Definition of Income for Trust Purposes

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1, 20, 25, and 26
[REG-106513-00] RIN 1545-AX96

TITLE: Definition of Income for Trust Purposes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations revising the
definition of income under section 643(b) of the Internal Revenue
Code to take into account changes in the definition of trust
accounting income under state laws. The proposed regulations also
clarify the situations in which capital gains are included in
distributable net income under section 643(a)(3). Conforming
amendments are made to regulations affecting ordinary trusts, pooled
income funds, charitable remainder trusts, trusts that qualify for
the gift and estate tax marital deduction, and trusts that are
exempt from generation-skipping transfer taxes. This document also
provides notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by May 18,
2001. Outlines of topics to be discussed at the public hearing
scheduled for June 8, 2001 must be received by May 18, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-106513-00), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU
(REG-106513-00), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers
may submit comments electronically via the Internet by selecting the
"Tax Regs" option on the IRS Home Page, or by submitting comments
directly to the IRS Internet site at:

http://www.irs.ustreas.gov/tax_regs/regslist.html. The public
hearing will be held in the IRS Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Bradford Poston at (202) 622-3060 (not a toll-free
number); concerning submissions of comments, the hearing, and/or to
be placed on the building access list to attend the hearing, Guy R.
Traynor, 202-622-8452 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 643(b) provides a definition of the term income for purposes
of subparts A through D of part I of subchapter J of the Internal
Revenue Code (Code) . The term income, when not modified by any
other term, means the amount of income of the trust or estate
determined under the terms of the governing instrument and
applicable local law. Section 1.643(b)-1 further provides that trust
provisions that depart fundamentally from the concepts of local law
in determining what constitutes income will not be recognized.

 These statutory and regulatory provisions date back to a time when,
under state statutes, dividends and interest were considered income
and were allocated to the income beneficiary while capital gains
were allocated to the principal of the trust. Changes in the types
of available investments and in investment philosophies have caused
states to revise, or to consider revising, these traditional
concepts of income and principal.

 The prudent investor standard for managing trust assets has been
enacted by many states and encourages fiduciaries to adopt an
investment strategy designed to maximize the total return on trust
assets. Under this investment strategy, trust assets should be
invested for total positive return, that is, ordinary income plus
appreciation, in order to maximize the value of the trust. Thus,
under certain economic circumstances, equities, rather than bonds,
would constitute a greater portion of the trust assets than they
would under traditional investment standards. One of the concerns
with shifting trust investments toward equities and away from bonds
is the potential adverse impact on the income beneficiary. Based on
the traditional concepts of income and principal, the income
beneficiary is entitled only to the dividends and interest earned by
the trust assets. The dividend return on equities as a percentage of
their value traditionally has been substantially less than the
interest return on bonds.

 To ensure that the income beneficiary is not penalized if a trustee
adopts a total return investment strategy, many states have made, or
are considering making, revisions to the definitions of income and
principal. Some state statutes permit the trustee to make an
equitable adjustment between income and principal if necessary to
ensure that both the income beneficiary and the remainder
beneficiary are treated impartially, based on what is fair and
reasonable to all of the beneficiaries. Thus, a receipt of capital
gains that previously would have been allocated to principal may be
allocated by the trustee to income if necessary to treat both
parties impartially. Conversely, a receipt of dividends or interest
that previously would have been allocated to income may be allocated
by the trustee to principal if necessary to treat both parties
impartially.

 Other states are proposing legislation that would allow the trustee
to pay a unitrust amount to the income beneficiary in satisfaction
of that beneficiary's right to the income from the trust. This
unitrust amount will be a fixed percentage, sometimes required to be
within a range set by state statute, of the fair market value of the
trust assets determined annually.

 Questions have arisen concerning how these state statutory changes
affect the definition of income provided in section 643(b) and the
other Code provisions that rely on the section 643(b) definition of
income. This definition of income affects trusts including, but not
limited to, ordinary trusts, charitable remainder trusts, pooled
income funds, and qualified subchapter S trusts.

 In addition, trusts that qualify for the gift or estate tax marital
deduction must pay to the spouse all the income from the property.
All the income is considered paid to the spouse if the effect of the
trust is to give the spouse substantially that degree of beneficial
enjoyment of the trust property that the principles of trust law
accord to a person who is unqualifiedly designated as the life
beneficiary of a trust. Section 25.2523(e)-1(f) of the Gift Tax
Regulations and §20.2056(b)-5(f) of the Estate Tax Regulations.
Questions have arisen whether the spouse is entitled to all the
income from the property in a state that permits equitable
adjustments or unitrust payments.

 Similarly, questions have arisen as to whether an otherwise exempt
trust which uses equitable adjustments or unitrust payments will be
subject to the generation- skipping transfer tax provisions of
chapter 13 of the Code.

