Taxation of a New York Statutory Unitrust

Article excerpt

Whether to convert a trust to a unitrust under New York's revised Prudent Investor Act is a difficult question. One issue is how the unitrust will be taxed for income tax purposes and what the tax implications are for income beneficiaries. Recently finalized regulations for IRC section 643 revise the definition of income for trust purposes and provide guidance with respect to unitrust issues.

Background

Effective January 1, 2002, New York Estates, Powers, and Trusts Law (EPTL) section 11-2.4 allows a trustee to elect to redefine trust income as a 4% unitrust amount instead of the amount determined under traditional principal and income rules. For trusts in administration as of January 1, 2002, the election must be made on or before December 31, 2005. For trusts established after January 1, 2002, the election must be made by the end of the second full year of the trust. For both old and new trusts, the election to adopt the unitrust methodology for determining income may be made by the trustee, either with the consent of all interested persons or at the trustee's own discretion.

The IRS Position on Statutory Unitrusts

In the late 1990s, the IRS began considering questions raised by states that were planning to allow trustees to elect the unitrust methodology for determining income. The existing IRC section 643 regulations dated back to the 1950s and were too confusing to apply to unitrust situations, perhaps unnecessarily deterring trustees from electing the unitrust methodology.

In proposing new regulations, the IRS stated that it made amendments in order to "permit trustees to implement a total return investment strategy and to follow the applicable state statutes designed to treat the income and remainder beneficiaries impartially" [Proposed Regulations section 1.643(b); IRB. 2001-16]. Many states have incorporated "elective statutory unitrust" and "trustee's power to adjust" provisions in their prudent investor and principal and income statutes. The new regulations are designed to conform to these statutes.

With respect to state statutory unitrusts, the new regulation honors a definition of accounting income that is determined under a state law unitrust if the payout is between 3% and 5% of the annual fair market value of the trust.

At the end of 2003, the 1RS published the regulations as final effective January 2, 2004 (IRB 2004-5; T.D. 9102). The regulations revise the definition of trust accounting income under IRC section 643(b) and clarify the inclusion of capital gains in distributable net income under section 643(a)-3. The regulations provide guidance for the inclusion of capital gains in the taxable income of beneficiaries in certain unitrust situations.

Treasury Regulations section 1.643(a)-3 states the following:

(a) In general. Except as provided in section 1.643(a)-6 and paragraph (b) of this section, gains from the sale or exchange of capital assets are ordinarily excluded from distributable net income and are not ordinarily considered as paid, credited, or required to be distributed to any beneficiary.

(b) Capital gains included in distributable net income. Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law)

(1) Allocated to income (but if income under the state statute is defined as, or consists of, a unitmst amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph section 1. …