Tax Treatment of Pass-Through Income by Trusts
Many tax practitioners who work with high-net-worth families are asked to prepare fiduciary income tax returns for trusts. Preparing fiduciary returns for trust accounts that are invested in basic stocks, bonds, and cash is complicated enough.
by Todd A. Sacco, CPA, PFS, JD Dec 20, 2019, 13:24 PM
Many tax practitioners who work with high-net-worth families are asked to prepare fiduciary income tax returns for trusts. Preparing fiduciary returns for trust accounts that are invested in basic stocks, bonds, and cash is complicated enough. Those trusts that are also invested in hedge funds, private equity funds, master limited partnerships, and other pass-through entities structured as limited partnerships or limited liability companies amp up the complication. Specifically, the reporting of “phantom” income and deductions from these types of entities raises many complex issues.
Subchapter J of the Internal Revenue Code (IRC) sets forth the rules to determine whether trust income will be taxable to the trust or its beneficiaries. For income tax purposes, a trust may be classified as “simple” or “complex.” A trust is considered simple if under the terms of the trust agreement all income is required to be distributed currently, the trust makes no charitable contributions for the taxable year, and no corpus is distributed in the current year.1 Any trust, other than a grantor trust, that is not a simple trust is deemed to be a complex trust.
Income may be taxed to the trust or to its beneficiaries. Income typically includes interest, dividends, rents, royalties, and business income. Principal is always taxable at the trust level. Principal typically includes capital gains.
A trust must calculate its income in two important ways. First, the trust must calculate its distributable net income (DNI).2 DNI is used to allocate income between a trust and its beneficiaries by providing the trust with a deduction equal to its DNI. A proportionate share of income equal to DNI is taxed to the beneficiaries. If the partnership investment is a hedge fund, the determination of income should include a thorough review of all Schedule K-1 items and footnotes, especially items that would be allocated to income or principal that have been netted as “Other Income” or “Other Deductions.”
Second, a trust must calculate its fiduciary accounting income (FAI). This concept is not found in the tax code. Rather, it is a product of state law. In short, FAI is the amount that the trustee has available to distribute to the income beneficiaries, as directed by the terms of the trust agreement or other governing document. It is calculated by subtracting the total trust expenditures that are allocated to income from the total trust receipts that are allocated to income.3
Determining the proper allocation to principal or income has often proved difficult for trustees. Rather than continue to rely on the common law, the Uniform Law Commissioners proposed the Uniform Principal and Income Act in 1931. Forty-one states have since adopted the Revised Uniform Principal and Income Act (RUPIA) as last amended or revised in 2000. In those states, if the governing trust instrument does not address the allocation between principal and income, the RUPIA will govern. Principal is defined under the RUPIA as “property held in trust for distribution to a remainder beneficiary when the trust terminates.” Income is defined as “the current return that the fiduciary receives from an asset that is held as principal.”
But state law and the RUPIA weren’t crafted to deal with defining what is income or principal from a partnership interest. This can make calculating DNI and FAI for the trust difficult. In addition, IRC Subchapters J and K provide conflicting instructions regarding the proper treatment of K-1 income by a trust.4
Distributions of cash from the partnership, rather than flow-through income reported on Schedule K-1, are used to determine FAI.5 However, not all cash distributed from a partnership is allocated to income. The RUPIA provides that money received in exchange for part or all of a trust’s interest in the entity, and money received in total or partial liquidation are allocated to principal.
Many partnerships distribute cash to the partners to enable them to make income tax payments on their shares of the partnership’s income. If these are included in FAI, they should be distributed to the beneficiaries under the RUPIA, leaving the trust with no cash to pay its tax. If the trustee determines that the distribution was solely made to pay taxes, then he or she can properly allocate it to principal.
In summary, cash distributions other than those made for the sale or liquidation of a partnership interest or for taxes should be used to calculate FAI. Distributions to the beneficiaries will carry out some of the trust’s income and make it taxable to the beneficiaries. Any remaining items of taxable income, including allocated Schedule K-1 items, are taxable to the trust.
1 Internal Revenue Code Section 651(a); Reg. Section 1.651(a)-4.
2 Internal Revenue Code Section 661.
3 See Byrle M. Abbin, “Income Taxation of Fiduciaries and Beneficiaries,” Section 203.1 at 2-5.
4 David R. Nave, “The Good, the Bad & the Ugly of Trusts Investing in Partnerships,” Journal of Pass Through Entities, May - June 2006.
5 RUPIA Section 401(b).
By Todd A. Sacco, CPA, PFS, JD
Todd A. Sacco, CPA, PFS, JD, is senior manager with Lally & Co. LLC in Pittsburgh and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at tasacco@lallycpas.com.
For more information on 2017's landmark federal tax reform, check out the Federal Tax Reform Guide presented by the Pennsylvania CPA Journal.