Explanation of provisions

Definition of Income

 The proposed regulations will amend the definition of income under
§1.643(b)-1 to take into account certain state statutory
changes to the concepts of income and principal. Under the proposed
regulations, trust provisions that depart fundamentally from
traditional concepts of income and principal (that is, allocating
ordinary income to income and capital gains to principal) will
generally continue to be disregarded, as they are under the current
regulations. However, amounts allocated between income and principal
pursuant to applicable state law will be respected if state law
provides for a reasonable apportionment between the income and
remainder beneficiaries of the total return of the trust for the
year, taking into account ordinary income, capital gains, and, in
some situations, unrealized appreciation. For example, a state law
that provides for the income beneficiary to receive each year a
unitrust amount of between 3% and 5% of the annual fair market value
of the trust assets is a reasonable apportionment of the total
return of the trust. Similarly, a state law that permits the trustee
to make equitable adjustments between income and principal to
fulfill the trustee's duty of impartiality between the income and
remainder beneficiaries is a reasonable apportionment of the total
return of the trust.

 In addition, an allocation of capital gains to income will be
respected under certain .Lrcumstances. Such an allocation will be
respected if directed by the terms of the governing instrument and
applicable local law. Similarly, if a trustee, pursuant to a
discretionary power granted to the trustee by local law or by the
governing instrument (if not inconsistent with local law), allocates
capital gains to income, the allocation will be respected, provided
the power is exercised in a reasonable and consistent manner. The
proposed changes to the regulations will permit trustees to
implement a total return investment strategy and to follow the
applicable state statutes designed to treat the income and remainder
beneficiaries impartially. At the same time, the limitations imposed
by the proposed regulations ensure that the Code provisions relying
on the definition of income under section 643(b) are not undermined
by an unlimited ability of the trustee to allocate between income
and principal.

Pooled Income Funds

 A special rule is proposed to be added to the regulations covering
pooled income funds to address the problems arising from the
potential application of the new state statutes to these funds. A
pooled income fund as defined in section 642(c)(5) is a split-
interest trust created and maintained by certain types of charitable
organizations. Noncharitable beneficiaries receive the income from
the commingled fund during their lives and the charitable
organization receives the remainder interests. The income that is to
be paid to the noncharitable beneficiaries is income as defined in
section 643(b). §1.642(c)-5(i).

A pooled income fund is a trust subject to taxation under section
641. It is entitled to a distribution deduction under section 661
for income distributed to the noncharitable beneficiaries. In
addition, it receives a charitable deduction under section 642(c)(3)
for any amount of net long-term capital gain which pursuant to the
terms of the governing instrument is permanently set aside for
charitable purposes. A pooled income fund is taxed on any net short-
term capital gain that is not required to be distributed to the
income beneficiaries pursuant to the terms of the governing
instrument and applicable local law.

Under traditional principles of income and principal, ordinary
income would be paid to the income beneficiaries. Any net long-term
capital gain would be allocated to principal to be held for the
ultimate benefit of the charitable remainderman and therefore would
qualify for the charitable deduction under section 642(c)(3). If a
pooled income fund were to pay the income beneficiaries a unitrust
amount in satisfaction of their right to income, as provided by
proposed state statutes, long- term capital gains would no longer
qualify for the charitable deduction. Any net long- term capital
gain not required to be distributed during the current year would be
added to principal. However, the amount of the gain would not be
permanently set aside for charitable purposes because this amount
may used in the future to make the unitrust payment to the income
beneficiaries. A similar situation arises if the trustee is
permitted under state law to make equitable adjustments with respect
to unrealized appreciation in the value of the trust assets. A
portion of any subsequently realized capital gain may already have
been treated as distributed to the income beneficiaries in
accordance with an equitable adjustment distribution.

The proposed regulations will amend §1.642(c)-2(c) to address
these issues for pooled income funds. Thus, no net long-term capital
gain qualifies for the charitable deduction if, under the terms of
the governing instrument and applicable state law, income may be a
unitrust amount or may include an equitable adjustment with respect
to unrealized appreciation in the value of the trust assets.

