Journal of Financial Planning: June 2024
As a senior financial planner with Apella Wealth (https://apellawealth.com/), Claire Thornton, CFP®, EA, works with women experiencing formative life transitions including the loss of a partner, navigating windfalls, and planning growing careers and families. Claire earned her Master of Science in Taxation from Golden Gate University.
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If you are a CERTIFIED FINANCIAL PLANNERTM professional who provides estate planning advice, chances are you are intimately familiar with various trust types—both revocable and irrevocable—and when they should be integrated into a client’s plan. What is oftentimes missing from our vernacular as planners is how irrevocable trusts are treated once they are funded; what determines the amount that is distributed to a beneficiary? When do income or capital gains get taxed to the trust versus the beneficiary? Today, we set out to better understand the inner workings of irrevocable trusts from an accounting and tax perspective. Our goal here is to exercise new muscles as the proverbial quarterback in conversations with tax preparers, attorneys, and clients on irrevocable trust matters.
Before we dive into the mechanics of irrevocable trusts, I will start by emphasizing that this is intended as a 10,000-foot view of trust accounting and taxation. It is not a replacement for the advice of an attorney or CPA. While it is critical to equip ourselves with a baseline understanding of the technical components at the intersection of tax, trust, and estate planning, recognizing when planning advice shifts into the realm of legal advice is of the utmost importance. Simply put, any time you are giving advice to a client that impacts their rights as a beneficiary you are giving legal advice, so take heed whenever you are interpreting a trust document.
Irrevocable trusts comprise two classes of beneficiaries: income beneficiaries and remaindermen beneficiaries. As may be self-evident, the right to income is given to the former and the right to principal (corpus) is given to the latter. These can be the same beneficiary (a grantor leaves their two kids’ assets in trust as 50/50 beneficiaries) or they can be separate beneficiaries (a grantor names their surviving spouse as income beneficiary during her lifetime and their kids as remaindermen beneficiaries as is common in a qualified terminable interest property (QTIP) trust). If you’re curious how we ended up with this rather complex structure of income and remaindermen beneficiaries, its beginnings date back to the Middle Ages (with the concept of trusts originating under Roman Civil Law). In the Middle Ages, land was a lord’s only real income-producing asset, and when he was away crusading, villagers would work the land and enjoy its fruits. If the lord was lucky enough to return from battle, the land was still his.
Simple and Complex Trusts
While there are two beneficiary types, there are also two irrevocable trust structures that we must familiarize ourselves with: simple and complex trusts. Under IRC 651(a), a simple trust is defined as one that must distribute all income currently—at minimum once per year—to the income beneficiary. A simple trust makes no principal distributions or distributions to charity. In the case of simple trusts or complex trusts with income beneficiaries, every year, the trustee must calculate fiduciary accounting income (also known as trust accounting income) to determine the amount that is required to be paid out to the income beneficiary. We will cover this concept in greater detail later.
In contrast to a simple trust, a complex trust is any irrevocable trust that does not fit the definition of a simple trust. The IRC does not provide a specific definition for complex trusts, so this is the best we have to work with in delineating the difference.
It is important to note that a trust may be simple one year and complex the next. For example, the last will and testament of a late grandmother states that a testamentary trust is funded for the benefit of her granddaughter. The will further states that income is distributed annually to the granddaughter until she reaches age 21 when she can receive one-third outright. At age 25, she is entitled to half of the remainder, and at age 30, the remaining balance of the trust. This trust shifts between simple and complex, depending on the year; up until age 21, the trust is simple because it only distributes income. At ages 21, 25, and 30, the trust is complex because it is distributing a portion of the principal balance, too. The trust reverts to a simple trust in the years in between these age milestones. What happens when a trust is required to distribute income at least annually and is also authorized to distribute principal? If the trustee makes no principal distributions, it remains simple. If principal distributions are made, it is complex.
Let’s look at another example: a couple creates an irrevocable trust for their son and makes an inter vivos (during life) gift into the trust. The trust states that he has no rights to mandatory income, but discretionary distributions can be made by the third-party professional fiduciary trustee as needed. For this reason, the trust will always be treated as complex.
Determining Beneficiaries’ Income
We care about the distinction between simple and complex trusts because trustees of trusts with mandatory income distributions must calculate fiduciary accounting income (FAI) annually, as was mentioned earlier. For me, the most difficult component to grasp in learning these fundamentals is that FAI is an accounting concept, not a tax concept. It is FAI, not taxable income, that determines how much an income beneficiary is entitled to receive. In contrast, the tax return’s K-1 determines the character of that income and is an entirely different calculation, which we will cover in detail further below. To determine FAI, the trustee should first turn to the trust agreement for guidance on what types of income and expenses are distributed to the income beneficiary versus those that remain in trust for the benefit of the remaindermen beneficiary.
