TEN THINGS ESTATE PLANNERS NEED TO KNOW ABOUT INCOME

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TEN THINGS ESTATE PLANNERS NEED TO KNOW ABOUT INCOME Powered By Docstoc
					TEN THINGS ESTATE PLANNERS NEED TO KNOW ABOUT
              INCOME TAX MATTERS




                        BY

                MICKEY R. DAVIS
             BRACEWELL & GIULIANI LLP
              711 Louisiana, Suite 2300
             Houston, Texas 77002–2770
                   (713) 221-1154
              mickey.davis@bgllp.com




   THE SAN ANTONIO ESTATE PLANNERS COUNCIL'S
         DOCKET CALL IN PROBATE COURT

                San Antonio, Texas
                February 16, 2007
        TEN THINGS ESTATE PLANNERS NEED TO KNOW ABOUT INCOME TAX MATTERS

                                                              TABLE OF CONTENTS

                                                                                                                                                                Page

I.     INTRODUCTION AND OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                               1
       A.  Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         1
       B.  Scope. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      1
       C.  Importance of Subchapter J. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                   1
       D.  Approach of this Outline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 1

II.    OVERVIEW OF TRUST AND ESTATE TAXATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                               1
       A.  Simple Trusts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        1
           1.     Mandatory Income Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                         1
           2.     No Charitable Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                    1
           3.     No Distributions in Excess of Current Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                               2
           4.     Effect of Simple Trust Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                       2
       B.  Estates and Complex Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  2
           1.     Treatment as a Complex Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                       2
           2.     Impact of Complex Trust Treatment Upon Distributions of Current Income . . . . . . . . . . . . .                                                     2
           3.     Other Effects of Complex Trust Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                               2
                  a.     Income Retained by the Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                          2
                  b.     Application of the "Tier Rules" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                           2
                  c.     Undistributed Net Income, and the Accumulation Distributions and the Throwback
                         Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           3
           4.     Special Distribution Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                   3
                  a.     Specific Bequests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                   3
                  b.     Gain on Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                     3
                  c.     DNI Carry-out of In-Kind Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                3
                  d.     The 65 Day Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                   3
                  e.     Distributions Discharging Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                               3
                  f.     Grantor Trust Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                     3
           5.     Recent Rules Equating Trusts with Estates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                              3
           6.     Rules Equating Estates with Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                         4
                  a.     The 65 Day Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                   4
                  b.     The Separate Share Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                       4
                  c.     Extension of the "Related Party" Rules to Estates . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                     4
           7.     Repeal of Accumulation Distribution Rules and Section 644 . . . . . . . . . . . . . . . . . . . . . . . . .                                          4
                  a.     Continued Application to Foreign Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                 4
                  b.     Pre-March '84 Multiple Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                           4
                  c.     Sales within Two Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                        4

III.   THE TOP TEN THINGS THAT ESTATE PLANNERS NEED TO KNOW ABOUT INCOME TAX
       MATTERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4
       1.   ESTATE DISTRIBUTIONS CARRY OUT DISTRIBUTABLE NET INCOME . . . . . . . . . . . . . . . . . . . . . . .                                                      4
            a.    Specific Sums of Money and Specific Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                 5
                  i.         Requirement of Ascertainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                       5
                  ii.        Formula Bequests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                5
                  iii.       Payments from Current Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                          5
                  iv.        Distributions of Real Estate Where Title has Vested . . . . . . . . . . . . . . . . . . . . . . . . . .                                   5
            b.    The Separate Share Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                    6
            c.    Income From Property Specifically Bequeathed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                   6
            d.    Interest on Pecuniary Bequests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                       7
       2.   AN ESTATE MAY RECOGNIZE GAINS AND LOSSES WHEN IT MAKES DISTRIBUTIONS IN KIND . . .                                                                         7
            a.    Distributions Satisfying the Estate's Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                              7
            b.    Distributions of Assets to Fund Pecuniary Gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                7
            c.    Pension and IRA Accounts Used to Fund Pecuniary Bequests . . . . . . . . . . . . . . . . . . . . . . . .                                             8
                  i.         No Receipt By Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  8
                  ii.        No IRD Transfer by Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                     8
                  iii.       Constructive Receipt Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                      8
                  iv.        Proper Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  8
     d.   Section 643(e)(3) Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.   ESTATE BENEFICIARIES MAY RECOGNIZE GAINS AND LOSSES IF THE ESTATE MAKES
     UNAUTHORIZED NON PRO RATA DISTRIBUTIONS IN KIND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4.   INCOME IN RESPECT OF A DECEDENT IS TAXED TO THE RECIPIENT . . . . . . . . . . . . . . . . . . . . . . . . 9
     a.   IRD Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
     b.   Recognizing IRD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
     c.   Deductions in Respect of a Decedent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
5.   IMPACT OF DEATH UPON BASIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
     a.   General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
     b.   Exceptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
          i.      No New Basis for IRD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
          ii.     No New Basis for Deathbed Transfers to Decedent . . . . . . . . . . . . . . . . . . . . . . . . . . 10
6.   THE EXECUTOR CAN ELECT TO DEDUCT MANY EXPENSES FOR EITHER INCOME OR ESTATE TAX
     PURPOSES (BUT NOT BOTH) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
     a.   Section 642(g) Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
     b.   Method of Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
     c.   Payments From Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
     d.   Regulatory Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
     e.   Estate Management Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
     f.   Estate Transmission Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
     g.   Reduction for Unrelated Estate Management Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
     h.   Special Rule for Estate Management Expenses Deducted on Estate Tax Return . . . . . . . . . . 12
     i.   Effective Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
7.   WHEN AN ESTATE OR TRUST ALLOCATES "INCOME," THAT MEANS FIDUCIARY ACCOUNTING
     INCOME, NOT TAXABLE INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
     a.   Look to the Governing Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
     b.   "Fair and Reasonable" Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
     c.   Specific Trust Code Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
          i.      Terms of the Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          ii.     Grants of Discretionary Authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          iii.    Application of the Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          iv.     When in Doubt, It's Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          v.      Fair and Reasonable Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
     d.   Accrued Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          i.      General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          ii.     Trapping Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          iii.    Post-Death Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
     e.   Receipts from Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
          i.      Application to "Entities" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          ii.     General Rule–Distributions are Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          iii.    When Distributions are Not Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          iv.     Partial Liquidations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          v.      Information from the Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
     f.   Business and Farming Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          i.      Treatment as a Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          ii.     Cash Flow vs. Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          iii.    Types of Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
          iv.     Comparing Former Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
     g.   Interest and Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
     h.   Deferred Compensation, Annuities, and Similar Payments . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          i.      Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          ii.     New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
     i.   Liquidating Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          i.      Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          ii.     New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
     j.   Minerals, Water and Other Natural Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          i.      Specific Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          ii.     "Equitable" Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          iii.    Compare Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          iv.     "Deemed" Equitable Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
          v.      Affect on Depletion Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
     k.   Timber. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
                     i.     Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       16
                     ii.    New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         16
                     iii.   Applying Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              16
                l.   Underproductive Property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              16
                     i.     Prior Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       16
                     ii.    New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         16
                m.   Other Sales Proceeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         16
                n.   Equitable Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          16
                o.   Allocation of Disbursements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              17
                     i.     Allocations to Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              17
                     ii.    Administration Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 17
                p.   Allocations to Principal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        17
                     i.     Trustee and Other Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              17
                     ii.    Expenses that Affect Principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  17
                     iii.   Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        17
                     iv.    Reserves for Extraordinary Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                       17
                     v.     Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     17
                     vi.    Taxes Attributable to Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                  17
                     vii.   Taxes from Pass-Through Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                      17
                     viii. Equitable Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                17
                q.   Unitrusts and the Power to Adjust. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 17
                     i.     Unitrusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     17
                     ii.    The Power to Adjust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .             18
                     iii.   Statement of the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              18
                     iv.    Availability of the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .               18
                     v.     Limitations of the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                18
                     vi.    Comments on the Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 19
      8.        NON-PRO RATA DIVISIONS OF COMMUNITY PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                    19
      9.        DEDUCTION OF INTEREST PAID ON PECUNIARY BEQUESTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                                    19
      10.       UNDERSTANDING THE GRANTOR TRUST RULES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                             20
                a.   Reversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   20
                b.   Power to Revoke . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        20
                c.   Retention of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        20
                d.   Retention of Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         21
                e.   Certain Administrative Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                21
                f.   Section 678 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    21
                     i.     Power to Vest Trust Property in One's Self . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                          21
                     ii.    Releases of Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .            22
                     iii.   Renunciations of Powers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 22
                g.   Gift and Estate Taxation of Grantor Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                     22

IV.   CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Income Tax Matters                                                                                                    1



TEN THINGS ESTATE PLANNERS NEED TO                                 Most estate planners can summarize their
KNOW ABOUT INCOME TAX MATTERS                                understanding about estate and trust income tax issues
                                                             by citing two rules: (i) an inheritance is income tax free
I.   INTRODUCTION AND OVERVIEW                               to the recipient; and (ii) assets get a step-up in basis at
                                                             death. These rules are at best overly simplistic, and at
A.    Overview.                                              worst, downright misleading. This outline points out a
      The goal of this outline is to provide some            number of income tax notions that every estate planner
practical guidelines on estate planning and admini-          should know, whether in the process of administering
stration from a federal income tax viewpoint. The            an estate or while designing sophisticated income or
outline provides a review of general federal income tax      wealth shifting techniques. The goal of the outline is
rules applicable to estates and trusts. It then focuses on   not to explain how to undertake these complex estate
ten income tax issues with which every estate planner        planning or administration efforts. Rather, it seeks to
should be familiar.                                          provide essential background knowledge about income
                                                             tax issues that are fundamental to the practice of estate
B.    Scope.                                                 planning.
      This outline provides a brief overview of general
fiduciary tax principles, but does not purport to be a       II. OVERVIEW OF TRUST AND ESTATE
detailed analysis of Subchapter J of the Internal            TAXATION
Revenue Code of 1986 (the "Code"). For the most part,
this outline assumes that the reader has a passing                A brief review of the fundamental principles of
familiarity with important federal income tax issues         income taxation of trusts and estates serves as a useful
associated with the administration of trusts and estates.    background. Trusts fall into one of two categories,
The outline reviews recent changes to the fiduciary          simple or complex. In general, estates are taxed as
income tax arena brought about by Congress and the           though they were complex trusts.
IRS. In addition, since they now play an increasingly
important role in sophisticated estate planning, a brief     A.    Simple Trusts.
overview of the grantor trust rules is provided.                   To qualify as a simple trust, a trust must satisfy
                                                             three requirements.
C.     Importance of Subchapter J.
       Attorneys tend to de-emphasize federal income         1. Mandatory Income Distributions. The first
tax issues in estate planning and administration, since      requirement for simple trust treatment is that the trust
they usually do not do income tax compliance work for        must, by its terms, require the trustee to distribute all
estates and trusts. There is a strong and growing belief,    income at least annually. I.R.C. § 651(a)(1). "Income"
however, that income taxation of trusts, estates,            for this purpose means fiduciary accounting income
grantors and beneficiaries will become increasingly          determined under local law -- not taxable income.
important. The increase in the unified credit, the           I.R.C. § 643(b). As discussed in detail below, this
prevalent use of the unlimited marital deduction, and        provision is an area where the application of state law
the generous generation-skipping tax exemption all           can have a controlling impact upon the income taxation
have resulted in a decline in the number of estates for      of the entity and its beneficiaries. In Texas, "fiduciary
which transfer taxes are due. Increasing use of bypass,      accounting income" is determined under the Texas
marital deduction, and generation-skipping trusts            Trust Code and the relevant provisions of the governing
suggests that more and more wealth, and the income           instrument. For periods beginning January 1, 2004, the
resulting from that wealth, can be expected to be held       relevant provisions are those of the new Texas Uniform
in trust. In addition, in a setting in which income tax      Principal and Income Act described below. Note that
brackets for trusts are highly compressed, the IRS can       to qualify as a simple trust, the trustee need not
be expected to focus increased attention to the              distribute all of its taxable or distributable net income.
application of the grantor trust rules which seek to shift   Note also that "income" refers to the amount of income,
the tax liability for trust income away from the trust       not the actual physical identification or labeling of the
itself. In short, we can expect the government to devote     distributed asset on the trustee's books of account.
more of its enforcement resources to the long-neglected      Thus, even if the trustee distributes an asset categorized
area of income taxation of decedents, estates, trusts, and   on the trustee's books as corpus, that distribution will
beneficiaries. Careless inattention to the federal income    nevertheless be treated as carrying out the trust's
tax principles associated with planning and                  income, to the extent that the trust has income as of the
administration can not only increase overall taxes paid      last day of its fiscal year.
by a family, but can also result in unintended shifts in
the beneficial interests of distributees.                    2. No Charitable Distributions.            The second
                                                             requirement to qualify as a simple trust is that the trust
D.   Approach of this Outline.                               must not provide that any amounts are to be paid,
2                                                                         2007 DOCKET CALL IN PROBATE COURT



permanently set aside, or used for charitable purposes.       2. Impact of Complex Trust Treatment Upon
I.R.C. § 651(a)(2).                                           Distributions of Current Income. To the extent current
                                                              income is distributed, it doesn't matter whether the trust
3. No Distributions in Excess of Current Income.              is simple or complex. Both trusts get a distribution
Finally, to qualify as a simple trust, the trust must make    deduction that washes out the distributable net income.
no actual distributions of corpus in the particular tax       I.R.C. §§ 651(a); 661(a)(1). Beneficiaries include the
year in question. I.R.C. § 651(a). The precise rule is        income on their income tax returns subject to the same
that simple trust treatment does not apply in any year        timing and characterization rules. If distributions are
that the trust distributes amounts in excess of its           made to multiple beneficiaries, they generally include
fiduciary accounting income. Of course, for this              that income on their respective income tax returns pro
purpose, the trustee can distribute any assets, whether       rata in proportion to the total amount that each
they are received with an income label or held as part of     beneficiary receives. I.R.C. §§ 652(b) and (c); 662(b)
corpus, but they will be regarded as income distribu-         and (c).
tions so long as the aggregate value of all distributions
for the year do not exceed the amount of fiduciary            3. Other Effects of Complex Trust Treatment. The
accounting income for the year. The trust loses simple        key difference between simple and complex trusts is the
trust status only if "corpus" is distributed in the sense     treatment of accumulated income, and the treatment of
that the value of all property distributed during the year    distributions made among mandatory vs. discretionary
exceeds the amount of fiduciary accounting income for         distributees.
the year.
                                                              a. Income Retained by the Trust. When an estate or
4. Effect of Simple Trust Treatment. If the trust             complex trust retains taxable income, the entity itself
meets the three-part test for a simple trust, the trust is    becomes a taxpayer. The trust or estate must pay tax on
generally taxed as a conduit. The trust is allowed a          taxable income in excess of its distribution deduction.
distribution deduction that washes ordinary income of         This retained net income may thereafter be held as part
the trust out to the beneficiaries. The amount and            of the principal under local law, but the governing
character of the income passes through pro rata to the        instrument may provide for different treatment.
recipients, unless the instrument validly directs a           Distributions that exceed current income are treated as
different allocation of various items of income.              a distribution of corpus, which are tax free to the
Conduit taxation, measured by the notation of                 beneficiary under Code Section 102.
"Distributable Net Income ("DNI") as defined in
Section 643(a) of the Code, is much as though the             b. Application of the "Tier Rules". The so-called
beneficiaries owned the income-producing property             "tier rules" are designed to address the problem that
themselves and earned the income directly (except to          arises by the general pro rata carry-out rules for DNI
the extent that fiduciary accounting income differs from      when a trust makes distributions of income to both
distributable net income). Until the recent modification      mandatory and discretionary income beneficiaries. DNI
of Treasury Regulation 1.643(a)-3, capital gains were         is allocated first to "Tier I distributions," which are
virtually never distributable from the trust, except in its   either required current distributions of income, or
final year. The new Regulation substantially broadens         income used for any required distribution. I.R.C.
the circumstances under which capital gains may be            § 662(a)(1). Tier II distributions are all other distrib-
passed out to the trust's beneficiaries.                      ution, whether required or discretionary, and whether
                                                              made from current income, accumulated income, or
B.   Estates and Complex Trusts.                              corpus. I.R.C. § 662(a)(2).