Charitable Remainder Unitrusts

A charitable remainder unitrust is a split-interest trust that
provides for a specified distribution to one or more noncharitable
beneficiaries for life or a term of years, with an irrevocable
remainder interest held for the benefit of a charitable
organization. Under section 664(d)(2), the amount distributed to the
noncharitable beneficiaries is a fixed percentage (not less than 5%
and not more than 50%) of the annual fair market value of the trust
assets. Alternatively, under section 664(d)(3), the unitrust amount
may be the lesser of this fixed percentage amount or trust income
(with or without a make-up amount). For this purpose, trust income
means income as defined under section 643(b) and the applicable
regulations. §1.664-3(a)(1)(i)(b). Under proposed state
statutes, trust income could be a fixed percentage of the annual
fair market value of the trust assets, and the fixed percentage may
be less than 5%. A net income charitable remainder unitrust using
such a state statutory definition of income would in substance be a
fixed percentage unitrust with a percentage less than the 5%
required by section 664(d)(2). Therefore, the proposed regulations
will amend §1.664-3(a)(1)(i)(b) to provide that income under
the terms of the governing instrument and applicable local law may
not be determined by reference to a fixed percentage of the annual
fair market value of the trust property. If the applicable state law
defines income as a unitrust amount, the governing instrument of a
net income charitable remainder unitrust must provide its own
definition of trust income. In addition, the proposed regulations
will provide that capital gains .Ltributable to appreciation in the
value of assets after the date contributed to the trust or purchased
by the trust may be allocated to income under the terms of the
governing instrument and applicable local law. Such an allocation,
however, may not be discretionary with the trustee. The section 664
regulations already prohibit the allocation of pre- contribution
gains to income.

Capital Gains and Distributable Net Income

Section 643(a)(3) provides that gains from the sale or exchange of
capital assets are excluded from distributable net income to the
extent that these gains are allocated to corpus and they are not
either paid, credited, or required to be distributed, to a
beneficiary during the year, or paid, permanently set aside, or to
be used for a charitable purpose. The circumstances in which capital
gains are considered paid or credited to a beneficiary during the
year, and therefore included in distributable net income, are not
entirely clear. In addition, the revisions to state law definitions
of income have precipitated additional questions in this area. The
question arises, for example, whether realized capital gains are
included in the unitrust amount distributed to the income
beneficiary under local law, if the unitrust amount exceeds the
trust's ordinary income.

 The proposed regulations will amend §1.643(a)-3(a) to clarify
the circumstances in which capital gains are includible in
distributable net income for the year. In general, capital gains are
included in distributable net income to the extent they are,
pursuant to the terms of the governing instrument or local law, or
pursuant to a reasonable and consistent exercise of discretion by
the fiduciary (in accordance with a power granted to the fiduciary
by the governing instrument or local law): allocated to income;
allocated to corpus but treated by the fiduciary on the trust's
books, records, and tax returns as part of a distribution to a
beneficiary; or allocated to corpus but utilized by the fiduciary in
determining the amount which is distributed or required to be
distributed to a beneficiary. As is the case under the current
regulations, capital gains that are paid, permanently set aside, or
to be used for the purposes specified in section 642(c) are included
in the distributable net income. Capital losses are netted at the
trust level against any capital gains, except for a capital gain
that is utilized in determining the amount that is distributed or
required to be distributed to a particular beneficiary. Under the
proposed regulations, capital gains will be included in
distributable net income under certain circumstances that are
directed by the terms of the governing instrument and applicable
local law. Thus, any capital gain that is included in the section
643(b) definition of income is included in distributable net income.
Similarly, any capital gain that is used to determine the amount or
the timing of a distribution to a beneficiary is included in
distributable net income.

 Capital gains are also included in distributable net income if the
fiduciary, pursuant to a discretionary power granted by local law or
by the governing instrument (if not inconsistent with local law),
treats the capital gains as distributed to a beneficiary, provided
the power is exercised in a reasonable and consistent manner. Thus,
if a trustee exercises a discretionary power by consistently
treating any distribution in excess of ordinary income as being made
from realized capital gains, any capital gain so distributed is
included in distributable net income.

 The provisions of sections 643(b) and 643(a)(3) are further
intertwined when consideration is given to the new state statutory
provisions defining income. If, under the terms of the governing
instrument or applicable local law, realized capital gains are
treated as income to the extent the unitrust amount or the equitable
adjustment amount exceeds ordinary income, capital gains so treated
are included in distributable net income. A similar result is
achieved for capital gains consistently allocated to income by the
fiduciary pursuant to a discretionary power. In any other situation,
capital gains will be excluded from distributable net income and
will be taxed to the trust.

Distributions in Kind

 The proposed regulations will clarify the consequences of certain
distributions of property in kind for purposes of the distribution
deductions under sections 651 and 661. Thus, if property is
distributed to a beneficiary in satisfaction of the beneficiary's
right to income, the trust will be treated as having sold the
property for its fair market value on the date of distribution.

