Delaware Uniform Principal and Income Act

TREATMENT OF CAPITAL GAINS

IN DETERMINING DNI

Delaware Uniform Principal and Income Act

November 20, 2015

Norris P. Wright

Gordon, Fournaris & Mammarella, P.A.

1925 Lovering Avenue

Wilmington, DE 19806

Tel: (302) 652-2900

Fax: (302) 652-1142

Determining Distributable Net Income – Code and Regulations.

The determination of the distributable net income (“DNI”) of a trust or estate is necessary in order to determine what taxable income is to be reported by a beneficiary in connection with a distribution made to the beneficiary (and conversely, what taxable income is left to the fiduciary) and what the character of the taxable income so distributed is.

The focus of this portion of my presentation is under what circumstances capital gains may be allocated to DNI so as to be carried out to a beneficiary who receives a distribution. Thus, there will not be an in depth analysis of how DNI is computed – just a general overview before turning to the capital gains discussion.

Calculation of DNI.

Section 643(a) of the Internal Revenue Code (“IRC”) and the Treasury Regulations thereunder provide that DNI is basically the taxable income of the trust or estate, with certain modifications:

Start with taxable income; then
Add back (i) the personal exemption and (ii) the distribution deduction; then
Subtract out (i) capital gains / add back capital losses allocable to principal and (ii) extraordinary dividends and taxable stock dividends allocated to principal for a simple trust; then
Add back net tax-exempt income.

Treatment of Capital Gains
Under § 643(a)(3) of the IRC, capital gains are normally taxed to the trust or estate because they are typically allocated to principal, and thus not part of DNI. Notwithstanding that general rule, capital gains that are allocated to principal are included in DNI if they are:
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.

Easy Example:
Trust Income: / DNI:
Interest/Dividends / $20,000 / Taxable Income / $14,900
Trust Deductions: / Add Exemption / 100
Trustee Fees / $ 5,000 / DNI / $15,000
Taxable Income:
Interest / Dividends / $20,000
Less Trustee Fees / 5,000
Net: / $15,000
Less Exemptions / (100)
Taxable Income: / $14,900
Example with Capital Gain:
Trust Income: / DNI:
Interest/Dividends / $20,000 / Taxable Income: / $24,900
LT Capital Gain / 10,000 / Less LT Capital Gain / (10,000)
Trust Deductions: / Add Exemption / 100
Trustee Fees / $ 5,000 / DNI / $15,000
Taxable Income:
Interest / Dividends / $20,000
LT Capital Gain / $10,000
Less Trustee Fees / ( 5,000)
Net: / $25,000
Less Exemption / (100)
Taxable Income: / $24,900

Treasury Regulations Under § 643 of the IRC Regarding Capital Gains and Losses in DNI.

The Treasury Regulations under § 643 were revised substantially in 2004. These changes will be discussed in more detail by another panelist, but in general, the new regulations (Treas.Regs. § 643(b)(1)) provide that:
“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 will generally not be recognized. …, items such as dividends, interest, and rents are generally allocated to income and proceeds from the sale or exchange of trust assets are generally allocated to principal.
…an allocation of amounts 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 and tax-exempt income, capital gains, and appreciation.
… Similarly, a state statute that permits the trustee to make 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. … Allocations pursuant to methods prescribed by such state statutes for apportioning the total return of a trust between income and principal will be respected.

In summary, the Regulations specifically acknowledge that capital gains may be allocated to income under (1) a state unitrust statute, (2) a state power to adjust statute, (3) the terms of the governing instrument [and state law], or (4) a discretionary power granted to the trustee under either local law or under the governing instrument, provided that the power is exercised in a reasonable and impartial manner.

Under Treas. Regs § 1.643(a)(3) there is further authority for allocating capital gain to income. It provides that:

Gains from the sale or exchange of capital assets may be allocated to 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):
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));
Allocated to corpus but treated consistently by the fiduciary on the trust’s books and records and tax returns as part of a distribution to a beneficiary; or
Allocated to corpus but actually distributed to a beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.

There are several very helpful examples provided in the new regulations which will also be discussed by another panelist in more detail.
The regulations under §643 of the IRC provide a good deal of flexibility to a fiduciary in determining whether to allocate capital gains to DNI or not, relying on the provisions in the governing instrument and applicable local law. The applicable local law here in Delaware is the Delaware Uniform Principal and Income Act found in Chapter 61 of Title 12 of the Delaware Code; and 12 Del. C. §§ 3325(23) and 3325(30).
There are consistency and impartiality requirements either specifically stated or implicit in making such allocations.

DELAWARE UNIFORM PRINCIPAL AND INCOME ACT

The Uniform Principal and Income Act (“UPIA”) was revised in 1997 to address the changing use of trusts over the years, the varying type of assets trusts were holding, the adoption in many states of the Prudent Investor Rule, rather than the Prudent Man Rule, regarding the investment parameters available to trustees, and to provide greater flexibility to trustees, generally.