1. Treatment as a Complex Trust. Any trust that is            Example 1: A trust instrument requires the trustee to
not a simple trust is complex, and all estates are taxed      distribute $50,000 of income to A each year, and
as though they were complex trusts. Often, a trust is         permits the trustee to distribute to B as much principal
complex merely because its terms do not require the           and income as B may require. In a year in which the
distribution of all income annually. Even non-                trust has $60,000 of taxable income, the trustee makes
accumulation trusts may be complex because they               distributions totaling $50,000 to A, and $25,000 to B.
provide for charity, or make distributions in excess of       If the general pro rata rules were applied to these
income. An otherwise simple trust which makes excess          distributions, A would report $40,000 of taxable
distributions in some years but not in others (e.g.,          income ($60,000 x ($50,000/$75,000)) and B would
discretionary distributions of principal, or distributions    report $20,000 ($60,000 x ($25,000/$75,000)). In other
in the year of termination), can be complex in some           words, income would be reported in the ratio of the
years and simple in others.                                   total distributions made to each beneficiary. The tier
                                                              rules, however, require instead that all DNI be allocated
                                                              first to A to the extent of the required distribution
Income Tax Matters                                                                                                   3



($50,000), with only the balance ($10,000) allocated to     out to the extent of the lesser of basis or fair market
B–a result much more in keeping with the terms of the       value of the asset. However, the executor or trustee
trust agreement's description of the distributions.         may elect to treat the distribution as a realization event,
Except in the limited circumstances noted in the            with the corresponding basis adjustment and effect on
following paragraph, the balance of the distribution to     the DNI carry out. I.R.C. § 643(e)(3).
B ($15,000) is treated as a tax-free distribution of
corpus.                                                     d. The 65 Day Rule. If the trustee of a complex trust
                                                            (or an executor) makes a distribution during the first 65
c. Undistributed Net Income, and the Accumulation           days of its tax year, it may elect to treat those
Distributions and the Throwback Rules. For years prior      distributions as having been made on the last day of the
to 1998, regardless of whether a trust's retained income    prior year. If this election is made, DNI for the prior
was treated as principal or income under the governing      year will be carried out and reported by the distributees
instrument, it was required to be tracked by the trustee    as though they actually received the distribution on the
as "undistributed net income" (UNI) for income tax          last day of the trust or estate's prior year. I.R.C.
purposes. I.R.C. § 665(a). Distributable net income         § 663(b).
not distributed to beneficiaries in a given year, net of
the amount of the taxes paid by the trust, was known as     e. Distributions Discharging Obligations. Theoreti-
UNI, available for distribution in future years. The        cally, distributions that discharge a person's legal
later distribution of this UNI was referred to as an        obligation to the recipient of the distribution will cause
"accumulation distribution." The throwback rules            the obligated person to be treated as the beneficiary.
imposed an additional tax upon accumulation                 Treas. Reg. § 1.643(c)-1(a). Neither this regulation nor
distributions that was designed to be a rough               Treasury Regulation Section 1.662(a)-4, which also
approximation of the tax that the ultimate beneficiary      deals with distributions discharging legal obligations,
would have paid in the year that the income was             has been litigated.
recognized by the trust, as if there had been no
accumulation. This tax was measured by a series of          f.    Grantor Trust Rules. If a trust is characterized as
computations which sought to approximate the                a "grantor trust," then the grantor trust rules are given
additional tax that would have paid if an average           preference over the foregoing rules taxing income to the
distribution had been made to the beneficiary in a          trust or its beneficiaries. I.R.C. § 671. The grantor
typical year. The Taxpayer Relief Act of 1997 repealed      trust rules are discussed below, beginning at page 20
the accumulation distribution and throwback rules for
distributions after 1997, except for distributions from     5. Recent Rules Equating Trusts with Estates. For
trusts formed before March 1, 1984, and then only for       the most part, estates and trusts are treated the same for
distributions to a beneficiary who is entitled to receive   income tax purposes after the grantor's death.
distributions from multiple trusts formed for tax           Historically, there have been several relatively minor
avoidance purposes. I.R.C. § 665(c).                        differences, though, most of which gave estates a slight
                                                            edge from an income tax standpoint over post-death
4. Special Distribution Rules. The general rules            revocable trusts used as estate surrogates. The
outlined above are subject to a number of exceptions        Taxpayer Relief Act of 1997 largely eliminated these
and refinements. For example:                               differences. Under the new rules, after a grantor's
                                                            death, the trustee of a revocable trust created by the
a. Specific Bequests. Distributions of specific             grantor, and the executor of the grantor's estate (if any),
bequests, devises or legacies do not carry out DNI.         may irrevocably elect to treat a "qualified revocable
I.R.C. § 663(a)(1).                                         trust" as part of the grantor's estate for income tax
                                                            purposes. I.R.C. § 645. This election should cure a
b. Gain on Distributions. Distributions of property         whole array of potential income tax disparities,
in kind (as opposed to cash) to satisfy an obligation of    including, but not limited to, fiscal year-end selection,
the entity, including an obligation to make distributions   holding periods for S stock, waiver of active
of income to a beneficiary, are effectively treated as a    participation for passive losses, use of the $600
sale or exchange of the distributed property by the trust   allowance in lieu of personal exemption, income tax
or estate that may generate gain or loss (and               deductions for charitable set asides, Section 194
correspondingly adjust basis), and carry out DNI to the     amortization of reforestation expenditures, avoidance of
extent of the fair market value of the property. Rev.       estimated tax payment requirements for two years, etc.
Rul 68-392, 1968-2 CB 284.                                  The election must be made on the estate's first timely
                                                            income tax return (including extensions), and applies
c. DNI Carry-out of In-Kind Distributions. In-kind          until "the date which is 6 months after the date of the
distributions that are not themselves gain realization      final determination of the liability for tax imposed by
events are governed by Section 643(e). DNI is carried
4                                                                        2007 DOCKET CALL IN PROBATE COURT



chapter 11," or if no estate tax return is due, two years   a. Continued Application to Foreign Trusts. The
after the date of death.                                    repeal does not apply to foreign trusts, or (except to the
                                                            extent permitted by regulations) to domestic trusts that
6. Rules Equating Estates with Trusts. In those few         were at one time foreign trusts. I.R.C. § 665(c)(1).
areas where revocable trusts held the edge over estates,
changes were made to bring estates in line with trusts.     b. Pre-March '84 Multiple Trusts. The repeal also
Thus:                                                       does not apply to trusts created before March 1, 1984
                                                            unless it can be established that the "multiple trust" rule
a. The 65 Day Rule. The 65-day rule is extended to          described in Section 643(f) does not apply. I.R.C.
estates, so that an executor who makes distributions        § 665(c)(2). Section 643(f) applies to aggregate
during the first 65 days of an estate's fiscal year can     multiple trusts if: (i) the trusts have substantially the
treat them as having been made during the prior year.       same grantor and primary beneficiary; and (ii) a
This rule allows post-year-end planning to minimize         principle purpose of the trusts is the avoidance of
DNI left in an estate. I.R.C. § 663(b).                     income tax. Note that the statute seems to require the
                                                            taxpayer to establish the non-applicability of the
b. The Separate Share Rule. The "separate share             multiple trust rule. Therefore, beneficiaries of pre-
rule" is applied to estates. This rule acts as an           March 1, 1984 trusts may still be required to undertake
exception to the general rule that DNI gets carried out     this computation if they are beneficiaries of more than
pro rata based upon distributions made in any given         one trust created by the same grantor.
year. Instead, by applying the separate share rule, DNI
is allocated to estate beneficiaries based upon             c. Sales within Two Years. Also repealed is the
distributions of their respective "share" of the estate's   somewhat related rule taxing trusts that sell property
DNI. I.R.C. § 663(c). The IRS has now issued final          within two years of contribution at the tax rate of the
regulations applying the separate share rules to estates.   grantor. This change applies to sales or exchanges after
See T.D. 8849, 2000-2 I.R.B. 245; Treas. Reg.               the date of enactment. Former I.R.C. § 644.
§ 1.663(c)-4.
                                                            III. THE TOP TEN THINGS THAT ESTATE
c. Extension of the "Related Party" Rules to Estates.       PLANNERS NEED TO KNOW ABOUT INCOME
In one area that estates held an edge, the advantage was    TAX MATTERS
taken away to a certain degree. Specifically, the
"related party" rules, which prohibit recognition of              With apologies to David Letterman, here is my
losses in transactions between related parties, were        own personal list of the top ten income tax issues that
extended to transactions between an estate and its          every estate planner should know. I don't pretend to
beneficiaries. They continue to apply to trusts and their   present them in order of importance (or, for that matter,
beneficiaries. The new rules do not apply, however, to      in any particular order). There are certainly other
disallow losses if depreciated assets are used to fund      income tax issues that merit consideration. (Send your
pecuniary gifts. I.R.C. § 267(b)(13). Qualified             favorites to me at mdavis@mrd-law.com. I'll try to
revocable trusts can now get this same post-death loss      work them into the next version of this outline.)
recognition treatment when funding pecuniary gifts by       Mastery of these ten, however, should give you a good
electing to be treated as estates under new Section 645.    background in fundamental income tax issues that arise
                                                            in the estate planning and administration context.
7. Repeal of Accumulation Distribution Rules and            Most estate planners think of an inheritance as being
Section 644. As noted above, the accumulation               free from income tax. I.R.C. § 102(a). Nevertheless, I
distribution throwback rules are repealed for most trusts   start my "top ten list" with four important income tax
for distributions made in years beginning after             issues that arise when estate assets are distributed.
August 5, 1997. These rules sought to impose                These areas are the carry out of estate income; the
additional income taxes on beneficiaries who received       recognition of gain by the estate at the time of funding
a distribution from a trust that had accumulated income     certain gifts; the impact upon beneficiaries of making
in prior years at marginal rates lower than the             unauthorized non-pro rata distributions of assets in
beneficiary's. The goal of the tax was to keep trustees     kind; and the impact of distributing IRD assets. The
from accumulating income in years when the trust's tax      income tax effect of estate distributions is an important
brackets were lower than the beneficiary's, and then        area both in terms of language included in the
distributing that accumulated income in later years.        governing instrument and the steps taken and elections
The tax computation was complex, and ever since the         made by the executor in the administration of the estate.
advent of trust income tax rate compression (which
started in 1986), rarely resulted in any additional tax     1. E STATE D ISTRIBUTIONS C ARRY O UT
being paid. I.R.C. § 665(c).                                DISTRIBUTABLE NET INCOME. The general rule is that
Income Tax Matters                                                                                                      5