Trusts Qualifying for Gift and Estate Tax Marital Deduction

  Certain transfers of property in trust for the benefit of the
spouse qualify for the marital deduction for gift and estate tax
purposes. These transfers include a life estate with a general power
of appointment described in sections 2523(e) and 2056(b)(5) and
qualified terminal interest property described in sections 2523(f)
and 2056(b)(7). One of the requirements of these provisions is that
the spouse must be entitled for life to all the income from the
trust property. The rules for determining whether the spouse is
entitled to all the income from either a life estate with a general
power of appointment trust or a qualified terminable interest trust
are set forth in §20.2056(b)-5(f) of the Estate Tax Regulations
and §25.2523(e)-1(f) of the Gift Tax Regulations. These rules
provide that if an interest is transferred in trust, the spouse is
entitled for life to all the income from the entire interest or a
specific portion of the entire interest if the effect of the trust
is to give the spouse substantially that degree of beneficial
enjoyment of the trust property during the spouse's life which the
principles of the law of trusts accord a person who is unqualifiedly
designated as the life beneficiary of a trust.

  The proposed regulations will provide that a spouse's interest
satisfies the income standard set forth in
§§20.2056(b)-5(f) and 25.2523(e)-1(f) if the spouse is
entitled to income as defined under a state statute that provides
for a reasonable apportionment between the income and remainder
beneficiaries of the total return of the trust and that meets the
requirements of §1.643(b)-1(a). As the examples under
§1.643(b)-1(a) make clear, reasonable apportionment can be
accomplished through a unitrust definition of income or by giving
the trustee the power to make equitable adjustments between income
and principal. In addition, a conforming amendment is made to
§20.2056A-5(c)(2) providing rules regarding distributions of
income from a qualified domestic trust.

Trusts Exempt From Generation-Skipping Transfer Tax

 In general, under the effective date rules accompanying the
generation-skipping transfer (GST) tax statutory provisions, a trust
that was irrevocable on September 25, 1985, is not subject to the
GST tax provisions, unless a GST transfer is made out of corpus
added to the trust after that date. Section 1433(b)(2)(A) of the Tax
Reform Act of 1986 (TRA), Public Law 99-514 (100 Stat. 2085, 2731),
1986-3 (Vol. 1) C.B. 1, 634. The regulations provide guidance on
when certain changes made to the terms of an exempt trust will not
be treated as causing the trust to lose its exempt or grandfathered
status. One safe-harbor in §26.2601-1(b)(4)(i)(D) is for
modifications that will not shift a beneficial interest in the trust
to a lower generation beneficiary or increase the amount of a GST
transfer.

 Under the proposed regulations, the administration of a pre-
September 25, 1985 trust in conformance with a state law that
defines income as a unitrust amount, or permits equitable
adjustments between income and principal to ensure impartiality, and
that meets the requirements of §1.643(b)-1(a) will not be
treated as a modification that shifts a beneficial interest to a
lower generation beneficiary, or increases the amount of a
generation- skipping transfer.

Proposed Effective Date

 The regulations are proposed to apply to trusts and estates for
taxable years that begin on or after the date that final regulations
are published in the Federal

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also
has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not apply to these
regulations, and, because these regulations do not impose a
collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a
Regulatory Flexibility Analysis is not required. Pursuant to section
7805(f) of the Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (preferably a
signed original and eight (8) copies) and comments sent via the
Internet that are submitted timely to the IRS. The IRS and Treasury
request comments on the clarity of the proposed regulations and how
they may be made easier to understand. All comments will be
available for public inspection and copying. A public hearing has
been scheduled for June 8, 2001, in the IRS Auditorium, Internal
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC.

Owing to building security procedures, visitors must enter at the 10
Street entrance, located between Constitution and Pennsylvania th
Avenues, NW. Because of access restrictions, visitors will not be
admitted beyond the immediate entrance area more than 15 minutes
before the hearing starts. For information about having your name
placed on the building access list to attend the hearing, see the
"FOR FURTHER INFORMATION CONTACT" section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written or
electronic comments and an outline of the topics to be discussed and
the time to be devoted to each topic (preferably a signed original
and eight (8) copies) by May 18, 2001. A period of 10 minutes will
be allotted to each person making comments. An agenda showing the
scheduling of the speakers will be prepared after the deadline for
receiving outlines has passed. Copies of the agenda will be
available free of charge at the hearing.

Drafting Information

Various personnel from offices of the IRS and the Treasury
Department participated in the development of these proposed
regulations. List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 20

Estate taxes, Reporting and recordkeeping requirements.

26 CFR Part 25

Gift taxes, Reporting and recordkeeping requirements.

26 CFR Part 26

Estate taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1, 20, 25, and 26 are proposed to be
amended as follows:

PART 1---INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In §1.642(c)-2, paragraph (c) is amended by adding a
sentence after the first sentence to read as follows:

§1.642(c)-2 Unlimited deduction for amounts permanently set
aside for a charitable purpose.

