is IRD even if the deceased partner made cash withdrawals from the partnership as an advance against that income. In addition, a share of profits for periods after the partner's death can be IRD.

 

4.     Identifying IRD

 

Helpful guidelines for identifying IRD refer to income that would have been taxable to the decedent had death not occurred prior to receipt.[6]/ Some cases refer to there being a legally significant arrangement that elevates the income above a mere expectancy and there being no outstanding economically material contingencies at the decedent's death. To establish that the decedent would have received and included the income had death not intervened, it is necessary to establish that the decedent, not the ultimate recipient, performed the substantive acts that spawned the entitlement. Thus, the recipient's acquisition must be "passive," not due to efforts made to generate the right (as opposed to enforcing it) after the decedent's death.

 

5.     Tax Consequences of IRD

 

There are three primary tax consequences of an item being regarded as IRD, not all of which being disadvantageous, depending on the circumstances.

 

               a.      Taxable Income

 

First, income represented by the right to receive IRD is taxable in the year it is received.

 

               b.      Character of Income

 

Second, under §691(a)(3), the character of the income is the same as if it was received by the decedent.

 

               c.      Basis

 

Third, rather than a new basis at death, the item has a §1014(c) basis equal to what the decedent's basis would have been if living. This treatment is necessary because otherwise, to the extent of a new basis, the IRD would not be taxable as income as received.

 

 

     Examples and Analysis

 

           D negotiated a sale of property prior to death that failed to close because of housing code violations. The sale was completed after D's death because the buyer agreed to take the property subject to the violations in exchange for a $2,000 reduction in the purchase price. According to Estate of Napolitano v. Commissioner, 63 T.C.M. (CCH) 3092 (1992), the sale proceeds were not IRD because the sale was not complete prior to death. D's basis in the property was $50,000 and the sale price was $240,000, so avoiding IRD treatment meant that a basis adjustment at death was available and the sale generated no gain.

          

 

 

 

6.     Deductions in Respect of a Decedent

 

As a counterpart to the rules governing income in respect of a decedent, a taxpayer who makes certain payments that would have been deductible if paid by a decedent prior to death is entitled to a §691(b) deduction in respect of the decedent. Those expenditures specifically are limited to §162 business expenses, §212 expenses of producing income or managing or safeguarding income producing property, §163 interest, and §164 deductible taxes (or the §27 credit for foreign taxes).

 

               a.      Depletable Property

 

In addition, the recipient of depletable property is entitled to any §611 percentage depletion attributable to income received therefrom, under Treas. Reg. §1.691(b)-1(b).

 

               b.      Tax Treatment

 

In each case, the deduction is available to the recipient of property to which the expenditure is attributable, and without limitation by the otherwise applicable §642(g) rule denying double duty for deductions that may be taken on either the estate or income tax return. These deductions in respect of a decedent specifically are excepted from the operation of §642(g) because, had they been incurred by the decedent during life, they would have reduced the decedent's estate for estate tax purposes and still would have been deductible for income tax purposes.

 

7.     Deduction For Taxes Attributable to IRD

 

In addition to DRD, an income tax deduction is allowed under §691(c) for estate or generation-skipping transfer taxes attributable to IRD.

 

               a.      Theory Behind Deduction

 

This deduction is based on a theory that, had the income been received by the decedent during life, any income tax incurred thereon would have been paid prior to imposition of the estate or generation-skipping transfer tax, resulting in a smaller estate subject to those taxes and, thus, less of those taxes being payable. To approximate that result without recomputing the estate or generation-skipping transfer tax after the income tax on the IRD has been computed, Congress substituted an income tax deduction for the estate or generation-skipping transfer taxes attributable to the IRD. The general objective is to obtain a result that is administratively easier than recomputation of the wealth transfer tax and that gives some rough approximation of what would have happened if the IRD had been received during the decedent's life.

 

               b.      Benefit of IRD

 

In some cases an item will be income no matter who receives it, so treatment as IRD carries no detriment and allows the §691(c) deduction that otherwise would not be available. In those cases it pays to argue in favor of IRD treatment, which shows that the IRD label is not always detrimental.