Delaware revised its version of the UPIA in 2009, creating the Delaware Uniform Principal and Income Act (the “Delaware Act”). It closely follows the UPIA but also adds a few clarifications.

The essence of the UPIA is found in Subchapter I and, in particular, in Section 103, which is set forth in section 61-103 in the Delaware Act. As in the UPIA, section 61-103 of the Delaware Act provides that the allocation between principal and income is controlled in the first instance by the terms of the trust or the will. If the trust or will confers discretion upon the fiduciary with respect to the allocation of principal and income, the fiduciary may allocate between principal and income in accordance with that discretion. In the absence of any controlling provisions in the trust or will or of any discretion, the allocation between principal and income will generally be controlled by the provisions of the Delaware Act, principally by the default-type provisions of Subchapter IV, except that the fiduciary may choose to make adjustments between principal and income pursuant to Section 61-104 (Power to Adjust) if adherence to Section 61-103 would not produce a result that is fair and reasonable. This reasonableness standard was present in Delaware’s Section 6102 prior to the adoption of the Delaware Act in 2009, and that standard is now reflected in new Sections 61-103 and 61-104 of the Delaware Act.

However, Delaware chose to further confirm a trustee’s discretionary power to allocate receipts and disbursements between income and principal by providing specifically that a fiduciary may exercise such discretionary power given to the fiduciary under the terms of the trust or the will, whether or not the exercise would provide a result different than a result required or permitted under the Delaware Act, but also if such discretion is provided under local law, specifically cross-referencing Section 3325(23) of Title 12 which provides that a trustee may:

“(23) Decide, in accordance with § 61-103(b) of this title, how and in what proportions and receipts or disbursements are credited, charged or apportioned as between principal and income, including the ability to create reserves out of income for depreciation, amortization or obsolescence;”

It is also worth noting that Section 3325(30) of Title 12 also adds clarity to the administrative powers of a fiduciary regarding allocations of gains to be part of an amount distributed.

“(30) Take such actions as are necessary to cause gains from the sale or exchange of trust assets, as determined for federal income-tax purposes, to be taxed for federal income-tax purposes as part of a distribution of income (including income which has been increased by an adjustment from principal to income under § 61-104 of this title), a unitrust distribution, or a distribution of principal to a beneficiary.”

It should be noted that although much of the UPIA would have been new to Delaware when the Delaware Act was adopted in 2009, Sections 61-104 (Power to Adjust) and 61-105 (Judicial Review) of the UPIA were not new to Delaware; these sections already existed as Sections 6113 and 6114 of Title 12.

Delaware added the Power to Adjust in 2005 and the above-cited specific administrative powers to its statutes in 2009, so as to address the revisions to Treasury Regulations under IRS § 643, issued late in 2003. Basically, Treas. Regs. § 1.643(b) recognize a trustee’s discretionary power to allocate receipts and disbursements between principal and income based not only on the governing instrument, but also under applicable local law. Therefore, Delaware sought to make it abundantly clear that such discretion existed under Delaware “local law.”

Allocating Receipts and Disbursements To or Between Principal and Income – The Delaware Act.

SECTION 61-103. FIDUCIARY DUTIES; GENERAL PRINCIPLES.

In allocating receipts and disbursements to or between principal and income, and with respect to any matter within the scope of subchapters II and III of this chapter, a fiduciary:
Shall administer a trust or estate in accordance with the terms of the trust or the will, even if there is a different provision in this chapter.
May administer a trust or estate by the exercise of a discretionary power of administration given to the fiduciary by the terms of the trust or the will, or by local law, including but not limited to, § 3325(23) of this title, even if the exercise of the power produces a result different from a result required or permitted by this chapter;
Shall administer a trust or estate in accordance with this chapter if the terms of the trust or the will do not contain a different provision or do not give the fiduciary a discretionary power of administration; and
Shall add a receipt or charge a disbursement to principal to the extent that the terms of the trust and this chapter do not provide a rule for allocating the receipt or disbursement to or between principal and income.

In exercising the power to adjust under §61-104(a) of this title, or a discretionary power of administration regarding a matter within the scope of this chapter, whether granted by the terms of a trust, a will, or this chapter, a fiduciary shall administer a trust or estate impartially, based on what is fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust or the will clearly manifest an intention that the fiduciary shall or may favor 1 or more of the beneficiaries. A determination in accordance with this chapter is presumed to be fair and reasonable to all of the beneficiaries.

The Power to Adjust – The Delaware Act

SECTION 61-104. TRUSTEE’S POWER TO ADJUST.