* * * * *

(c) * * * No amount of net long-term capital gain shall be
considered permanently set aside for charitable purposes if it is
possible, under the terms of the fund's governing instrument or
applicable local law, that the income beneficiaries' right to income
may, at any time, be satisfied by the payment of either an amount
equal to a fixed percentage of the annual fair market value of the
trust property or any amount based on unrealized appreciation in the
value of the trust property. * * *

* * * * *

Par. 3. Section 1.643(a)-3 is revised to read as follows:

§1.643(a)-3 Capital gains and losses.

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

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

(1) Allocated to income;

(2) Allocated to corpus but treated by the fiduciary on the trust's
books, records, and tax returns as part of a distribution to a
beneficiary; or

(3) Allocated to corpus but utilized by the fiduciary in determining
the amount which is distributed or required to be distributed to a
beneficiary.

(c) Charitable contributions included in distributable net income.
If capital gains are paid, permanently set aside, or to be used for
the purposes specified in section 642(c), so that a charitable
deduction is allowed under that section in respect of the gains,
they must be included in the computation of distributable net
income.

(d) Capital losses. Losses from the sale or exchange of capital
assets shall first be netted at the trust level against any gains
from the sale or exchange of capital assets, except for a capital
gain that is utilized under paragraph (b)(3) of this section in
determining the amount that is distributed or required to be
distributed to a particular beneficiary. See §1.642(h)-1 with
respect to capital loss carryovers in the year of final termination
of an estate or trust.

 (e) Examples. The following examples illustrate the rules of this
 section:

 Example 1. Under the terms of Trust's governing instrument, all
income is to be paid to A for life. Trustee is given discretionary
powers to invade principal for A's benefit and to deem discretionary
distributions to be made from capital gains realized during the
year. During Trust's first taxable year, Trust has $5,000 of
dividend income and $10,000 of capital gain from the sale of
securities. Pursuant to the terms of the governing instrument and
applicable local law, Trustee allocates the $10,000 capital gain to
principal. During the year, Trustee distributes to A $5,000,
representing A's right to trust income. In addition, Trustee
distributes to A $12,000, pursuant to the discretionary power to
distribute principal. Trustee does not exercise the discretionary
power to deem the discretionary distributions of principal as being
paid from capital gains realized during the year. Therefore, the
capital gains realized during the year are not included in
distributable net income and the $10,000 of capital gain is taxed to
the trust.

 Example 2. The facts are the same as in Example 1, except that
Trustee intends to follow a regular practice of treating
discretionary distributions as being paid first from any net capital
gains realized by Trust during the year. Trustee evidences this
treatment by including the $10,000 capital gain in distributable net
income on Trust's federal income tax return so that it is taxed to
A. This treatment of the capital gains is a reasonable exercise of
Trustee's discretion. In future years Trustee must treat all
discretionary distributions as being made first from any realized
capital gains.

 Example 3. The facts are the same as in Example 1, except that
pursuant to the terms of the governing instrument (in a provision
not inconsistent with applicable local law), capital gains realized
by Trust are allocated to income. Because the capital gains are
allocated to income pursuant to the terms of the governing
instrument, the $10,000 capital gain is included in Trust's
distributable net income for the taxable year.

 Example 4. The facts are the same as in Example 1, except that
Trustee decides that discretionary distributions will be made only
to the extent Trust has realized capital gains during the year and
thus the discretionary distribution to A is $ 10,000, rather than
$12,000. Because Trustee will .Lnsistently use the amount of any
realized capital gain to determine the amount of the discretionary
distribution to the beneficiary, the $10,000 capital gain is
included in Trust's distributable net income for the taxable year.

 Example 5. Trust's assets consist of Blackacre and other property.
Under the terms of Trust's governing instrument, Trustee is directed
to hold Blackacre for ten years and then sell it and distribute all
the sales proceeds to A. Because Trustee uses the amount of the
sales proceeds that includes any realized capital gain to determine
the amount required to be distributed to A, any capital gain
realized from the sale of Blackacre is included in Trust's
distributable net income for the taxable year.

 Example 6. Under the terms of Trust's governing instrument, all
income is to be paid to A during the Trust's term. When A reaches
35, Trust is to terminate and all the principal is to be distributed
to A. All capital gains realized in the year of termination are
included in distributable net income. See §1.641(b)-3 for the
determination of the year of final termination and the taxability of
capital gains realized after the terminating event and before final
distribution.

 Example 7. The facts are the same as Example 6, except Trustee is
directed to distribute only one-half of the principal to A when A
reaches 35. Trust assets consist entirely of stock in corporation M.
If Trustee sells one-half of the stock and distributes the sales
proceeds to A, all the capital gain attributable to that sale is
included in distributable net income. If Trustee sells all the stock
and distributes one-half of the sales proceeds to A, one-half of the
capital gain attributable to that sale is included in distributable
net income.