any distribution from an estate will carry with it a          the estate's beneficiaries will not be taxed on the estate's
portion of the estate's distributable net income ("DNI").     DNI as a result of the distribution.
Estate distributions are generally treated as coming first
from the estate's current income, with tax free               i.    Requirement of Ascertainability. In order to
distributions of "corpus" arising only if distributions       qualify as a gift or bequest of "a specific sum of
exceed DNI. If distributions are made to multiple             money" under the Treasury Regulations, the amount of
beneficiaries, DNI is allocated to them pro rata.             the bequest of money or the identity of the specific
                                                              property must be ascertainable under the terms of the
Example 2: Assume A and B are beneficiaries of an             governing instrument as of the date of the decedent's
estate worth $1,000,000. During the year, the executor        death. In the case of the decedent's estate, the
distributes $200,000 to A and $50,000 to B. During the        governing instrument is the decedent's Will.
same year, the estate earns income of $100,000. Unless
the separate share rule discussed at page 6 below             ii. Formula Bequests. Under the Treasury Regula-
applies, the distributions are treated as coming first        tions, a marital deduction or credit shelter formula
from estate income, and are treated as passing to the         bequest typically does not qualify as a gift of "a specific
beneficiaries pro rata. Therefore, A will report income       sum of money." The identity of the property and the
of $80,000 ($100,000 x ($200,000/$250,000)); B will           exact sum of money specified are both dependent upon
report income of $20,000 ($100,000 x                          the exercise of the executor's discretion. For example,
($50,000/$250,000)). The estate will be entitled to a         if the executor elects to deduct administration expenses
distribution deduction of $100,000. If the estate had         on the estate's income tax return, the amount of the
instead distributed only $50,000 to A and $25,000 to B,       formula marital gift will be higher than if those
each would have included the full amount received in          expenses are deducted on the estate tax return. Since
income, the estate would have received a $75,000              the issues relating to the final computation of the
distribution deduction, and would have reported the           marital deduction or credit shelter bequest cannot be
remaining $25,000 as income on the estate's income tax        resolved on the date of the decedent's death, the IRS
return.                                                       takes the position that the bequest will not be
                                                              considered "a specific sum of money." Treas. Reg.
Section 663 (b) of the Code has permitted complex             § 1.663(a)-1(b)(1); Rev. Rul. 60-87, 1960-1 C.B. 286.
trusts to treat distributions made during the first 65 days   Thus, funding of formula bequests whose amounts
of the trust's tax year as though they were made on the       cannot be ascertained at the date of death does carry out
last day of the preceding tax year. This election enables     distributable net income from the estate.
trustees to take a second look at DNI after the trust's
books have been closed for the year, to shift income out      iii. Payments from Current Income. In addition,
to beneficiaries. The Taxpayer Relief Act of 1997             amounts that an executor can pay, under the express
extends the application of the 65 day rule to estates for     terms of the will, only from current or accumulated
tax years beginning after August 5, 1997. As a result,        income of the estate will carry out the estate's
for example, the executor of an estate can make               distributable net income. Treas. Reg. § 1.663(a)-
distributions during the first 65 days of Year 2, and         1(b)(2)(i).
elect to treat them as though they were made on the last
day of Year 1. If the executor makes this election, the       iv. Distributions of Real Estate Where Title has
distributions carry out the estate's Year 1 DNI, and the      Vested. The transfer of real estate does not carry out
beneficiaries include the distributions in income as          DNI when conveyed to the devisee thereof if, under
though they were received on the last day of the estate's     local law, title vests immediately in the distributee,
Year 1 fiscal year.                                           even if subject to administration. Treas. Reg.
                                                              § 1.661(a)-2(e); Rev. Rul. 68-49, 1968-1 C.B. 304.
The general rule regarding DNI carry-out is subject to        Title vests immediately under Section 37 of the Texas
some important exceptions.                                    Probate Code. See Welder v. Hitchcock, 617 S.W.2d
                                                              294, 297 (Tex. Civ. App.--Corpus Christi 1981, writ
a. Specific Sums of Money and Specific Property.              ref'd n.r.e.). Therefore, a transfer by an executor of real
Section 663(a)(1) of the Code contains a special              property to the person or entity entitled thereto should
provision relating to gifts or bequests of "a specific sum    not carry with it any of the estate's distributable net
of money" or "specific property." If the executor pays        income. Presumably, this rule applies both to specific
these gifts or bequests all at once, or in not more than      devisees of real estate and to devisees of the residue of
three installments, the distributions will effectively be     the estate. Otherwise, the no-carry-out rule would be
treated as coming from the "corpus" of the estate. As a       subsumed within the more general rule that specific
result, the estate will not receive a distribution            bequests do not carry out DNI. Rev. Rul. 68-49,
deduction for these distributions. By the same token,         1968-1 C.B. 304. Note, however, that the IRS Office of
                                                              the Chief Counsel recently released an IRS Service
6                                                                         2007 DOCKET CALL IN PROBATE COURT



Center Advice Memorandum (SCA 1998-012) which                Apparently, application of the separate share rules to
purports to limit this rule to specifically devised real     estates was simply one of a host of small statutory
estate (not real estate passing as part of the residuary     changes that sought to bring the taxation rules for trusts
estate) if the executor has substantial power and control    and estates in line with one another. In practice,
over the real property (including a power of sale).          however, application of the separate share rules to
                                                             estates may prove to be very complex. Unlike separate
b. The Separate Share Rule. Generally, in the                share trusts, which are typically divided on simple
context of estate distributions made to multiple             fractional lines (e.g., "one-third for each of my
beneficiaries, DNI is carried out pro rata among the         children") the "shares" of estates may be hard to
distributees of the estate. For example, in a year in        identify, let alone account for. Under the final
which the estate has $10,000 of DNI, if the executor         Regulations, a revocable trust that elects to be treated as
distributes $15,000 to A and $5,000 to B, A will             part of the decedent's estate is a separate share. The
include $7,500 of DNI in his income, and B will              residuary estate (and each portion of a residuary estate)
include $2,500 in his income, since the distributions        is a separate share. A share may be considered as
were made 75% to A and 25% to B. The Taxpayer                separate even though more than one beneficiary has an
Relief Act of 1997 has made a substantial modification       interest in it. For example, two beneficiaries may have
to the pro rata rule by applying the "separate share rule"   equal, disproportionate, or indeterminate interests in
to estates. Under this rule, DNI is allocated among          one share which is economically separate and
estate beneficiaries based upon distributions of their       independent from another share in which one or more
respective "share" of the estate's DNI. I.R.C. § 663(c).     beneficiaries have an interest. Moreover, the same
The Committee Report describing this change provides         person may be a beneficiary of more than one separate
that there are separate shares of an estate "when the        share. A bequests of a specific sum of money paid in
governing instrument of the estate (e.g., the will and       more than three installments (or otherwise not
applicable local law) creates separate economic              qualifying as a specific bequest under Section 663(a)(1)
interests in one beneficiary or class of beneficiaries       of the Code) is a separate share. If the residuary estate
such that the economic interests of those beneficiaries      is a separate share, than presumably pre-residuary
(e.g., rights to income or gains from specific items of      pecuniary bequests (such as marital deduction formula
property) are not affected by economic interests             bequests) are also separate shares. For a good
accruing to another separate beneficiary or class of         discussion of some of the complexities associated with
beneficiaries."      The IRS has now issued final            the application of the separate share rules to estates, see
regulations applying the separate share rules to estates.    Cantrell, Separate Share Regulations Propose
See T.D. 8849, 2000-2 I.R.B. 245; Treas. Reg.                Surprising Changes, TRUSTS & ESTATES, March 1999
§ 1.663(c)-4. As a result of this change, the executor       at 56.
will have to determine whether the Will (or the intestate
succession law) creates separate economic interests in       c. Income From Property Specifically Bequeathed.
one beneficiary or class of beneficiaries.                   The 2003 Texas Legislature enacted two major pieces
                                                             of legislation that affect the administration of trusts in
Example 3: A Will bequeaths all of the decedent's            Texas. These statutes, the Uniform Prudent Investor
IBM stock to X and the balance of the estate to Y.           Act and the Uniform Principal and Income Act (dubbed
During the year, the IBM stock pays $20,000 of               by the estate planning community as the "UPIA
dividends. No other income is earned. The executor           Twins") apply to all trusts existing on or created after
distributes $20,000 to X and $20,000 to Y. Prior to the      January 1, 2004. For existing trusts, the new rules
adoption of the separate share rule, the total               apply to all acts or decisions relating to the trust
distributions to X and Y would have simply been              occurring after December 31, 2003. Section 378B of
aggregated and the total DNI of the estate in the year of    the Probate Code now provides that income from the
distribution would have been carried out pro rata.           assets of a decedent's estate that accrues after the date
Under the separate share rules, the distribution of          of death of the testator and before distribution, is to be
$20,000 to X carries out all of the DNI to X. No DNI         allocated as provided in the Texas Uniform Principal
is carried out to Y. Thus, application of the separate       and Income Act. See also Zahn v. National Bank of
share rule more accurately reflects the economic             Commerce, 328 S.W.2d 783 (Tex. Civ. App.--Dallas,
interests of the beneficiaries resulting from estate         1954, writ ref'd n.r.e.). Historically, if the property was
distributions.                                               distributed by the estate, together with the income to
                                                             which the devisee was entitled, the distribution of
Distributions to beneficiaries who don't have "separate      income might or might not have been treated as taxable
shares" continue to be subject to the former "pro rata"      income by the beneficiary. Until the adoption of the
rules. As noted above, application of the separate share     separate share rules, DNI was distributed on a pro rata
rule is mandatory. The executor doesn't elect separate       basis among all beneficiaries receiving distributions.
share treatment, nor may it be elected out of.               The items of income were not specifically identified
Income Tax Matters                                                                                                    7



and traced. As a result, the beneficiary may well have       by an in-kind distribution to a beneficiary is the lesser
been taxed not on the income item actually received,         of the adjusted basis of the property prior to
but on his or her pro rata share of all income distributed   distribution, or the fair market value of the property at
to beneficiaries. However, since the income earned on        the time of the distribution. I.R.C. § 643(e). The estate
property specifically bequeathed appears to be a             does not generally recognize gain or loss as a result of
"separate economic interest . . .", the separate share       making a distribution to a beneficiary. This general
rules should change this result. This change means that      rule is subject to some important exceptions.
if an estate makes a current distribution of income from
specifically bequeathed property to the devisee of the       a. Distributions Satisfying the Estate's Obligations.
property, the distribution will carry the DNI associated     Distributions which satisfy an obligation of the estate
with it out to that beneficiary, regardless of the amount    are recognition events for the estate. The fair market
of the estate's other DNI or distributions. If the estate    value of the property is treated as being received by the
accumulates the income past the end of its fiscal year,      estate as a result of the distribution, and the estate will
the estate itself will pay tax on the income. When the       recognize any gain or loss if the estate's basis in the
income is ultimately distributed in some later year, the     property is different from its fair market value at the
beneficiary will be entitled to only the net (after tax)     time of distribution. Rev. Rul. 74-178, 1974-1 C.B.
income under Section 378B of the Texas Probate Code.         196. Thus, for example, if the estate owes a debt of
In addition, the later distribution should not carry out     $10,000, and transfers an asset worth $10,000 with a
DNI under the separate share rules, since it is not a        basis of $8,000 in satisfaction of the debt, the estate
distribution of current income, and since the                will recognize a $2,000 gain.
accumulation distribution throwback rules (which still
apply to certain pre-1985 trusts) do not apply to estates.   b. Distributions of Assets to Fund Pecuniary Gifts.
As this example illustrates, the separate share rules,       A concept related to the "discharge of obligation"
while complex to administer, have the advantage of           notion is a distribution of assets to fund a bequest of "a
making the income tax treatment of estate distributions      specific dollar amount," including a formula pecuniary
more closely follow economic reality.                        bequest.

d. Interest on Pecuniary Bequests. The Texas                 Example 4. A formula gift requires an executor to
Uniform Principal and Income Act requires that a             distribute $400,000 worth of property. If the executor
devisee of a pecuniary bequest (that is, a gift of a fixed   funds this bequest with assets worth $400,000 at the
dollar amount), whether or not in trust, is entitled to      time of distribution, but worth only $380,000 at the date
interest on the bequest, beginning one year after the        of death, the estate will recognize a $20,000 gain.
date of death. Tex. Prop. Code § 116.051(3). The
amount of interest that will be paid on pecuniary            The rules governing this area should not be confused
bequests is the legal rate of interest on open accounts      with the "specific sum of money" rules which govern
provided for under Section 302.002 of the Texas              DNI carry outs. Unless the formula language is drawn
Finance Code (currently, six percent). The provision         very narrowly, most formula gifts do not constitute gifts
for paying interest on pecuniary bequests does not limit     of a "specific sum of money," exempt from DNI
itself to payments from estate income. The executor          carryout, because they usually cannot be fixed exactly
must charge this "interest" expense to income in             at the date of death (for example, most formula marital
determining the estate's "net" income to be allocated to     bequests must await the executor's determination of
other beneficiaries. Tex. Prop. Code § 116.051(4).           whether administration expenses will be deducted on
Note that former Section 378B(f), which started the          the estate tax return or the estate's income tax return
running of interest one year after Letters Testamentary      before they can be computed). Such gifts are, however,
were issued, was repealed by the legislature in favor of     treated as bequests of "a specific dollar amount" for
the new provisions of the Trust Code. Unfortunately,         gain recognition purposes, regardless of whether they
it was then later re-enacted (apparently unintentionally)    can be precisely computed at the date of death. As a ,
in legislation correcting references to the Texas            result, gains or losses we be recognized by the estate if
Finance Code. Presumably only the Trust Code                 the formula gift describes a pecuniary amount to be
provision applies. For a discussion of the income tax        satisfied with date-of-distribution values, as opposed to
issues associated with the deductibility of this interest    a fractional share of the residue of the estate. Compare
payment by the estate, see page 19, below                    Treas. Reg. § 1.663(a)-1(b) (to qualify as bequest of
                                                             specific sum of money or specific bequest of property,
2. AN ESTATE MAY RECOGNIZE GAINS AND                         and thereby avoid DNI carry-out, the amount of money
LOSSES WHEN IT MAKES DISTRIBUTIONS IN KIND.                  or the identity of property must be ascertainable under
Unless a specific exception applies, all estate              the will as of the date of death) with Treas. Reg.
distributions, whether in cash or in kind, carry out the     § 1.661(a)-2(f)(1) (no gain or loss recognized unless
estate's DNI. Generally, the amount of DNI carried out       distribution is in satisfaction of a right to receive a
8                                                                        2007 DOCKET CALL IN PROBATE COURT



