Definition of ‘Trust & Estate Income’: IRC 643(b) Tax Overview

Definition of Trust & Estate Income

While the general IRS income tax rules for US persons can be complicated, when it comes to trust and estates —  the definitions and concepts can become overwhelming for any U.S. Taxpayer. That is because many taxpayers do not encounter issues involving trust and/or estate income until after a loved one has passed – and at a time in which dealing with income tax implications is usually not at the top of their immediate to-do list. The Internal Revenue Code provides various definitions of terms listed in Title 26 of the code (IRC). One of the most important definitions that some taxpayers will have to be aware of is how income is defined for trust and estate purposes. Let’s walk through the basics of 26 USC 643(b).

26 U.S. Code § 643 – Definitions applicable to subparts A, B, C, and D

• • • (b) Income

      • • For purposes of this subpart and subparts B, C, and D, the term “income”, when not preceded by the words “taxable”, “distributable net”, “undistributed net”, or “gross”, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

Regulation  1.643(b)-1 Definition of income

• • • For purposes of subparts A through D, part I, subchapter J, chapter 1 of the Internal Revenue Code, “income,” when not preceded by the words “taxable,” “distributable net,” “undistributed net,” or “gross,” means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Trust provisions that depart fundamentally from traditional principles of income and principal will generally not be recognized. For example, if a trust instrument directs that all the trust income shall be paid to the income beneficiary but defines ordinary dividends and interest as principal, the trust will not be considered one that under its governing instrument is required to distribute all its income currently for purposes of section 642(b) (relating to the personal exemption) and section 651 (relating to simple trusts). Thus, items such as dividends, interest, and rents are generally allocated to income and proceeds from the sale or exchange of trust assets are generally allocated to principal.

    • However, an allocation of amounts between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary and tax-exempt income, capital gains, and appreciation. For example, a state statute providing that income is a unitrust amount of no less than 3% and no more than 5% of the fair market value of the trust assets, whether determined annually or averaged on a multiple year basis, is a reasonable apportionment of the total return of the trust. Similarly, a state statute that permits the trustee to make adjustments between income and principal to fulfill the trustee’s duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust.

    • Generally, these adjustments are permitted by state statutes when the trustee invests and manages the trust assets under the state’s prudent investor standard, the trust describes the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and the trustee after applying the state statutory rules regarding the allocation of receipts and disbursements to income and principal, is unable to administer the trust impartially. Allocations pursuant to methods prescribed by such state statutes for apportioning the total return of a trust between income and principal will be respected regardless of whether the trust provides that the income must be distributed to one or more beneficiaries or may be accumulated in whole or in part, and regardless of which alternate permitted method is actually used, provided the trust complies with all requirements of the state statute for switching methods.

    • A switch between methods of determining trust income authorized by state statute will not constitute a recognition event for purposes of section 1001 and will not result in a taxable gift from the trust’s grantor or any of the trust’s beneficiaries. A switch to a method not specifically authorized by state statute, but valid under state law (including a switch via judicial decision or a binding non-judicial settlement) may constitute a recognition event to the trust or its beneficiaries for purposes of section 1001 and may result in taxable gifts from the trust’s grantor and beneficiaries, based on the relevant facts and circumstances. In addition, an allocation to income of all or a part of the gains from the sale or exchange of trust assets will generally be respected if the allocation is made either pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law. This section is effective for taxable years of trusts and estates ending after January 2, 2004.

Section 643(b) Analysis

In working through the 26 U.S.C. 643(b) definition, it is important to take note that there are various limitations. For example, the definition immediately clarifies and limits the definition of ‘income’ relative to phrases such as taxable, distributable net, undistributed net, or gross. Thus, the definition begins by explaining that the definition of the term income may be impacted based on these other phrases preceding the word ‘income’ — but if these other phrases are not preceding the word income, then the definition continues. For trust and estate purposes, income is determined under the specific instrument and local law. For example, is there a grantor trust in place or a non-grantor trust in place –– is it revocable or irrevocable and where was the trust or estate formed? These types of issues will impact the definition and how it is applied. Moreover, if the income involves extraordinary dividends or taxable stock dividends eligible to the corpus miniature not be considered trust and estate income.

Section 1059(c) Extraordinary Dividends

The concept of extraordinary dividends can be complex. From a baseline perspective, it means that is not your ‘typical’ or ‘recurring’ dividend that a stock may pay out monthly, quarterly, semi-annually, or annually.

Here is a copy of the statute to help introduce the concept:

• • • (c) Extraordinary dividend defined

    • For purposes of this section—

      • (1) In general

        • The term “extraordinary dividend” means any dividend with respect to a share of stock if the amount of such dividend equals or exceeds the threshold percentage of the taxpayer’s adjusted basis in such share of stock.

      • (2) Threshold percentage The term “threshold percentage” means—

        • (A) 5 percent in the case of stock which is preferred as to dividends, and

        • (B) 10 percent in the case of any other stock.

      • (3) Aggregation of dividends

        • (A) Aggregation within 85-day period

          • All dividends—

            • (i) which are received by the taxpayer (or a person described in subparagraph (C)) with respect to any share of stock, and

            • (ii) which have ex-dividend dates within the same period of 85 consecutive days, shall be treated as 1 dividend.

        • (B) Aggregation within 1 year where dividends exceed 20 percent of adjusted basis

          •  All dividends—

            • (i) which are received by the taxpayer (or a person described in subparagraph (C)) with respect to any share of stock, and

            • (ii) which have ex-dividend dates during the same period of 365 consecutive days,

              •   shall be treated as extraordinary dividends if the aggregate of such dividends exceeds 20 percent of the taxpayer’s adjusted basis in such stock (determined without regard to this section).

        • (C) Substituted basis transactions

          • In the case of any stock, a person is described in this subparagraph if—

            • •  (i)the basis of such stock in the hands of such person is determined in whole or in part by reference to the basis of such stock in the hands of the taxpayer, or

              • (ii)the basis of such stock in the hands of the taxpayer is determined in whole or in part by reference to the basis of such stock in the hands of such person.

    • (4) Fair market value determination

      • • If the taxpayer establishes to the satisfaction of the Secretary the fair market value of any share of stock as of the day before the ex-dividend date, the taxpayer may elect to apply paragraphs (1) and (3) by substituting such value for the taxpayer’s adjusted basis.

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