 Example 8. The facts are the same as Example 6, except Trustee is
directed to pay B $10,000 before distributing the remainder of Trust
assets to A. No portion of the capital gains is allocable to B
because the distribution to B is a gift of a specific sum of money
within the meaning of section 663(a)(1).

 Example 9. State law provides that a trustee may make an election
to pay an income beneficiary an amount equal to four percent of the
annual fair market value of the trust assets in full satisfaction of
that beneficiary's right to income. State law provides that this
unitrust amount shall be considered paid first from ordinary income,
then from net short-term capital gain, then from net long-term
capital gain, and finally from return of principal. Trust's
governing instrument provides that A is to receive each year income
as defined under State law. Trustee makes the unitrust election
under State law. At the beginning of the taxable year, Trust assets
are valued at $500,000. During the year, Trust receives $5,000 of
dividend income and realizes $80,000 of net long-term gain from the
sale of capital assets. Trustee distributes to A $20,000 (4% of
$500,000) in satisfaction of A's right to income. Net long-term
capital gain in the amount of $15,000 is allocated to income
pursuant to the State law ordering rule and is included in
distributable net income for the taxable year.

 Example 10. The facts are the same as in Example 9, except that
neither State law nor Trust's governing instrument has an ordering
rule for the character of the unitrust amount, but leaves such a
decision to the discretion of Trustee. Trustee intends to follow a
regular practice of treating principal as distributed to the
beneficiary to the extent that the unitrust amount exceeds Trust's
ordinary income. Trustee evidences this treatment by not including
any capital gains in distributable net income on Trust's Federal
income tax return so that the entire $80,000 capital gain is taxed
to Trust. This treatment of the capital gains is a reasonable
exercise of Trustee's discretion. In future years Trustee must
consistently follow this treatment with respect to all realized
capital gains.

 Example 11. The facts are the same as in Example 9, except that
neither State law nor Trust's governing instrument has an ordering
rule for the character of the unitrust amount, but leaves such a
decision to the discretion of Trustee. Trustee intends to follow a
regular practice of treating net capital gains as distributed to the
beneficiary to the extent the unitrust amount exceeds Trust's
ordinary income. Trustee evidences this treatment by including
$15,000 of the capital gain in distributable net income on Trust's
Federal income tax return. This treatment of the capital gains is a
reasonable exercise of Trustee's discretion. In future years Trustee
must consistently treat realized capital gain, if any, as
distributed to the beneficiary to the extent that the unitrust
amount exceeds ordinary income.

Par. 4. Section 1.643(b)-1 is revised to read as follows:

§1.643(b)-1 Definition of income.

 For purposes of subparts A through D, part I, subchapter J, chapter
1 of the Internal Revenue Code, income, when not preceded by the
words "taxable," "distributable net," "undistributed net," or
"gross," means the amount of income of an estate or trust for the
taxable year determined under the terms of the governing instrument
and applicable local law. Trust provisions that depart fundamentally
from traditional principles of income and principal, that is,
allocating ordinary income to income and capital gains to principal,
will generally not be recognized. However, amounts allocated between
income and principal pursuant to applicable local law will be
respected if local law provides for a reasonable apportionment
between the income and remainder beneficiaries of the total return
of the trust for the year, including ordinary income, capital gains,
and appreciation. For example, a state law that provides for the
income beneficiary to receive each year a unitrust amount of between
3% and 5% of the annual fair market value of the trust assets is a
reasonable apportionment of the total return of the trust.
Similarly, a state law that permits the trustee to make equitable
adjustments between income and principal to fulfill the trustee's
duty of impartiality between the income and remainder beneficiaries
is generally a reasonable apportionment of the total return of the
trust. These adjustments are permitted when the trustee invests and
manages the trust assets under the state's prudent investor
standard, the trust describes the amount that shall or must be
distributed to a beneficiary by referring to the trust's income, and
the trustee after applying the state statutory rules regarding
allocation of income and principal is unable to administer the trust
impartially. In addition, an allocation of capital gains to income
will be respected if the allocation is made either pursuant to the
terms of the governing instrument and local law, or pursuant to a
reasonable and consistent exercise of a discretionary power granted
to the fiduciary by local law or by the governing instrument, if not
inconsistent with local law.

Par. 5. In §1.651(a)-2, paragraph (d) is added to read as
follows:

§1.651(a)-2 Income required to be distributed currently.

* * * * *

  ( d) If a trust distributes property in kind as part of its
requirement to distribute currently all the income as defined under
section 643(b) and the applicable regulations, the trust shall be
treated as having sold the property for its fair market value on the
date of distribution. If no amount in excess of the amount of income
as defined under section 643(b) and the applicable regulations is
distributed by the trust during the year, the trust will qualify for
treatment under section 651 even though property in kind was
distributed as part of a distribution of all such income.