specific dollar amount or specific property other than       the taxpayer with respect to any transaction involving
that distributed). See also Treas. Reg. § 1.1014-4(a)(3);    these benefits.
Rev. Rul. 60-87, 1960-1 C.B. 286. For fiscal years
beginning on or before August 1, 1997, estates could         ii. No IRD Transfer by Estate. Separate and apart
recognize losses in transactions with beneficiaries.         from the gain recognition rules of Treasury Regulation
Although the Taxpayer Relief Act of 1997 repealed this       Section 1.661(a)-2(f)(1) is the IRD recognition rule of
rule for most purposes, an estate may still recognize a      Section 691 of the Code. However, the recognition
loss if it distributes an asset that has declined in value   rules of Section 691(a)(2) of the Code, by their terms,
in satisfaction of a pecuniary bequest.             I.R.C.   apply only if the right to receive income in respect of a
§ 267(b)(13). Note, however, that loss recognition is        decedent is transferred "by the estate of the decedent or
denied to trusts used as estate surrogates as a result of    a person who receives such right by reason of the death
the related party rules of Section 267(b)(6) of the Code,    of the decedent . . ." (emphasis added). If the
except for qualified revocable trusts electing to be         testamentary trustee is the beneficiary, there is simply
treated as estates under Section 646 of the Code.            no transfer by the estate. Moreover, there is no transfer
                                                             by any "person" who receives such right by reason of
c. Pension and IRA Accounts Used to Fund                     the decedent's death. The Code expressly excludes
Pecuniary Bequests. Several commentators have                from the definition of "transfer" requiring IRD
argued that if a pension asset is used to satisfy a          acceleration any "transmission at death . . . to a person
pecuniary legacy, the use of that asset will be treated as   pursuant to the right of such person to receive such
a taxable sale or exchange, and this treatment will          amount by reason of the death of the decedent . . .".
accelerate the income tax due. This analysis is based        I.R.C. § 691(a)(2) (emphasis added). In that event, the
upon Treasury Regulation 1.661(a)-2(f)(1), which             recipient (here, the trust) includes these amounts in
requires an estate to recognize gain when funding a          gross income not when the right to the payment is
pecuniary bequest with an asset whose fair market            received, but only when the payments themselves (i.e.,
value exceeds its basis, as though the asset is sold for     the distributions from the retirement plan) are actually
its fair market value at the date of funding. See Rev.       received. I.R.C. § 691(a)(1)(B).
Rul. 60-87, 1960-1 C.B. 286. If an estate uses an asset
constituting income in respect of a decedent to satisfy      iii. Constructive Receipt Rules. The general rules
a pecuniary bequest, application of this principle would     which describe the timing of recognition for income
cause the gain to be accelerated. In this author's           attributable to an IRD asset are reinforced by the
opinion, however, it can be persuasively argued that         statutes expressly governing pension distributions.
this acceleration will not occur if the beneficiary is not   Amounts held in qualified plans and IRA's are taxable
the estate, but the trustee named in the participant's       to the recipient only when actually distributed. I.R.C.
Will. Three lines of analysis confirm this result:           §§ 72, 402(a). The mere fact that benefits under the
                                                             plan or IRA are made available, or that the participant
i.    No Receipt By Estate. The recognition rules            or beneficiary has access to them, is not determinative,
under Treasury Regulation Section 1.661(a)-2(f)(1)           since the constructive receipt rules do not apply to
apply only in the context of a distribution by the estate    these assets. I.R.C. §§ 402(a)(1), 408.
in satisfaction of a right to receive a specific dollar
amount. When a "testamentary trustee" is named as the        iv. Proper Tax Treatment.             Therefore, if the
beneficiary of a pension plan or IRA, there is clearly no    testamentary trustee receives, whether by a spouse's
distribution by the estate, and no acceleration event        disclaimer or by direct designation by the participant,
should occur to the estate. The estate, after all, is        the right to receive plan distributions, no income tax
subjected to taxation only on income received by the         should be payable until such time as distributions are
estate during the period of administration or settlement     actually made from the plan or IRA to the trust, even if
of the estate. I.R.C. § 641(a)(3). Pension benefits          the assignment of the right to receive plan assets
payable directly to the trustee of the trust established     otherwise reduces (or eliminates) the amount that the
under the Will of the plan participant are never             estate needs to distribute in satisfaction of a pecuniary
"received by the estate." This fact remains true even if     bequest. Instead, the testamentary trust should be able
the Will contains instructions directing the testamentary    to defer taxation on pension and IRA proceeds until
trustee to use these funds in whole or in part to fund a     such time as those accounts are distributed (which may
pecuniary bequest. The fact that the executor takes          be until they are required to be distributed in
these non-testamentary transfers into account in             accordance with the minimum required distribution
measuring the amount of other amounts needed to fund         rules). See PLR 9630034 (pecuniary disclaimer by
the pecuniary bequest should not change this result.         spouse of ½ interest in decedent's IRA does not cause
Since the non-probate pension assets are not subject to      recognition to spouse or estate).
administration, the estate cannot properly be said to be
Income Tax Matters                                                                                                     9



d. Section 643(e)(3) Election. The executor may               instrument should expressly authorize non-pro rata
elect under Section 643(e)(3) of the Code to recognize        distributions.
gain and loss on the distribution of appreciated and
depreciated property. If this election is made, the           See page 19 for a discussion of an analogous issue in
amount of the distribution for income tax purposes will       the context of non-pro rata divisions of community
be the fair market value of the property at the time of       property between the estate and the surviving spouse.
the distribution. The Section 643(e) election must be
made on an "all or nothing" basis, so that the executor       4.   INCOME IN RESPECT OF A DECEDENT IS TAXED
may not select certain assets and elect to recognize gain     TO THE RECIPIENT. A major exception to the rule that
or loss on only those assets. Of course, if the executor      an inheritance is income tax free applies to beneficiaries
wants to obtain the effect of having selected certain         who receive payments that constitute income in respect
assets, he or she may actually "sell" the selected assets     of a decedent. I.R.C. § 691.
to the beneficiary for the fair market value of those
assets, recognizing gain in the estate. The executor can      a. IRD Defined. Income in respect of a decedent
thereafter distribute the sales proceeds received to the      ("IRD") is not defined by statute, and the definition in
beneficiary who purchased the assets. Note that if an         the Treasury Regulations is not particularly helpful.
executor makes a Section 643(e)(3) election in a year         Generally, however, IRD is comprised of items which
that an IRD asset is distributed by the estate, gain          would have been taxable income to the decedent if he
would be accelerated, even if the distribution is             or she had lived, but because of the decedent's death
otherwise subject to a Section 691(a)(2) exception,           and tax reporting method, is not includable in the
since the asset representing the IRD will be treated as       decedent's final Form 1040. Examples of IRD include
having been sold by the estate in that year. For fiscal       accrued interest; dividends declared but not payable;
years beginning after August 1, 1997, the Section             unrecognized gain on installment obligations; bonuses
643(e)(3) election (or an actual sale to a beneficiary)       and other compensation or commissions paid or payable
can cause the estate to recognize gains, but not losses,      following the decedent's death; and amounts in IRAs
since under the principles of Section 267 of the Code,        and qualified benefit plans upon which the decedent has
the estate and its beneficiary are now treated as related     not been taxed. A helpful test for determining whether
taxpayers. I.R.C. § 267(b)(13).                               an estate must treat an asset as IRD is set forth in Estate
                                                              of Peterson v. Commissioner, 667 F.2d 675 (8th Cir.
3. ESTATE BENEFICIARIES MAY RECOGNIZE                         1981). The estate's basis in an IRD asset is equal to its
GAINS AND LOSSES IF THE ESTATE MAKES                          basis in the hands of the decedent. No step-up is
UNAUTHORIZED NON PRO RATA DISTRIBUTIONS IN                    provided. I.R.C. § 1014(c).
KIND. If an estate makes unauthorized non-pro rata
distributions of property to its beneficiaries, the IRS has   b. Recognizing IRD. If the executor distributes an
ruled that the distributions are equivalent to a pro rata     IRD asset in a manner which will cause the estate to
distribution of undivided interests in the property,          recognize gain on the distribution, or if a Section
followed by an exchange of interests by the                   643(e)(3) election is made and the asset is distributed in
beneficiaries. This deemed exchange will presumably           the year of the election, the result will be to tax the
be taxable to both beneficiaries to the extent that values    income inherent in the item to the decedent's estate.
differ from basis. Rev. Rul. 69-486, 1969-2 C.B. 159.         Absent one of these recognition events, if the estate of
                                                              the decedent transmits the right to an IRD asset to
                                                              another person who would be entitled to report that
Example 5: A decedent's estate passes equally to A and        income when received, the transferee, and not the
B, and contains two assets, stock and a farm. At the          estate, will recognize the income. Thus, if a right to
date of death, the stock was worth $100,000 and the           IRD is transferred by an estate to a specific or residuary
farm worth $110,000. At the date of distribution, each        legatee, only the legatee must include the amounts in
are worth $120,000. If the executor gives the stock to        income when received. Treas. Reg. § 1.691(a)-4(b)(2).
A and the farm to B and if the will fails to authorize        If IRD is to be recognized by the estate, the tax costs
non-pro rata distributions, the IRS takes the view that       may be substantial. In a setting where a substantial
A and B each received one-half of each asset from the         IRD asset is distributed from the estate in a manner
estate. A then "sold" his interest in the farm (with a        causing recognition, a material decrease in the amount
basis of $55,000) for stock worth $60,000, resulting in       passing to other heirs might result.
a $5,000 gain to A. Likewise, B "sold" his interest in
the stock (with a basis of $50,000) for a one-half            Example 6: In 2007, X dies with a $2.5 million estate.
interest in the farm worth $60,000, resulting in a            The Will makes a formula marital gift of $500,000 to
$10,000 gain to B. To avoid this result, the governing        the spouse, leaving the rest of the estate to a bypass
                                                              trust. If an IRD asset worth $500,000 but with a basis
10                                                                      2007 DOCKET CALL IN PROBATE COURT



of $0 is used to fund this marital gift, the estate will    Sections 2036 and 2038 of the Code. Although often
recognize a $500,000 gain. The spouse will receive the      called a "step up" in basis, various assets may be
$500,000 worth of property, but the estate will owe         stepped up or down as of the date of death. The
income tax of some $173,900, presumably paid from           adjustment to the basis of a decedent's assets occurs
the residue of the estate passing to the bypass trust.      regardless of whether the estate is large enough to be
Payment of this tax would leave only $1,826,100 to          subject to federal estate tax. Original basis is simply
fund the bypass trust.                                      ignored and federal estate tax values are substituted.
                                                            Note that the new cost basis applies not only to the
Under these circumstances, the testator may wish to         decedent's separate property but also to both halves of
consider making a specific bequest of the IRD asset to      the community property owned by a married decedent.
insure that the income will be taxed to the ultimate        I.R.C. § 1014(b)(6).
beneficiary as received, and will not be accelerated to
the estate.                                                 b. Exceptions. There are two important exceptions
                                                            to the basis adjustment rule.
c. Deductions in Respect of a Decedent. A concept
analogous to income in respect of a decedent is applied     i.    No New Basis for IRD. Items which constitute
to certain deductible expenses accrued at the date of the   income in respect of a decedent receive a carryover
decedent's death. Those "deductions in respect of a         basis. I.R.C. § 1014(c). This rule is necessary to
decedent" ("DRD") are allowable under Code Section          prevent recipients of income in respect of a decedent
2053(a)(3) for estate tax purposes as claims against the    from avoiding federal income tax with respect to items
estate, and are also allowed as deductions in respect of    in which the income receivable by a decedent was
a decedent for income tax purposes to the person or         being measured against his basis in the asset.
entity paying those expenses. I.R.C. § 691(b). The
general rule disallowing both income and estate tax         ii. No New Basis for Deathbed Transfers to
deductions for administration expenses, discussed           Decedent. Section 1014(e) of the Code provides a
below at page 10 does not apply to DRD. The theory          special exception for appreciated property given to a
behind allowing this "double" deduction is that had the     decedent within one year of death, which passes from
decedent actually paid this accrued expense prior to        the decedent back to the donor as a result of the
death, he could have claimed an income tax deduction,       decedent's death. This rule is presumably designed to
and the cash on hand in his estate would be reduced,        prevent avaricious taxpayers from transferring property
thereby effecting an estate tax savings as well. Of         to dying individuals, only to have the property
course, interest, administration expenses, and other        bequeathed back to them with a new cost basis.
items not accrued at the date of the decedent's death are
subject to the normal election rules of Section 642(g) of   6. THE EXECUTOR CAN ELECT TO DEDUCT MANY
the Code discussed below.                                   EXPENSES FOR EITHER INCOME OR ESTATE TAX
                                                            PURPOSES (BUT NOT BOTH). An executor is often
5. IMPACT OF DEATH UPON BASIS.                     Most     confronted with a choice of deducting estate
practitioners describing the impact of death upon basis     administration expenses on the estate tax return, or the
use a kind of short-hand by saying that assets get a        estate's income tax return. In most instances, double
"step-up" in basis at death. In inflationary times, this    deductions are disallowed. I.R.C. § 642(g). Between
oversimplification is often accurate. However, it is        1986 and 1992, the decision about where to deduct an
important to remember that the basis of an asset may        expense was simplified by the fact that the lowest
step up or down. For most assets, the original cost         effective federal estate tax bracket (37%) was always
basis in the hands of the decedent is simply irrelevant.    higher than the highest marginal income tax bracket
It is equally important to remember that the basis          applied to estates (typically 31%). If estate tax was
adjustment rule is subject to some important exceptions.    due, a greater tax benefit was always obtained by
                                                            deducting expenses on the estate tax return. Between
a. General Rule. In general, the estate of a decedent       1993 and 2003, the analysis was more difficult. Now
receives a new cost basis in its assets equal to the fair   that the highest income tax bracket for estates is 35%,
market value of the property at the appropriate valua-      while the lowest effective estate tax bracket is 45%, the
tion date. I.R.C. § 1014. In most cases, the basis is the   old analysis once again applies.
date-of-death value of the property. However, if the
alternate valuation date for estate property has been       a. Section 642(g) Expenses. The executor must
validly elected, that value fixes the cost basis of the     make an election to take administration expenses as a
estate's assets. I.R.C. § 1014(a)(3). The basis             deduction for income tax purposes by virtue of Section
adjustment rule also applies to a decedent's assets held    212 of the Code, or to deduct those same expenses as
by a revocable trust used as an estate surrogate, since     an estate tax deduction under Section 2053 of the Code.
they are deemed to pass from the decedent pursuant to
Income Tax Matters                                                                                                    11