Oftentimes, the trust agreement does not provide specific instruction on how to determine this split. Hence, the Uniform Principal and Income Act (UPIA) exists to coordinate the rules regarding fiduciary accounting income in all states. In short, UPIA acts as a guiding light for trustees in determining FAI when the trust is silent on the matter. Under UPIA, capital gains are designated toward principal (i.e., stay in trust for the future benefit of the remaindermen beneficiary) where interest and dividends are designated as income distributed to the income beneficiary. Trustee and advisory fees are split 50/50 between principal and income.
Example: Simple Trust. Let’s look at a quick example of how this works: as of December 31, a simple trust had realized gains of $20,000, taxable interest of $7,000, tax-exempt interest of $3,000, dividends of $13,000, and trustee fees of $2,000. The FAI is $22,000 ($10,000 total interest + $13,000 dividends – $1,000 trustee fee). As a result, the trustee must distribute $22,000 to the income beneficiary.
Now that FAI is determined, we will switch our brains from accounting rules to income tax rules to determine the character of the income a beneficiary will pay tax on. The first part of this calculation is called distributable net income (DNI). Unlike FAI, DNI is calculated for both simple and complex trusts. In short, DNI is the maximum distribution deduction a trust can take and is also the maximum amount that is taxable to the beneficiary. If a trustee chooses to distribute more than DNI, the excess amount is tax-free to the beneficiary.
Example: Complex Trust. For example, it is determined that a complex trust has DNI of $15,000 for the year but the trustee chooses to distribute $20,000 to the beneficiary for their lifestyle needs. The maximum amount the beneficiary will be taxed on is $15,000 and the remaining $5,000 will pass tax-free to them. In turn, the trust will take a $15,000 tax deduction. While DNI is the maximum distribution deduction a trust can take, it is not required to distribute anything as we learned earlier under complex trust rules. So, what if a trustee distributes less than DNI to a beneficiary? Continuing with the example above, if DNI is $15,000 but a trustee distributes only $3,000 to a beneficiary, the beneficiary will have only $3,000 in taxable income and the trust will take a $3,000 deduction. This $3,000 is called the income distribution deduction (IDD). IDD is the lesser of DNI or actual distributions made (minus tax-exempt income).
Our intent today is not to practice the DNI computation, but rather understand its purpose. We can also take heart in knowing that, unlike FAI, DNI and IDD calculations can be found on Schedule B of the 1041 fiduciary tax return. Let’s break down Schedule B in its core components. To follow the calculations for DNI, refer to lines 1 through 7 of the Schedule. Lines 8 through 10 deal with actual distributions made; line 8 is reserved for complex trusts with an income beneficiary (where the maximum distribution amount is FAI), line 9 is reserved for simple trusts or complex trusts with required distributions, and, lastly, line 10 is reserved for discretionary distributions made by complex trusts with no income beneficiary. Line 11 removes tax-exempt income from total distributions, and line 14 removes tax-exempt income from DNI. Our primary focus is on line 15: the final IDD calculation. It is line 15 that determines what flows through on a beneficiary’s K-1 and what the trust will take as a deduction. While this discussion around IDD may feel exhausting, it is not exhaustive; there are further rules to navigate around IDD if non-cash distributions are made. This is beyond the scope of today’s discussion; however, planners should be aware of this further complexity if a trustee deviates from making cash distributions.
If you’re a lifelong learner, you likely enjoy education for education’s sake; however, I’d like to also inject a practical element to this conversation and rein these concepts back to how they tie into our role as planners. If you manage the investments within an irrevocable trust, you play a critical role in ensuring distributions are carried out as required under the trust document or UPIA. A trustee may not know what their duties are when it comes to simple and complex trusts, so the more active role you play in ensuring FAI and IDD are carried out properly, the greater value you are adding to the relationship. A complex trust that allows discretionary distributions has up to 65 days following year-end to make distributions to beneficiaries. This means that you will know exactly what income was generated in the trust for that year. Take this as an opportunity to coordinate with the tax preparer to determine the optimal amount to pass through to the beneficiary on their tax return versus keep in trust (which will pay tax at compressed tax rates). In contrast, simple trusts do not have a time limit on when mandatory income distributions are made; however, the beneficiary will be taxed on IDD whether any distributions are actually taken, so keep on top of income beneficiary FAI distributions to ensure they’re in tandem with what they’re being taxed on. Catching an oversight like this is a huge win and further strengthens the relationship and role you play in your clients’ lives.