Par. 6. In §1.661(a)-2, paragraph (f) is revised to read as
follows:

§1.661(a)-2 Deduction for distributions to beneficiaries.

* * * * *

  (f) Gain or loss is realized by the trust or estate (or the other
beneficiaries) by reason of a distribution of property in kind if
the distribution is in satisfaction of a right to receive a
distribution of a specific dollar amount, of specific property other
than that distributed, or of income as defined under section 643(b)
and the applicable regulations, if income is required to be
distributed currently. In addition, gain or loss is realized if the
trustee or executor makes the election to recognize gain or loss
under section 643(e).

  Par. 7. In §1.664-3, paragraph (a)(1)(i)(b)(3) is revised to
  read as follows:

§1.664-3 Charitable remainder unitrust.

(a) * * *

(1) * * *

(i) * * *

(b) * * *

 (3) For purposes of this paragraph (a)(1)(i)(b), trust income
generally means income as defined under section 643(b) and the
applicable regulations. However, trust income may not be determined
by reference to a fixed percentage of the annual fair market value
of the trust property. If applicable state law provides that income
is a unitrust amount, the trust's governing instrument must contain
its own definition of trust income. In addition, capital gain
attributable to appreciation in the value of a trust asset after the
date it was contributed to the trust or purchased by the trust may
be allocated to income pursuant to applicable local law and the
terms of the governing instrument but not pursuant to a
discretionary power granted the trustee.

* * * * *

PART 20--ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16,
1954

 Par. 8. The authority citation for part 20 continues to read in
part as follows: Authority: 26 U.S.C. 7805 * * *

 Par. 9. Section 20.2056(b)-5 is amended by adding a new sentence to
the end of paragraph (f)(1) to read as follows: §20.2056(b)-5
Marital deduction; life estate with power of appointment in
surviving spouse.

* * * * *

 (f) * * *

 (1) * * * In addition, the surviving spouse's interest shall meet
the condition set forth in paragraph (a)(1) of this section, if the
spouse is entitled to income as defined by a state statute that
provides for a reasonable apportionment between the income and
remainder beneficiaries of the total return of the trust and that
meets the requirements of §1.643(b)-1 of the this chapter.

* * * * *

Par. 10. Section 20.2056(b)-7 is amended by adding a new sentence to
the end of paragraph (d)(1) to read as follows: §20.2056(b)-7
Election with respect to life estate for surviving spouse.

* * * * *

(d) * * *

(1) * * * A power under applicable state law that permits the
trustee to adjust between income and principal to fulfill the
trustee's duty of impartiality between the income and remainder
beneficiaries that meets the requirements of §1.643(b)-1 of
this chapter will not be considered a power to appoint trust
property to a person other than the surviving spouse.

* * * * *

Par. 11. Section 20.2056(b)-10 is amended by adding a new sentence
at the end of the section to read as follows:

§20.2056(b)-10 Effective dates.

* * * In addition, the rule in the last sentence of
§20.2056(b)-5(f) (1) and the rule in the last sentence of
§20.2056(b)-7(d)(1) regarding the spouse's right to income if
the state statute provides for the reasonable apportionment between
the income and remainder beneficiaries of the total return of the
trust are applicable with respect to trusts for taxable years that
begin on or after the date that final regulations are published   in
the Federal Register.

Par. 12. Section 20.2056A-5 is amended by adding a new sentence in
paragraph (c)(2) after the third sentence to read as follows:

§20.2056A-5 Imposition of section 2056A estate tax.

* * * * *

(c) * * *

(2) * * * However, distributions made to the surviving spouse as the
income beneficiary in conformance with applicable state law that
defines the term income as a unitrust amount, or permits the trustee
to adjust between principal and income to fulfill the trustee's duty
of impartiality between income and principal beneficiaries, will be
considered distributions of trust income, if the state statute
provides for a reasonable apportionment between the income and
remainder beneficiaries of the total return of the trust and meets
the requirements of §1.643(b)-1 of this chapter. * * *

* * * * *

Par. 13. Section 20.2056A-13 is revised to read as follows:

§20.2056A-13 Effective dates.

Except as provided in this section, the provisions of
§§20.2056A-1 through 20.2056A-12 are applicable with
respect to estates of decedents dying after August 22, 1995. The
rule in the fourth sentence of §20.2056A-5(c) regarding
unitrusts and distributions of income to the surviving spouse in
conformance with applicable state law that provides for the
reasonable apportionment between the income and remainder
beneficiaries of the total return of the trust is applicable with
respect to trusts for taxable years that begin on or after the date
that final regulations are published in the Federal Register.

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Par. 14. The authority citation for part 25 continues to read in
part as follows: Authority: 26 U.S.C. 7805 * * *

Par. 15. Section 25.2523(e)-1 is amended by adding a new sentence to
the end of paragraph (f)(1) to read as follows: §25.2523(e)-1
Marital deduction; life estate with power of appointment in donee
spouse.