No double deduction is permitted. Expenses to which           concurring opinion written by Justice O'Connor, she
this election applies include executors' fees, attorneys'     noted that the measure of materiality is a matter within
fees, accountants' fees, appraisal fees, court costs, and     the province of the Commissioner to set forth by
other administration expenses, provided that they are         regulation. Since the regulations that were in force at
ordinary and necessary in collection, preservation, and       the date of death did not establish a test for materiality,
management of the estate. There is no requirement that        and since the Tax Court opinion in this case was
the estate be engaged in a trade or business or that the      consistent with current law and regulations, no loss of
expenses be applicable to the production of income.           the marital deduction was appropriate in this particular
Treas. Reg. § 1.212-1(i). Note, however, that expenses        case. Justice O'Connor specifically noted, however
attributable to the production of tax-exempt income are       that "[t]here is no reason why this labyrinth should
denied as an income-tax deduction to estates, just as         exist, especially when the Commissioner is empowered
they are to individuals, under Section 265(1) of the          to promulgate new regulations and make the answer
Code.      Interest on estate taxes deferred under            clear. Indeed, nothing prevents the Commissioner from
Section 6166 of the Code, which now accrues at only           announcing by regulation the very position she
45% of the regular rate for interest on under payments,       advances in this litigation."
is no longer allowed as an estate tax or on income tax
deduction. I.R.C. §§ 2053(c)(1)(D); 163(k).                   d. Regulatory Guidance. Not surprisingly, the
                                                              Treasury Department, responding to Justice O'Connor's
b. Method of Election. Technically, the Code and              invitation, has announced new regulations providing
Treasury Regulations require the executor to file with        guidance on this issue. Treas. Reg. §§ 20.2013-4(b)(3),
the estate's income tax return a statement, in duplicate,     20.2055-3; 20.2056(b)-4(d). Unlike the "material
to the effect that the items have not been allowed as         limitation" rules under the prior regulations, the new
deductions from the gross estate of the decedent under        regulations permit deductions depending upon the
Section 2053 or 2054 and that all rights to have such         nature of the expenses in question. The regulation
items allowed at any time as deductions under                 provides that "estate management expenses" may be
Section 2053 or 2054 are waived. Treas. Reg.                  deducted as an income tax deduction (but not as an
§ 1.642(g)-1. Some executors tentatively claim                administrative expense for estate tax purposes) without
expenses on both returns, filing the income tax return        reducing the marital or charitable deduction. Expenses
waiver statement only after the estate has received a         that constitute "estate transmission expenses" will
closing letter and deductions on the estate tax return        require a dollar for dollar reduction in the amount of
have proven unnecessary. This approach can be                 marital or charitable deduction.
dangerous, however, if deductions are taken on the
estate tax return, and the estate receives a closing letter   e. Estate Management Expenses. Estate manage-
without examination of or adjustment to the return.           ment expenses are "expenses incurred in connection
Under these circumstances, presumably, the income tax         with the investment of the estate assets and their
waiver statement could not lawfully be filed, since the       preservation and maintenance during a reasonable
deductions in question will have been "allowed" as            period of administration. Examples of these expenses
deductions from the gross estate.                             include investment advisory fees, stock brokerage
                                                              commissions, custodial fees and interest." Treas. Reg.
c. Payments From Income. Increased attention has              §§ 20.2055-3(b)(1)(i) ; 20.2056(b)-4(d)(1)(i).
been focused on the interaction of state law and tax
rules in determining whether estate administration            f.    Estate Transmission Expenses.              Estate
expenses are chargeable to principal or income. The           transmission expenses are all estate administration
importance of this issue is illustrated by Commissioner       expenses that are not estate management expenses.
v. Estate of Hubert, 117 S.Ct. 1124 (1997) where the          These expenses reduce the amount of the marital or
executor charged administration expense to estate             charitable deduction if they are paid out of assets that
income for both state law and tax law purposes. The           would otherwise pass to the surviving spouse or to
IRS held that such an allocation constituted a "material      charity. Estate transmission expenses include expenses
limitation" on the rights to income otherwise afforded        incurred as a result of the "consequent necessity of
recipients of marital and charitable gifts, and denied        collecting the decedent's assets, paying the decedent's
estate tax deductions for the gifts to which these            debts and death taxes, and distributing the decedent's
expenses were allocated. After litigating the issue all       property to those who are entitled to receive it."
the way to the United States Supreme Court, limited           Examples of these expenses could include executor
guidance was given. The "plurality" opinion held that,        commissions and attorney fees (except to the extent of
under the facts presented, the executor's decision to         commissions or fees specifically related to investment,
charge expenses to income did not constitute a                preservation, and maintenance of assets), probate fees,
"material limitation" on the interest passing to the          expenses incurred in construction proceedings and
surviving spouse. In a somewhat more comprehensible           defending against Will contests, and appraisal fees.
12                                                                       2007 DOCKET CALL IN PROBATE COURT



Treas. Reg. §§ 20.2055-3(b)(1)(ii); 20.2056(b)-              modifier, it means fiduciary accounting income, and not
4(d)(1)(ii).                                                 taxable income. I.R.C. § 643(b). In measuring
                                                             fiduciary accounting income, the governing instrument
g. Reduction for Unrelated Estate Management                 and local law, not the Internal Revenue Code, control.
Expenses. In addition to reductions for estate               Therefore, estate planners should have a basic
transmission expenses, the final regulations require that    understanding of these state law rules.
the marital deduction be reduced by the amount of any
estate management expenses that are "paid from the           a. Look to the Governing Instrument. Beginning
marital share but attributable to a property interest not    January 1, 2004, trusts and estates are governed by the
included in the marital share." Treas. Reg §20.2056(b)-      new Texas Uniform Principal and Income Act. The
4(d)(1)(iii)(4). Similar language is applied to charitable   new Act provides that allocations between income and
gifts. Treas. Reg. § 20.2055-3(b)(4).                        principal will be made in accordance with the specific
                                                             provisions of the governing instrument. Provisions in
h. Special Rule for Estate Management Expenses               the a Will or trust agreement should therefore control
Deducted on Estate Tax Return. If estate management          allocations of income and expense, so long as they are
expenses are deducted on the estate tax return, the          specific enough to show that the testator or grantor
marital or charitable deduction must be reduced by the       chose to define a specific method of apportionment.
amount of any estate management expenses "that are           See Interfirst Bank v. King, 722 S.W.2d 18 (Tex. App.
deducted under section 2053 on the decedent's Federal        -- Tyler 1986, no writ). In the absence of specific
estate tax return." Treas. Reg. §§ 20.2055-3(b)(3);          provisions in the instrument, the provisions of the Act
20.2056(b)-4(d)(3). The justification for this position      control allocations between income and principal. Tex.
is the language in Section 2056(b)(9) of the Code,           Prob. Code Ann. § 378B(b); Tex. Prop. Code Ann. §
which provides that nothing in section 2056 or any           116.051. Former Section 113.101(b) of the Texas Trust
other estate tax provision shall allow the value of any      Code provided that if the governing instrument gave the
interest in property to be deducted for federal estate tax   trustee the discretion to allocate income or expenses,
purposes more than once with respect to the same             the exercise of that discretion in a manner contrary to
decedent.                                                    the terms of Trust Code was not actionable. Former
                                                             Tex. Prop. Code Ann. § 113.101(b). The discretion
Example 7: $150,000 of life insurance proceeds pass          was not, however, unlimited. A trustee must not act
to the decedent's child, and the balance of the estate       outside the bounds of reasonable judgment. Thorman
passes to the surviving spouse. The decedent's               v. Carr, 408 S.W.2d 259, 260 (Tex. Civ. App.--San
applicable credit amount had been fully utilized prior to    Antonio 1966) aff'd per curium, 412 S.W.2d 45 (Tex.
death. If estate management expenses of $150,000             1967).
were deducted for estate tax purposes, the marital
deduction would have to be reduced by $150,000.              b. "Fair and Reasonable" Allocations. The Act now
Otherwise, the estate "would be taking a deduction for       requires that the fiduciary must make allocations based
the same $150,000 in property under both sections 2053       upon what is "fair and reasonable" to all beneficiaries,
and 2056." As a result, the deduction would have the         and further provides that (i) a determination in
effect of sheltering from estate tax $150,000 of the         accordance with the Act is presumed to be "fair and
insurance proceeds passing to the decedent's child.          reasonable," and (ii) to the extent that the neither the
Treas. Reg § 20.2056(b)-4(d)(5), Ex.4.                       terms of the governing instrument or the Act provide a
                                                             rule for allocating a receipt or disbursement between
i.    Effective Date. The new regulation apply to            principal and income, it is to be allocated to principal.
estates of decedents dying on or after December 3,           Tex. Prop. Code § 116.004.             The Texas Bar
1999. Treas. Reg. §§ 20.2055-3(b)(7); 20.2056(b)-            Commentary for this section states that the new rule
4(d)(6).                                                     provides greater protection for fiduciaries by
                                                             establishing a certain presumption for "fair and
7. WHEN AN ESTATE OR TRUST ALLOCATES                         reasonable" allocations. A court may overturn a
"INCOME," THAT MEANS FIDUCIARY ACCOUNTING                    fiduciary's allocations only upon a showing of an abuse
INCOME, NOT TAXABLE INCOME. Estate planning                  of discretion. Tex. Prop. Code. Ann. § 116.006.
attorneys that spend too much of their time studying tax
rules sometimes forget that not every situation is           c.   Specific Trust Code Provisions.
governed by the Internal Revenue Code. Nowhere is
this failure more prevalent that in the area of allocating   (1) A Not-So-Unified Principal and Income Act.
and distributing estate and trust "income." In general,      Prior to 2004, principal and income allocations in Texas
when a trust (or the income tax rules applicable to          were based upon a highly customized version of the
estates and trusts) speaks of "income" without any           1962 Revised Uniform Principal and Income Act. In
                                                             2002, a special legislative committee of the Real Estate,
Income Tax Matters                                                                                                  13



Probate, and Trust Law Section of the Texas Bar began        may favor one or more of the beneficiaries." As noted
studying the 1997 version of the Uniform Principal and       above, a determination in accordance with the Act is
Income Act ("UPIA") promulgated by the Uniform               presumed to be fair and reasonable to all of the
Laws Commission. This statute has as its stated              beneficiaries. Tex. Prop. Code Ann. § 116.004.
purpose to "support the now widespread use of the
revocable living trust as a will substitute, to change the   d.   Accrued Income.
rules in those Acts that experience has shown need to
be changed, and to establish new rules to cover              i.    General Rule. Items accrued on the day before the
situations not provided for in the old Acts, including       date of death, such as rent, interest and annuities, are
rules that apply to financial instruments invented since     treated as principal under the Texas Trust Code, even if
1962." The State Bar committee identified a number of        those items are considered income (presumably, income
concerns with UPIA, and provided a number of                 in respect of a decedent) under the tax law. Tex. Prop.
recommended changes to UPIA prior to its adoption by         Code § 116.102(a). However, if the income is derived
the 2003 Texas Legislature. Because of the extent of         from an asset that is specifically bequeathed, the
the departure from prior law, and the uncertainty that       income is distributable to the recipient of that asset.
might arise if the Act were effective in the middle of an    Tex. Prop. Code § 116.051(l).
accounting year, the legislature deferred its effective
date until January 1, 2004.                                  ii. Trapping Distributions. A trust which must
                                                             distribute all of its "income" (i.e., fiduciary accounting
(2) Allocations in General. Section 116.004 of the           income measured under the Texas Trust Code) would
Texas Trust Code provides the outline for income and         be entitled to retain income accrued before the date of
principal allocations, with detailed guidance on specific    death, since these items are principal under local law.
forms of property and activities being provided by           Tex. Prop. Code § 116.101(b). The effect of retaining
Sections 116.151 through 116.206. Section 116.004            such property may be to trap the taxable income
provides five rules for determining how allocations are      attributable to this property within the trust. This
to be made:                                                  trapping of income presents an opportunity to use an
                                                             otherwise simple trust as a taxpayer in the year it is
i.   Terms of the Instrument. Under the first rule, a        funded. Naturally, since the trust's tax rates reach 35%
fiduciary must administer the trust or estate in             at only $10,450.00 in income (for 2007), the tax savings
accordance with the terms of the trust instrument or         generated by this technique are limited. In 2007, a
Will, even if the statute provides some different            simple trust with $10,750.00 in income ($300.00 of
provision.                                                   which would be excluded by the trust's allowance in
                                                             lieu of personal exemption) would pay a tax of
ii. Grants of Discretionary Authority. If the trust          $2,701.00 instead of $3,762.5 if the entire $10,750.00
instrument or Will grants the fiduciary the power to         were taxed to a beneficiary in the 35% bracket– a
make discretionary allocations, the fiduciary may            savings of only $1,061.50.
administer a trust or estate by the exercise of that
discretionary power of administration, even if the           iii. Post-Death Accruals. Although income accrued
exercise of the power produces results different from        before the date of death is principal, funds received by
the results required or permitted under the Act.             a trustee from an estate that constitute the estate's
                                                             income under Section 378B of the Texas Probate Code
iii. Application of the Act. If the governing                is treated as trust income under Section 116.152 of the
instrument does not contain a contrary provision or          Texas Trust Code. Tex. Prob. Code Ann. § 378B(g).
grant discretion to the fiduciary, the provisions of the     Tex. Prop. Code § 116.101(b)(2). Accordingly, this
Act must be follow.                                          post-death income passing from the estate to the trust
                                                             will not be "trapped."
iv. When in Doubt, It's Principal. If no provision of
the governing instrument or the Act controls, the receipt    e. Receipts from Entities. Under the former rules,
or disbursement must be allocated to principal.              cash dividends from corporations were clearly income,
                                                             as were distributions of, or rights to subscribe to,
v. Fair and Reasonable Allocation. Finally, in               securities of corporations other than the distributing
exercising a "power to adjust" as outlined below, or a       corporation. Former Tex. Prop. Code Ann. § 113.104.
discretionary power of administration, whether granted       Distributions from other entities, such as partnerships
under the governing instrument or the Act, the fiduciary     and LLCs, were more problematic. Under the Act,
"shall administer a trust or estate impartially, based on    however, all distributions from any "entity" are treated
what is fair and reasonable to all of the beneficiaries,     similarly. Tex. Prop. Code § 116.151.
except to the extent that the terms of the trust or will
clearly manifest an intention that the fiduciary shall or
14                                                                         2007 DOCKET CALL IN PROBATE COURT