A trustee may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and the trustee determines, after applying the rules in § 61-103(a) of this title, that the trustee is unable to comply with § 61-103(b) of this title.
In deciding whether and to what extent to exercise the power conferred by subsection (a) of this section, a trustee shall consider all factors relevant to the trust and its beneficiaries, including the following factors to the extent they are relevant:
The nature, purpose, and expected duration of the trust;
The intent of the settlor;
The identity and circumstances of the beneficiaries;
The needs for liquidity, regularity of income, and preservation and appreciation of capital;
The assets held in the trust; the extent to which they consist of financial assets, interests in closely held enterprises, tangible and intangible personal property, or real property; the extent to which an asset is used by a beneficiary; and whether an asset was purchased by the trustee or received from the settlor;
The net amount allocated to income under the other sections of this chapter and the increase or decrease in the value of the principal assets, which the trustee may estimate as to assets for which market values are not readily available;
Whether and to what extent the terms of the trust give the trustee the power to invade principal or accumulate income or prohibit the trustee from invading principal or accumulating income, and the extent to which the trustee has exercised a power from time to time to invade principal or accumulate income;
The actual and anticipated effect of economic conditions on principal and income and effects of inflation and deflation; and
The anticipated tax consequences of an adjustment.
A trustee may not make an adjustment:
That diminishes the income interest in a trust that requires all of the income to be paid at least annually to a spouse and for which an estate tax or gift tax marital deduction would be allowed, in whole or in part, if the trustee did not have the power to make the adjustment;
That reduces the actuarial value of the income interest in a trust to which a person transfers property with the intent to qualify for a gift tax exclusion;
That changes the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets;
From any amount that is permanently set aside for charitable purposes under a will or the terms of a trust unless both income and principal are so set aside;
If possessing or exercising the power to make an adjustment causes an individual to be treated as the owner of all or part of the trust for income tax purposes, and the individual would not be treated as the owner if the trustee did not possess the power to make an adjustment;
If possessing or exercising the power to make an adjustment causes all or part of the trust assets to be included for estate tax purposes in the estate of an individual who has the power to remove a trustee or appoint a trustee, or both, and the assets would not be included in the estate of the individual if the trustee did not possess the power to make an adjustment;
If the trustee is a beneficiary of the trust; or
If the trustee is not a beneficiary, but the adjustment would benefit the trustee directly or indirectly.
If paragraph (c) (5), (6), (7) or (8) of this section applies to a trustee and there is more than one trustee, a co-trustee to whom the provision does not apply may make the adjustment unless the exercise of the power by the remaining trustee or trustees is not permitted by the terms of the trust.
A trustee may release the entire power to adjust conferred by subsection (a) of this section or may release only the power to adjust from income to principal or the power to adjust from principal to income if the trustee is uncertain about whether possessing or exercising the power will cause a result described in paragraph (c)(1) through (6) or (c)(8) of this section or if the trustee determines that possessing or exercising the power will or may deprive the trust of a tax benefit or impose a tax burden not described in subsection (c) of this section. The release may be permanent or for a specified period, including a period measured by the life of an individual.
Terms of a trust that limit the power of a trustee to make an adjustment between principal and income do not affect the application of this section unless it is clear from the terms of the trust that the terms are intended to deny the trustee the power of adjustment conferred by subsection (a).
This section shall have no application to trusts governed by §§ 61-106 and 61-107 of this title. This section shall be construed as pertaining to the administration of a trust.
Following the exercise of the power conferred by subsection (a) of this section to adjust principal to income, the trustee:
Shall consider as ordinary income the amount so adjusted that is not capital gain net income described in paragraph (h)(2) of this section as paid from trust accounting income;
After calculating the trust’s capital gain net income described in § 1229(a)(26 U.S.C § 1229(a) of the Internal Revenue Code of 1986, as amended, may consider the amount so adjusted as paid from net short-term capital gain described in § 1222(2) (26 U.S.C. § 1222(7)) of the Internal Revenue Code of 1986, as amended; and
Shall then consider any remaining amount so adjusted as paid from the principal of the trust.
Summary

In the absence of a controlling provision or discretion provided in the governing instrument, the UPIA sets forth a number of default type rules that will provide direction to fiduciaries in the allocation of receipts and/or disbursements. These are fine as far as they go, but it is also clear that these default rules will likely not be appropriate in all cases; so therefore, the power to adjust concept was born. The power to adjust appears in section 61-104 of the Delaware Act and applies to trusts with respect to which the trustee is concerned that the amount to be distributed as income to current beneficiaries does not reflect what is fair and reasonable. In other words, the trustee believes that the income to be distributed is either too much or too little, given a variety of factors set forth in section 61-104of the Delaware Act, such as the nature and purpose of the trust; the intent of the grantor; identity and circumstances of the beneficiaries; type of assets held in the trust; and so on – and including the tax consequences of an adjustment. It is important to note that section 61-104 (and 61-105 – Judicial review being limited to abuse of discretion basically) were reflected in prior Delaware statutes and thus are not new concepts to Delaware.