* * * * *

(f) * * *

(1) * * * In addition, the spouse's interest shall meet the
condition set forth in paragraph (a)(1) of this section, if the
spouse is entitled to income as defined by a state statute that
provides for a reasonable apportionment between the income and
remainder beneficiaries of the total return of the trust and that
meets the requirements of §1.643(b)-1(a) of this chapter.

* * * * *

Par. 16. Section 25.2523(h)-2 is amended by adding a new sentence to
the end of the section to read as follows:

§25.2523(h)-2 Effective dates.

* * * In addition, the rule in the fourth sentence of
§25.2523(e)-1(f)(1) regarding the spouse's right to income if
the state statute provides for reasonable apportionment between the
income and remainder beneficiaries of the total return of the trust
is applicable with respect to trusts and estates for taxable years
that begin on or after the date the final regulations are published
in the Federal Register.

PART 26--GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE

TAX REFORM ACT OF 1986

Par. 17. The authority citation for part 26 continues to read in
part as follows: Authority: 26 U.S.C. 7805 * * *

Par. 18. Section 26.2601-1 is amended as follows:

1. Paragraph (b)(4)(i)(D)(2) is amended by adding a new sentence to
the end of the paragraph.

2. Paragraph (b)(4)(i)(E) is amended by adding Examples 11 and 12.

3. Paragraph (b)(4)(ii) is revised to read as follows.

The additions and revisions read as follows:

§26.2601-1 Effective dates.

* * * * *

(b) * * *

(4) * * *

(i) * * *

(D) * * *

(2) * * * In addition, administration of a trust in conformance with
applicable state law that defines the term income as a unitrust
amount, or permits the trustee to adjust between principal and
income to fulfill the trustee's duty of impartiality between income
and principal beneficiaries, will not be considered to shift a
beneficial interest in the trust, if the state statute provides for
a reasonable apportionment between the income and remainder
beneficiaries of the total return of the trust and meets the
requirements of §1.643(b)-1 of this chapter.

(e) * * *

 Example 11. Conversion of income interest to unitrust interest
under state statute. In 1980, Grantor, a resident of State X,
established an irrevocable trust for the benefit of Grantor's child,
A, and A's issue. The trust provides that trust income is payable to
A for life and upon A's death the remainder is to pass to A's issue,
per stirpes. In 2002, State X amends its income and principal
statute to define "income" as a unitrust amount of 4% of the fair
market value of the trust assets valued annually. For a trust
established prior to 2002, the statute provides that the new
definition of income will apply only if all the beneficiaries who
have an interest in the trust consent to the change within two years
after the effective date of the statute. The statute provides
specific procedures to establish the consent of the beneficiaries. A
and A's issue consent to the change in the definition of income
within the time period, and in accordance with the procedures,
prescribed by the state statute. The administration of the trust, in
accordance with the state statute defining income to be a 4%
unitrust amount, will not be considered to shift any beneficial
interest in the trust. Therefore, the trust will not be subject to
the provisions of chapter 13 of the Internal Revenue Code.

 Example 12. Equitable adjustments under state statute. The facts
are the same as in Example 11, except that in 2002, State X amends
its income and principal statute to permit the trustee to make
equitable adjustments between income and principal when the trustee
invests and manages the trust assets under the state's prudent
investor standard, the trust describes the amount that shall or must
be distributed to a beneficiary by referring to the trust's income,
and the trustee after applying the state statutory rules regarding
allocation of income and principal is unable to administer the trust
impartially. The provision permitting the trustees to make these
equitable adjustments is effective in 2002 for trusts created at any
time. The trustee invests and manages the trust assets under the
state's prudent investor standard, and pursuant to authorization in
the state statute, the trustee allocates receipts between the income
and principal accounts in a manner to ensure the impartial
administration of the trust. The administration of the trust in
accordance with the state statute will not be considered to shift
any beneficial interest in the trust. Therefore, the trust will not
be subject to the provisions of chapter 13 of the Internal Revenue
Code.

 ( ii) Effective dates. The rules in this paragraph (b)(4) are
applicable on and after December 20, 2000. However, the rule in the
last sentence of paragraph (b)(4)(i)(D)(2) of this section regarding
the administration of a trust in conformance with applicable state
law providing for a reasonable apportionment between the income and
remainder beneficiaries of the total return of the trust is
applicable with respect to trusts for taxable years that begin on or
after the date that final regulations are published in the Federal
Register.

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue

SEARCH:

You can search the entire Tax Professionals section, or all of Uncle Fed's Tax*Board. For a more focused search, put your search word(s) in quotes.

2001 Regulations Main | IRS Regulations Main | Home