i.   Application to "Entities". For purposes of this           ii. Cash Flow vs. Income. If a separate accounting is
provision, an "entity" includes corporations,                  undertaken, the trustee may determine the extent to
partnerships, limited liability companies, mutual funds,       which its net cash needs to be retained for working
REITs, common trust funds, and any other entity except         capital, acquisition or replacement of fixed assets, or
an estate, a trust, or a proprietorship.                       other reasonably foreseeable needs of the business, and
                                                               the extent to which the remaining net cash receipts are
ii. General Rule–Distributions are Income. In                  to be allocated to principal or income. If the assets of
general, distributions of money are allocated to income.       the business are sold outside the ordinary course of
                                                               business (and the sales proceeds are no longer required
iii. When Distributions are Not Income.                   A    in the conduct of the business) the proceeds are
distribution is allocated to principal if it is (i) property   allocated to principal. Tex. Prop. Code § 116.153(b).
other than money; (ii) money paid in a single or series
of distributions in redemption of the trust's interest in      iii. Types of Businesses. The activities to which this
the entity; (iii) money received in a total or partial         provision apply include retail, manufacturing, service
liquidation of the entity; (iv) or money received from a       and other traditional businesses; farming; raising and
mutual fund or REIT characterized as a "capital gain           selling livestock; management of rental properties;
dividend" for federal income tax purposes. Tex. Prop.          mineral extraction; timber operations; and derivative
Code § 116.151(c). According to the Uniform Act                operations.
comment, a "capital gain dividend" is the excess of the
fund's net long-term capital gain over its net short-term      iv. Comparing Former Law. Under former law,
capital loss. As a result, a capital gain dividend does        business and farming operations (presumably including
not include any net short-term capital gain, and cash          partnerships) were to be accounted for using generally
received by a trust because of a net short-term gain is        accepted accounting principals ("GAAP"). This
income under the Act.                                          requirement gave rise to a host of questions, including
                                                               how a trustee who couldn't justify the expense of
iv. Partial Liquidations. Money is received in partial         GAAP financial statements was to base allocations,
liquidation if the entity so indicates, or if the total        how an interest in a partnership was to be treated, and
distribution is greater than 20% of the entity's gross         how a trustee might to compel a partnership to provide
assets. Tex. Prop. Code § 116.151(d). However,                 GAAP accounting information.
money will not be treated as a partial liquidation (or be
taken into account in measuring "20% of the entity's           g. Interest and Rents. As under prior law, rents are
gross assets") to the extent of the trust's income tax on      treated as income, including amounts received for
the distributing entity's taxable income. Tex. Prop.           cancellation or renewal of a lease. Tex. Prop. Code
Code § 116.151(e).                                             Ann. § 116.161. Interest is also income, whether
                                                               denominated as fixed, variable, or floating. If a
v. Information from the Entity. If the distributing            fiduciary sells a note or other obligation to pay money
entity provides the trustee with a statement at or near        more than one year after it is acquired, the sales
the time of the distribution setting forth information         proceeds must be allocated to principal, even if the
about the source or character of a distribution, the           obligation was acquired for less than its value at
trustee is entitled to rely on that statement. Tex. Prop.      maturity. If the obligation is disposed of within one
Code § 116.151(f).                                             year after it is acquired, an amount received in excess
                                                               of its purchase price or value when acquired must be
f.    Business and Farming Operations. If a fiduciary          allocated to income. Tex. Prop. Code Ann. § 116.163.
operates a business or farming operation owned as a
sole proprietorship, he or she may elect, if it is in the
best interest of all beneficiaries, to account separately
for the business or activity, instead of accounting for it
as part of the trust's general assets. Tex. Prop. Code
Ann. § 116.153.

i.    Treatment as a Business. Treatment as a business
would mean, for example, that a interest earned in a
money market account used to hold rents from a
shopping center would not necessarily be income, but
would be added to other receipts and disbursements of
the shopping center business to measure "net" income.
Income Tax Matters                                                                                                      15



                                                               ii. New Rules. For assets acquired on or after
h. Deferred Compensation, Annuities, and Similar               January 1, 2004, the trustee is to allocate ten percent of
Payments.                                                      each receipt (not ten percent of the inventory value) to
                                                               income, and the balance to principal. For assets on
i.    Prior Law. In 1993, the Texas legislature rewrote        hand on January 1, 2004, the trustee may allocate
Section 113.109 of the Texas Trust Code to deal                receipts "in the manner provided by this Chapter or in
specifically with "deferred payment rights," including         any lawful manner used by the trustee before January 1,
qualified and non-qualified employee benefit plans.            2004 to make the same allocation." Tex. Prop. Code
Under the statute as rewritten, proceeds received were         Ann. § 116.173.
credited to income up to five percent of the "inventory
value" of the right, with the balance constituting             j.    Minerals, Water and Other Natural Resources.
principal. In the first year, the "inventory value" was
defined to mean the cost of property purchased by a            i.    Specific Allocations. The Texas Trust Code
trustee, the market value of the property at the time it       provides that nominal delay rentals are income, but
became subject to the trust, or, in the case of a              production payments are principal except to the extent
testamentary trust, the value used by the trustee as           of any factor for interest provided for in the governing
finally determined for estate tax purposes. Once the           instrument.
initial value was assigned, the inventory value was
adjusted by the five percent accrual, as though it were        ii. "Equitable" Allocations. With respect to royalties,
a promissory note bearing interest at five percent             shut-in-well payments, take-or-pay payments, bonuses,
compounded annually. Unfortunately, this approach              or delay rentals that are more than nominal, the trustee
ignored changes in the market value of the retirement          must allocate receipts "equitably." Receipts from
assets.                                                        working interest or other amounts not expressly
                                                               provided for must also be allocated "equitably."
ii. New Rules. The Act now provides that (i) to the            Amounts received for water are income if the water is
extent that the payer characterizes a payment as               renewable. If the water is not renewable, the proceeds
interest, a dividend, or equivalent payment, the payment       must be allocated "equitably."
is allocated to income; and (ii) if no part is so
designated, and if all or any part of the payment is           iii. Compare Prior Law. Under former law, the
require to be made, an allocation is made to income to         trustee was required to maintain a reserve for most
the extent of four percent of the "fair market value of        mineral royalties equal to the lesser of 27.5% of the
the future payment asset," less the amount allocated to        gross proceeds or 50% of the net proceeds. Former
income for a previous payment in the same accounting           Tex. Prop. Code Ann. § 113.107(d). For assets on hand
period. Fair market value is measured on the day the           on January 1, 2004, the trustee may allocate receipts "in
asset first becomes subject to the trust, or after the first   the manner provided by this Chapter or in any lawful
year, on the first day of the trust's year. Tex. Prop.         manner used by the trustee before January 1, 2004 to
Code Ann. § 116.172.                                           make the same allocation." Tex. Prop. Code Ann §
                                                               116.174.
i.   Liquidating Assets.
                                                               iv. "Deemed" Equitable Allocations. So how does a
i.    Prior Law. Under former law, proceeds from               fiduciary make sure that an allocation is being made
depletable property other than minerals (for example,          "equitably"? The statute provide no specific guidance
leaseholds, patents, copyrights and nonmineral                 expect that an allocation of a receipt is presumed to be
royalties) acquired by a trust on or after September 1,        equitable if the amount allocated to principal is equal to
1993, constituted income to the extent of five percent of      the amount allowed by the Internal Revenue Code as a
the inventory value, adjusted in the same manner as a          deduction for depletion (generally, 15%). Id.
promissory note bearing interest at five percent
compounded annually. Former Tex. Prop. Code Ann.               v. Affect on Depletion Deduction. Under current tax
§ 113.109. All proceeds from depletable property               rules, a depletion deduction is used by the trust or estate
acquired before September 1, 1993, constituted income          to the extent that the entity maintains a reserve, so all of
unless the trustee had a duty to change the form of the        the depletion deduction would be trapped in the trust. If
investment. If the trustee was required, either under          the grantor or testator wants all royalty income to be
local law or under the terms of the trust instrument, to       paid to the income beneficiary, this provision should be
alter the form of the investment, up to 5% of the value        altered by the terms of the will or trust. The effect of
of the asset disposed of is income, and the balance was        such an alteration is to cause the tax depletion to follow
allocable to principal. Id.                                    the trust income. See I.R.C. § 611(b)(3); Treas. Reg. §
                                                               1.611-1(c)(4).
16                                                                         2007 DOCKET CALL IN PROBATE COURT



k.   Timber.                                                  deduction was allowed for property passing to a trust,
                                                              and the property does not provide the spouse with
i.    Prior Law. Former law provided that receipts            sufficient income (and if the power to adjust discussed
from the disposition of timber were allocated "in             below does not cure the problem), the spouse may
accordance with what is reasonable and equitable to the       require the trustee to make the property productive of
income and remainder beneficiaries of the trust." No          income, convert the property within a reasonable period
specific guidance was given, and the trustee was left to      of time, or exercise the power to adjust. The trustee can
devise a fair allocation. Former Tex. Prop. Code Ann.         decide which of these steps to take. Tex. Prop. Code
§ 113.108. This provision was presumably designed to          Ann § 116.176.
deal with the bunching of income that arises when a
large stand of timber is cut and sold in a single year        m. Other Sales Proceeds. Proceeds from the sale of
after many years of growing time. The flexibility in the      or other disposition of property not classified as
Trust Code was presumably designed to allow the               underproductive are considered principal, and
trustee the ability to normalize income regardless of the     accordingly, capital gains are allocable as principal to
management technique used. In contrast to mineral             the trust absent provisions of the trust instrument to the
allocations, which went from specific to "equitable,"         contrary. Tex. Prop. Code Ann. § 116.161.
timber allocations now have specific rules.
                                                              n. Equitable Adjustments. The Act now permits a
ii. New Rules. The fiduciary is now required to               fiduciary to make adjustments between principal and
allocate net receipts: (i) to income to the extent the        income to offset the shifting economic interests or tax
amount of timber removed does not exceed the rate of          benefits between income beneficiaries and remainder
growth of timber during the accounting period in which        beneficiaries that arise from (i) elections that the
a beneficiary has a mandatory income interest; (ii) to        fiduciary makes from time to time regarding tax
principal to the extent that the amount of timber             matters; (ii) an income tax imposed upon the fiduciary
removed exceeds the rate of growth of timber, or the          or a beneficiary as a result of a distribution; or (iii) the
net receipts are from the sale of standing timber; (iii) to   ownership by an estate or trust of an entity whose
or between income and principal if the net receipts are       taxable income, whether or not distributable, is
from the lease of timberland or from a contract to cut        includable in the taxable income of the estate, trust or
timber, applying the rules of (i) and (ii) above; and (iv)    a beneficiary. Tex. Prop. Code § 11.206(a). A
to principal to the extent that advance payments,             mandatory adjustment must be made from income to
bonuses and other payments are not allocated by the           principal to the extent an election would otherwise
foregoing rules. Tex. Prop. Code § 116.175.                   decrease an estate tax marital or charitable deduction.
                                                              Tex. Prop. Code § 116.206(b). Prior to the adoption of
iii. Applying Prior Law. Again, for timber on hand            this section, Texas had no provision for equitable
on January 1, 2004, the trustee may allocate receipts "in     adjustment, although it had been a part of the common
the manner provided by this Chapter or in any lawful          law in other jurisdictions for some time.
manner used by the trustee before January 1, 2004 to
make the same allocation." Tex. Prop. Code Ann. §             Example 8: Equitable adjustments can be illustrated
116.175(d).                                                   by Estate of Bixby, 140 Cal. App. 2d 326, 295 P.2d 68
                                                              (1956). There, the executor elected under Section
l.   Underproductive Property.                                642(g) to take deductions for income tax purposes,
                                                              which reduced income taxes by $100,000.00, at the cost
i.    Prior Law. Former law provided that property            of $60,000.00 in estate tax savings. Based upon the
which did not produce an average net income, ignoring         terms of the Will, the income tax savings inured to the
depreciation and obsolescence, equal to 1% of its value       benefit of the income beneficiary, while the loss of
was considered "underproductive" property. If the             estate tax savings came at the expense of the remainder
trustee was under a duty to change the investment, and        beneficiaries. The court required the benefitted estate
was delayed from disposing of the investment for one          to pay $60,000.00 in damages to the remainder
year after the property became underproductive, and if        beneficiaries as an "equitable adjustment." As a result,
the property was sold for a profit prior to distribution,     the remainder beneficiaries were unharmed, and the
the income beneficiary was allocated the lesser of the        income beneficiaries received the net $40,000.00 tax
profit on the sale of the property or the amount of the       savings.
net sales proceeds sufficient to bring the return on the
property up to 4% simple interest during the delay
period. Former Tex. Prop. Code Ann. § 113.110.

ii. New Rules. The Act eliminates this provision and
provides instead only that if an estate tax marital
Income Tax Matters                                                                                                   17



o.   Allocation of Disbursements.                            activity. As with depletion, the effect of this provision
                                                             is to establish a reserve for depreciation, which will trap
i.   Allocations to Income.                                  the tax depreciation deduction within the trust to the
                                                             extent of the reserve so maintained. If the testator
(1) Trustee Fees. Trustee fees are required by statute       wishes to have depreciation deductions follow income,
to be allocated 50% against income (and 50% against          a different allocation of depreciation must be provided
principal.) Tex. Prop. Code Ann. §§ 116.201(a)(1);           for in the will or trust instrument. Tex. Prop. Code Ann.
116.202.(a)(1). Previous law allowed the trustee to          § 116.203.
allocate compensation as the trustee deemed to be just
and equitable.      Former Tex. Prop. Code Ann.              iv. Reserves for Extraordinary Expenses. Section
§ 113.111(a)(6). The new mandatory allocation can be         116.204 of the Act permits the trustee to transfer to
detrimental, as in the case of a marital deduction trust,    principal amounts to reimburse principal for
with income required to be paid, against which the           extraordinary expenses or to provide a reserve for
generation skipping exemption has been applied. If the       expected expenses. This provision permits the trustee
spouse does not require the income for support, the          to "regularize distributions if charges against income
family would be better served to have the trustee fees       are unusually large, by using reserves to withhold sums
charged 100% against income. The mandatory rule              from income distributions."
does, however, give the fiduciary certainty about how
the apportionment is to be made.                             v. Taxes. Section 116.205 of the Act provides for
                                                             express allocation against income taxes.
(2) Other Fees. Investment advisory, custodial
services and expenses for accountings, judicial              vi. Taxes Attributable to Receipts. Income tax
proceedings, or "other matters that involve both the         payments are charged against the account to which the
income and remainder interest" are also charged 50%          receipt is allocated.
against income and 50% against principal. Tex. Prop.
Code Ann. §§ 116.201(a); 116.202(a).                         vii. Taxes from Pass-Through Entities. Taxes in
                                                             excess of receipts from an entity are charged against
ii. Administration Expenses. Ordinary expenses               principal. For example partnership or S corporation
incurred for the administration, management or               taxable income allocable to the trust, if in excess of
preservation of trust property and the distribution of       distributions made to the trust, will create tax liability
income are allocated against income, including (i)           in excess of the receipts. The excess tax liability is
interest; (ii) ordinary repairs; (iii) regularly recurring   charged against principal.
taxes assessed against principal; (iv) expenses of a
proceeding that concerns primarily the income interest;      viii. Equitable Adjustments. As noted above, equitable
and (v) recurring premiums on insurance coving loss of       adjustments are permitted to offset the shifting of
principal (property and casualty insurance, but not title    economic interests or tax benefits between income
insurance. Tex. Prop. Code § 116.201.                        beneficiaries and remainder beneficiaries which arise
                                                             from elections and other decisions regarding tax
p.   Allocations to Principal.                               matters.

