Allows trustee to allocate to income gains from the sale or exchange of a capital asset to the extent the principal is re-characterized as income

Recent increases in tax rates applicable to realized capital gains and the enactment of the new 3.8% tax on undistributed net investment income (which includes realized capital gains) have made it increasingly important that, in order to achieve results which are reasonable and impartial to all beneficiaries, a trustee be able to effectively determine whether the realized capital gains of a trust are taxed to the current beneficiaries or to the trust (i.e., in essence to the remainder beneficiaries).

Accordingly, this measure would amend the New York Principal and Income Act (EPTL Article 11-A) to make clear that, unless the instrument provides otherwise, a trustee has the powers set forth in the regulations which would permit a reasonable and impartial allocation of realized capital gains to income and thereby permit the trustee to determine the incidence of such gains in a reasonable and impartial manner.

Whether the trust or the current beneficiaries are taxed on the capital gains turns on whether such gains are "excluded" vs. "included" in what is called "distributable net income" (DNI) under IRC § 643(a). If they are excluded from DNI, they will be taxed to the trust. If they are included in DNI, then amounts distributed (or required to be distributed) to the current beneficiaries will be considered, partially or fully, to "carry out" such gains and cause them to be taxed to such beneficiaries.

The relevant statutory provisions and regulations are as follows:

(a) The statute (unamended since the 1954 Code). § 643(a)(3)

(a) Distributable net income

For purposes of this part, the term "distributable net income" means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications-

Capital gains and losses

Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not

(A) paid, credited, or required to be distributed to any beneficiary during the taxable year ...., or

(b) The regulations (last amended in 2004)

§ 1.643(a)-3

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

(1) Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph § 1.643(a)-3(b)h

(2) Allocated to corpus but treated consistently 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 actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary. The above regulations, proposed in 2001 and finalized in 2004, were the result of the Treasury's decision to accommodate changes in state laws (spearheaded by New York) designed to facilitate total return investing by trustees.

As stated in the introduction to the proposed and final regulations.

(Proposed)

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....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.

(Final)

The IRS and the Treasury Department recognize that state statutes are in the process of changing traditional concepts of income and principal in response to investment strategies that seek total positive return on trust assets. These statutes are designed to ensure that, when a trust invests in assets that may generate little traditional income (including dividends, interest, and rents), the income and remainder beneficiaries are allocated reasonable amounts of the total return of the trust (including both traditional income and capital appreciation of trust assets) so that both classes of beneficiaries are treated impartially. Some statutes permit the trustee to pay to the person entitled to the income a unitrust amount based on a fixed percentage of the fair market value of the trust assets. Other statutes permit the trustee the discretion to make adjustments between income and principal to treat the beneficiaries impartially. Under the proposed regulations, a trust's definition of income in conformance with applicable state statutes will be respected for federal tax purposes when the state statutes provide for a reasonable apportionment of the total return of the trust.

In New York, total return investing by trustees is facilitated statutorily by the power to adjust provisions of EPTL 11 -2.3(b)(5) and the optional unitrust provisions of EPTL 11-2.4.1{1}

In addition to these statutes, the provisions of the trust itself may permit total return investing. E.g., a trustee who has unlimited discretion to distribute principal to a beneficiary to whom income must or may be paid is substantially free to invest without regard to the form of return because the power to distribute principal can be used in much the same manner as the power to adjust.

This measure, which would have no fiscal impact, would take effect immediately.

Legislative History:

None. New proposal.

{1} As stated by the Court of Appeals in In Re Heller, 6 NY3d 649 (2006) "The Prudent Investor Act encourages investing for total return on a portfolio ... The 2001 legislation allows trustees to pursue this strategy uninhibited by a constrained concept of trust accounting income A trustee investing for a portfolio's total return under the Prudent Investor Act may now adjust principal and income to compensate for the effects of the investment decisions on distribution to income beneficiaries Alternatively, the optional unitrust provision lets trustees elect unitrust status for a trust (EPTL 11-2 4) by which income is calculated according to a fixed formula