i.   Trustee and Other Fees. The 50% of trustee and          q.   Unitrusts and the Power to Adjust.
other fees not allocated to income are allocated to
principal.                                                         The Uniform Principal and Income Act establishes
                                                             two entirely new rules for measuring income. The first
ii. Expenses that Affect Principal. Also allocated to        permits the use of a so-called "unitrust" amount. The
principal are those expenses that primarily affect           second is a broad "power to adjust" granted to the
principal, including (i) title insurance premiums; (ii)      trustee in certain instances.
environmental expenses; and (iii) estate , inheritance
and other transfer taxes. Tex. Prop. Code § 116.202.         i.    Unitrusts. The Uniform Principal and Income Act
                                                             grants a trustee the power to convert an "all income"
iii. Depreciation. Under the Act, the trustee may            trust into one that pays a fixed percentage of trust
transfer to principal "a reasonable amount of the net        property to the beneficiary each year. The Texas
cash receipts from a principal assets that is subject to     legislation chose not to grant to trustees the discretion
depreciation," but may not transfer any amount for           to convert existing trusts, but still authorizes a grantor
depreciation (i) for a residence and its contents            or testator the ability to draft a trust that measures
available for use by a beneficiary; (ii) during the          income in this fashion.
administration of a decedent's estate; or (iii) for
proprietorship assets accounted for as a business
18                                                                        2007 DOCKET CALL IN PROBATE COURT



(1) Payout Percentages. Consistent with the new              the trustee determines necessary for health, education,
Regulations under Section 643 of the Code, the Trust         maintenance and support" would seem to qualify.
Code permits the payout percentage to be a fixed
percentage of not less than three or more than five          v. Limitations of the Power. The power to adjust
percent per year, valued at least annually. Tex. Prop.       was initially designed to allow a trustee investing
Code § 116.007(b)(2). The percentage may be applied          according to modern portfolio theory to adjust capital
to trust values in one year or more than one year.           gains to the income account in a portfolio otherwise
                                                             weighted toward growth assets. However, the power to
(2) Payout Deemed "All Income". In order to ensure           adjust is not available in a number of circumstances. In
that Texas non-charitable unitrusts satisfy IRS              particular, a trustee cannot make an adjustment:
regulations, the Texas statute specifically provides that
the distribution from a unitrust complying with the                      (1) that diminishes the income interest in a
statute "is considered a distribution of all of the income   trust that requires all of the income to be paid at least
from the unitrust and shall not be considered a              annually to a spouse and for which an estate tax or gift
fundamental departure from state law." Tex. Prop.            tax marital deduction would be allowed, in whole or in
Code § 116.007(c).                                           part, if the trustee did not have the power to make the
                                                             adjustment;
(3) Ordering Rules. Unless the governing instrument
provides otherwise, unitrust distributions are treated                  (2) that reduces the actuarial value of the
first as distributions of net accounting income, then        income interest in a trust to which a person transfers
from "ordinary accounting income not allocable to net        property with the intent to qualify for a gift tax
accounting income," then from short-term capital gains,      exclusion;
then from long-term capital gains, and finally from
principal. Tex. Prop. Code § 116.007(d).                                (3) that changes the amount payable to a
                                                             beneficiary as a fixed annuity or a fixed fraction of the
ii. The Power to Adjust. The hallmark of the                 value of the trust assets;
Uniform Principal and Income Act is the much-vaunted
"power to adjust." Most comments criticizing various                     (4) from any amount that is permanently set
provision of the Act have been met with the simple           aside for charitable purposes under a will or the terms
reply, "But that's okay. If that doesn't work out fairly,    of a trust unless both income and principal are so set
the trustee always has the power to adjust." This            aside;
simplistic response ignores the substantial limitations
placed upon this power.                                                 (5) if possessing or exercising the power to
                                                             make an adjustment causes an individual to be treated
iii. Statement of the Power. In its clearest form,           as the owner of all or part of the trust for income tax
Section 116.005(a) of the Texas Trust Code provides,         purposes, and the individual would not be treated as the
that a trustee may adjust between principal and income       owner if the trustee did not possess the power to make
to the extent that the trustee considers necessary if the    an adjustment;
trustee determines, after applying the rules requiring the
trustee to administer the trust in accordance with the                  (6) if possessing or exercising the power to
governing instrument and the Act, that the trustee is        make an adjustment causes all or part of the trust assets
unable to administer the trust or estate impartially,        to be included for estate tax purposes in the estate of an
based on what is fair and reasonable to all of the           individual who has the power to remove a trustee or
beneficiaries.                                               appoint a trustee, or both, and the assets would not be
                                                             included in the estate of the individual if the trustee did
iv. Availability of the Power. The power to adjust           not possess the power to make an adjustment;
arises only if the trustee invests and manages trust
assets as a prudent investor, and the terms of the                       (7) if the trustee is a beneficiary of the trust;
governing instrument describe the amount that may or         or
must be distributed to a beneficiary by referring to the
trust's income. Since the Uniform Prudent Investor Act                   (8) if the trustee is not a beneficiary, but the
now applies in Texas to all trusts unless the governing      adjustment would benefit the trustee directly or
instrument otherwise so provides, the power to adjust        indirectly.
should apply whenever the trust requires or permits the
trustee to distribute trust income to a beneficiary. Thus,   If items (5), (6), (7), or (8) applies to a trustee and there
presumably, a trust that provides that the trustee "may      is more than one trustee, a co-trustee to whom the
distribute so much of the income as the trustee              provision does not apply may make the adjustment
determines advisable, plus so much of the principal as       unless the exercise of the power by the remaining
Income Tax Matters                                                                                                  19



trustee or trustees is not permitted by the terms of the     For example, in the context of a community
trust.                                                       administrator, there appears to be no requirement to
                                                             account for specific assets upon the conclusion of the
vi. Comments on the Power. Since most clients                administration. Rather, the responsibility of the
prefer to have their spouses or children serve as the        survivor is only in the aggregate. See Leatherwood v.
trustee of the trusts created under their wills, and since   Arnold, 66 Tex. 414, 416, 1 S.W. 173, 174 (1886). Cf.
the power does not apply if the trustee is a beneficiary     Gonzalez v. Gonzalez, 469 S.W.2d 624, 630 (Tex. Civ.
of the trust, it seems unlikely that many trustees will be   App.–Corpus Christi 1971, writ ref'd n.r.e.) (power of
eligible to use the power unless a co-trustee who is not     an executor to distribute an estate does not include the
a close family member is willing to serve and make the       right to partition undivided interests, absent express
adjustment.                                                  grant of authority in the Will). As to partitions
                                                             generally, Texas courts in establishing the rights of co-
8. NON-PRO RATA DIVISIONS OF COMMUNITY                       owners of property subject to partition have adopted the
PROPERTY. Can an executor and the surviving spouse           concept of "owelty." The classic definition of "owelty"
make tax free non-pro rata divisions of community            is an amount paid or secured by one co-tenant to
property, so that the beneficiaries own 100% of a            another for the purpose of equalizing a partition.
community property asset while the spouse succeeds to        Although originally designed to address minor
100% of other community property assets of equal             variations in value, the concept has been expanded to
value? Two 1980 technical advice memoranda suggest           the situation where one co-tenant acquires all of the
that such a tax-free division is permissible. Both rely      commonly owned property, and the other takes only
on Revenue Ruling 76-83, 1976-1 C.B. 213, a ruling           cash. See, e.g., McGoodwin v. McGoodwin, 671 S.W.
involving similar issues in the divorce context, which       2d 880 (Tex. 1984). For an excellent discussion of
has since been rendered obsolete by the enactment of         partition issues in general, see Jenkins, Drafting Real
Section 1041 of the Code which expressly provides for        Estate Documents for the Estate Planning and Probate
non-recognition in the divorce context. Tech. Adv.           Practitioner, State Bar of Texas Advanced Drafting:
Mem. 8016050; Tech. Adv. Mem. 8037124. A more                Estate Planning and Probate Court (1993).
recent ruling seems to confirm this analysis, so long as
the division is if permitted by the governing instrument     9. DEDUCTION OF INTEREST PAID ON PECUNIARY
or by local law. Tech. Adv. Mem. 9422052. Does               BEQUESTS. Section 116.051(3) of the Texas Trust
Texas law permit such a non-pro rata division?               Code provides that the devisee of a pecuniary bequest
Remember that under Section 177(b) of the Texas              is entitled to interest on the bequest beginning one year
Probate Code, the executor of an estate takes possession     after the date of death at the legal rate on open accounts
of both halves of the community property of the              (currently, six percent). Payment of this interest is
decedent and the decedent's spouse. Section 385 of the       treated for tax purposes not as a distribution of income,
Texas Probate Code provides that when a husband or           but as an interest expense to the estate and interest
wife die leaving community property, the surviving           income to the beneficiary. Rev. Rul. 73-322, 1973-2
spouse may, at any time after the grant of letters           C.B. 44. Under Section 163(h) of the Code, interest is
testamentary and the filing of an inventory, make            non-deductible "personal interest" unless it comes
application to the court for a "partition" of the            within an exception, none of which expressly relates to
community property into "two equal moieties, one to be       interest on a pecuniary bequest. Section 163(d)(3) of
delivered to the survivor and the other to the executor      the Code defines "investment interest" as interest paid
or administrator id the deceased. The provisions of this     or accrued on indebtedness properly allocable to
Code respecting the partition and distribution of estates    property held for investment. Property held for
shall apply to such partition so far as the same are         investment is described by reference to Section
applicable." Tex. Prob Code § 385 (Vernon 2003). At          469(e)(1) of the Code, and includes property that
least one court has described equal moieties in this         produces interest, dividends, annuities, or royalties not
circumstance to be either two groups alike in                derived in the ordinary course of a trade or business.
magnitude, quantity, number or degree, or two groups         No case or ruling addresses the allocation of interest
alike in value or quality. Estate of Furr, 553 S.W.2d        expense when an estate incurs an expense as a result of
676, 679 (Tex. Civ. App.–Amarillo, 1977, writ ref'd          a delay in funding a pecuniary bequest. However, IRS
n.r.e.). Section 373 of the Probate Code deals with          Notice 89-35, 1989-13 I.R.B. 4, provides temporary
partitions and distributions of estate assets generally.     guidance on allocating interest expense on a debt
This section does not require the court to make a pro        incurred with respect to certain pass-through entities.
rata partition of each and every asset of the estate, but    Under that Notice, the debt and associated interest
permits the court to allocate assets among beneficiaries     expense must be allocated among the assets of the
to achieve a "fair, just and impartial" distribution of      entity using a reasonable method. Reasonable methods
estate assets. Similar powers perhaps apply to               of allocating debt among assets ordinarily include pro
independent executors acting without court supervision.      rata allocation based upon fair market value, book
20                                                                          2007 DOCKET CALL IN PROBATE COURT



value, or adjusted basis of the assets. Although this          they took place, or might reasonable be expected to take
Notice does not apply by its terms to indebtedness             place, within ten years of the trust's creation. Some of
incurred by an estate in funding a bequest, perhaps            these grandfathered so-called "Clifford trusts" are still
these principles can be applied by analogy to estates.         in existence. The new permitted reversion rule does not
This analysis would probably require the executor to           specify how to value the reversion for purposes of the
examine the activities of the estate. One could argue          five percent safe harbor test. If the "value of such
that a "debt" was incurred because the estate failed to        interest" is determined actuarially under principles such
distribute its assets to fund the pecuniary bequest within     as those in Treasury Regulation Section 20.2031-7, the
one year after letters testamentary were issued. As a          exception in Code Section 673(a) gives rise to what
result, the estate was able to retain assets, including        might loosely be called a "21/45" rule. That is, with
assets that generate portfolio income, as a result of its      applicable discount rates near seven percent, a grantor
delay in funding the bequest. In effect, the estate could      can retain a reversion if the trust property would not
be said to have "borrowed" these assets from the               return to the grantor except on the death of a benefic-
beneficiary during the period that the distribution was        iary under age 21 at the time of the trust's creation, or if
delayed, and it is as a result of this borrowing that the      the reversion would not occur for at least 45 years.
interest is owed under the provisions of the Texas             Since the discount rate used under Treasury Regulation
Probate Code. This analysis would mean that to the             Section 20.2031-7 varies monthly, the exact age or
extent that the assets ultimately distributed to the           duration for a permitted reversion will vary depending
beneficiary (or sold to pay the beneficiary) were assets       upon interest rates applicable in the month of the trust's
of a nature that produced interest, dividends, annuities,      creation.
or royalties not derived in the ordinary course of a trade
or business, the interest expense would be deductible to       b. Power to Revoke. Section 676 of the Code treats
the estate as "investment interest." It should be noted,       the trust as a nullity if the grantor retains a revocation
however, that in an example contained in the Proposed          power, unless the power to revoke does not arise until
Treasury Regulations issued regarding the separate             after a "safe" Section 673 period. Under Texas law, a
share rules, the IRS states (without explanation) that         grantor may revoke the trust unless it is made
interest paid on a spouse's elective share that is entitled    irrevocable by the express terms of the instrument
to no estate income, but only statutory interest, is           creating it. Tex. Prop. Code Ann. § 112.051(a)
income to the spouse under Section 61 of the Code, but         (Vernon 1995). Note that Section 676 of the Code
non-deductible to the estate under Section 163(h).             applies also to a power of revocation held by a non--
Prop. Treas. Reg. § 1.663(c)-5, Ex. 3. The focus of this       adverse party. Accordingly, inter vivos trusts with a
regulation is on the amount of DNI that will be carried        power of appointment should perhaps include a
out by the distribution; it properly rules that no DNI is      provision precluding the power holder from exercising
carried out. Its characterization of the interest expense      the power in favor of the grantor or the grantor' spouse.
as nondeductible under Section 163(h) is gratuitous,
and in this author's view, erroneous.                          c. Retention of Income. Section 677 of the Code is
                                                               the most commonly involved grantor trust provision,
10. UNDERSTANDING THE GRANTOR TRUST RULES.                     and is often invoked intentionally, as in the context of
Part E of Subchapter J provides a set of rules that            revocable inter vivos trusts used as Will substitutes (to
overrides the general trust taxation rules and causes the      which Section 676 applies as well). Code Section 677
income of the trust to be taxed to the grantor (or             applies grantor trust treatment to trusts the income of
someone treated as the grantor) to the extent that he or       which, without the consent of an adverse party, either
she has retained prohibited enjoyment or control of trust      must be paid to the grantor or his spouse, or may, in the
income or principal. The key to the inquiry is whether         discretion of the grantor or a non-adverse party, be paid
the grantor enjoys trust benefits, has retained so much        currently to the grantor or the grantor's spouse. Section
control, or has left so many "strings" attached to the         677 will also be invoked if trust income may be
trust as to be fairly treated as the true owner of the trust   accumulated for future payment to the grantor or the
property for income tax purposes.                              grantor's spouse. Income must be available for the
                                                               direct or indirect benefit of the grantor, but even a
a. Reversions. Section 673 of the Code treats the              relatively insubstantial "benefit" may give rise to
grantor as the owner of the trust if the principal or          grantor trust treatment. Section 677 is raised, for
income thereof will revert to the grantor if, as of the        example, merely by the use of trust income to pay
inception of the trust, the value of the reversion exceeds     premiums of life insurance on the life of the grantor or
five percent of the value of the trust. An exception is        the grantor's spouse, regardless of the ownership or
provided for reversions occurring only upon the death          beneficiary of the policy. In addition, payments that
of a minor beneficiary who is a descendant of the              discharge a legal or contractual obligation of the grantor
grantor. For trusts established on or before March 1,          (or the grantor's spouse) are treated as indirect
1986, reversions resulted in grantor trust treatment if        payments to the grantor. Section 677(b) provides an
Income Tax Matters                                                                                                     21



exception to this latter rule by limiting taxability only    addition, if the person holding the power cannot add
to amounts actually distributed in the proscribed            himself or herself as a beneficiary, the power does not
manner. The exception applies to discretionary               cause income or estate tax inclusion to the power
distributions of income for the support or maintenance       holder.
of someone that the grantor is obligated to support.
Note that the distributions needn't "discharge" the          e. Certain Administrative Powers.                Generally
grantor's legal obligations of support. Rather, Section      speaking, Section 675 powers are either non-fiduciary
677(b) applies to all actual distributions for support of    powers over closely held business stock, or powers in
someone whom the grantor is legally obligated to             the grantor or a non-adverse party to self-deal with the
support.                                                     trust. More specifically, the prohibited powers are a
                                                             power in the grantor, spouse, or non-adverse party
d. Retention of Control. Section 674 of the Code is          (without the consent of an adverse party) to deal with,
probably the most complex of the grantor trust               dispose of, or exchange either income or principal for
provisions, but its direct application is relatively well    less than full and adequate consideration, even if the
understood by most practitioners. Unfortunately, many        grantor cannot benefit thereby; a power in the grantor
draftsmen fear its more subtle applications. A Section       or spouse to borrow, or a power in a non-adverse party
674 problem usually arises when a grantor demands the        to lend to the grantor or spouse, on less than adequate
broadest powers, with even broader powers granted to         interest and security (see, e.g., PLR 9446008) (but the
"independent" trustees. Too often, practitioners fear        power to lend is permitted if it includes the broad power
that the powers granted are a bit too broad, or that the     to lend without regard to interest or security); the actual
"independent" trustee's powers will somehow be               borrowing of any portion of the trust by the grantor of
attributed back to the grantor. (But see, Rev. Rul.          spouse, except loans made but repaid in prior years, and
95-58, 1995-36 I.R.B. 16, revoking Rev. Rul. 79-353,         loans made for adequate security and interest if made
1979-2 C.B. 325, as modified by Rev. Rul. 81-51,             by an independent trustee; a power in the grantor,
1981-1 C.B. 458 -- these revoked rulings held that for       spouse, or non-adverse party (without the consent of the
transfer tax purposes, a grantor's right to replace a cor-   trustee) to act in a non-fiduciary capacity, to vote or
porate trustee conferred upon the grantor the powers of      direct voting in a corporation in which the aggregate
the trustee). As a result, many practitioners fail to take   holdings of voting stock by the grantor, the spouse, and
advantage of the considerable flexibility permitted          the trust are "significant," or to invest or veto
under Code Section 674. The exceptions to Section            investment, or to direct either, to the extent that the trust
674 are numerous. In summary, anyone can have the            holds securities in a corporation in which the aggregate
powers described in Section 674(b). Most drafters get        holdings of voting stock by the grantor, the spouse, and
the flexibility and control required by grantors in most     the trust are "significant"; and a power to reacquire the
situations under Section 674(b)(5)(A) (discretionary         trust corpus by substituting property of equivalent
distributions of corpus pursuant to an ascertainable         value. Again, in the context of trusts drafted to
standard) and (B) (advancement treatment) yielding           intentionally invoke the grantor trust rules, a power
adequate control over corpus; and Section 674(b)(6)          may be added permitting the grantor, in a non-fiduciary
(withholding income during minority) and (7)                 capacity, to reacquire trust property by substituting
(withholding income during disability) for fiduciary         property of equivalent value.            Since any such
accounting income. Section 674(d) of the Code                substitution requires the payment by the grantor of full
provides that anyone except the grantor and the              and adequate consideration, this power causes the trust
grantor's spouse can have the power to make                  to be a grantor trust for income tax purposes, but does
distributions of income or principal limited by an ascer-    not cause the trust's property to be included in the estate
tainable standard. Finally with no more than half of the     of the grantor for federal estate tax purposes.
trustees related or subordinate to the grantor, anyone
(other than the grantor and the grantor's spouse) can        f.   Section 678. Internal Revenue Code Section 678
have unlimited discretion under Section 674(c). Note         may apply rules similar to the grantor trust rules to
that the exceptions contained in Section 674 do not          persons other than grantors. This Code section is
generally apply if the grantor or a nonadverse party         applied in two parts, the first relating to the existence of
retains the right to add beneficiaries to the trust (other   a power, and the second relating to the release or
than after-born descendants). As a result, persons           modification of a power.
drafting trusts designed to intentionally invoke grantor
trust treatment frequently add a power in someone other      i.   Power to Vest Trust Property in One's Self.
than the grantor or a beneficiary to add a beneficiary       Section 678(a)(1) describes a power to vest income or
(often a charity) to the trust. This power causes the        corpus in one's self. This power held in conjunction
trust to be a grantor trust for income tax purposes, but     with another person, even if that person is not an
does not cause the property to be included in the estate     adverse party, is acceptable. The statute singles out for
of the grantor for federal estate tax purposes. In           grantor trusts treatment only those powers exercisable
22                                                                        2007 DOCKET CALL IN PROBATE COURT



solely by the power holder. Section 678 issues               unwithdrawn income is added to principal, the
typically arise in the context of testamentary trusts        beneficiary will be treated as the "owner" of the lapsed
when a beneficiary is the sole trustee of a complex trust    income. If the unwithdrawn income had been property
as, for example, when the surviving spouse is the sole       transferred to the trust by the grantor, the right to the
trustee of the bypass trust. In the context of inter vivos   income therefrom would generate grantor trust
trusts, a common source for exposure to this sort of         treatment pursuant to Code Section 677(a)(1).
power is a Crummey withdrawal right, granted to              Therefore, the continuing withdrawal right will cause
ensure that a trust beneficiary has a present interest       the person to be treated as the owner of lapsed property,
qualifying for an annual exclusion under Section             and continued lapses may cause the person to be treated
2503(b) of the Code. See PLR 9535047.                        as the owner of an increasing portion of the trust each
                                                             year. See, e.g., Mallinckrodt v. Nunan, 146 F.2d 1 (8th
     (a)   Direct and Indirect Powers. Treasury              Cir. 1945).
           Regulation Section 1.678(a)-(1)(b) expands
           Section 678(a)(1) of the Code to include any      iii. Renunciations of Powers. Section 678(d) of the
           power, directly or indirectly, to apply           Code provides an exception to both inclusion rules of
           income or principal to the person's indi-         Code Section 678(a) by permitting the power holder to
           vidual benefit. This rule is analogous to the     renounce or disclaim the tainted power within a
           grantor trust rule regarding retained income      "reasonable time" after the power holder becomes
           in Section 677 of the Code, and is subject to     aware of its existence. Neither the statute nor the
           similar exceptions. Thus, under Section           regulations define "reasonable time." Presumably, the
           678(c) of the Code (the sibling to Code           disclaimer rules in force prior to the adoption of Code
           Section 677(b)) a power to apply income to        Section 2518, or perhaps the more objective rules
           the support or maintenance of a person the        adopted thereby, would be helpful as an analogy. Does
           power holder is obligated to support or           the renunciation rule permit a beneficiary holding a "5
           maintain will not cause all trust income to be    or 5" power to avoid application of Section 678 of the
           taxed to the holder of the power. Rather,         Code by notifying the trustee of his declination to
           only amounts actually applied for the             withdraw funds each year within a "reasonable time"
           support or maintenance of someone that the        after the trustee advises him of a contribution?
           power holder is obligated to support will be      Revenue Ruling 81-6, 1981 C.B. 385, which holds that
           taxed to the power holder.                        a holder of a withdrawal right is taxed on the income
                                                             associated therewith under Code Section 678(a), does
     (b)   Limitation by Ascertainable Standard.             not address the disclaimer rules associated with a
           Unlike the transfer tax rules, Section 678 of     renunciation of the right.
           the Code does not contain an express
           exception for powers limited by an ascer-         g. Gift and Estate Taxation of Grantor Trusts. For
           tainable standard. A number of cases              years, practitioners have advocated the use of
           decided prior to the adoption of Section 678      "intentionally defective" grantor trusts to shift wealth.
           suggest that such an exception should be          Such a trust is designed to be excluded from the estate
           read into the statute. See Smither v. U.S.,       of the grantor for federal estate tax purposes, while
           108 F. Supp. 772 (S.D. Tex. 1952), aff'd,         remaining a grantor trust solely for federal income tax
           205 F.2d 518 (5th Cir. 1953); Funk v.             purposes. One use of such a trust is to allow income
           Commissioner, 185 F.2d 127 (3d Cir. 1950);        earned by trust assets to be taxed to the grantor, instead
           See also, U.S. v. De Bonchamps, 278 F.2d          of the trust, thereby increasing wealth transfer by the
           127 (9th Cir. 1960) (holding that an              amount of the tax liability, with no additional gift tax.
           ascertainable standard caused capital gains        Another use is to transfer S corporation stock to a trust
           to be taxed to an implied trust and not to the    for younger generation family members with
           life tenant holding the power).                   jeopardizing the S election.

ii. Releases of Powers. The second component of              Example 9: H transfers stock, worth $1 million (with
Section 678(a) of the Code relates to releases or            a basis of $1,000) into trusts for his children, reserving
modifications of powers described in Code Section            a power that causes the trust to be a "grantor trust"
678(a)(1). Generally, Section 678(a)(2) of the Code          solely for income tax purposes. Thereafter, the trustee
imposes grantor trust treatment on the power holder for      sells the stock and invests in a diversified portfolio that
any power released or modified in a fashion that would       produces $50,000 in taxable income each year. Since
give rise to the application of the grantor trust rules      the trust is a grantor trust, H must pay capital gain tax
were the release a transfer by the grantor. For example,     of $149,850 on the sale of the stock, and must pay
if a beneficiary has a power to withdraw income from         income tax of $17,500 on the ordinary income of the
a trust, but allows that power to lapse, so that the         trust each year. The trust can retain the $1,000,000
Income Tax Matters                                            23



sales proceeds and the $50,000 in income each year,
undiminished by federal income taxes.

Commentators have questioned whether the IRS might
take the position that the taxes paid by the grantor of a
grantor trust constitute an additional indirect gift to the
trust beneficiaries. Most practitioners have felt that
since the grantor is simply paying his or her own tax
bill, no gift tax should result.

In July of 2004, the IRS finally ruled that payment by
the grantor of the taxes of a grantor trust is not treated
as a gift, since the grantor is merely paying his or her
own tax liability. Rev. Rule 2004-64, 2004-27 I.R.S. 7.
The ruling goes on to hold, however, that if the trust
instrument contains language requiring the trustee to
reimburse the grantor for taxes, the reimbursement right
will cause the full value of the trust to be included in
the grantor's estate pursuant to Section 2036(a)(1) of the
Code. If instead of a mandatory provision, the trust
agreement grants the trustee discretionary authority to
reimburse the grantor, no Section 2036(a) inclusion will
result to the grantor, so long as "there is no
understanding, express or implied, between [the
grantor] and the trustee regarding the trustee's exercise
of discretion.

The estate tax inclusion rules articulated in Revenue
Ruling 2004-64 apply to trusts created on or after
October 4, 2004. This prospective application is
especially important in the context of grantor trust
designed to hold S corporation stock, since it appears
that the IRS would generally not rule favorably on
requests to ascertain the eligibility of these trusts to
hold S corporation stock unless the trust instrument
included reimbursement rights.

IV. CONCLUSION
      Federal income tax issues applicable to estates and
trusts are complex. Obviously, it is impossible to
discuss with each client the issues raised in this outline,
and craft a document uniquely suited to the goals of the
client. Such a task would be so demanding of the time
of professionals that the costs of providing estate
planning services would be prohibitive for all but the
most wealthy clients. As a result, estate planners are
required to exercise considerable professional
judgment. Familiarity with the rules discussed in this
outline should give you a good framework to use in
assisting clients with these matters.