Distributable Net Income

Cornelius and Beatrix Wenlock hold a combined estate of about $9,000,000, mostly in jointly titled accounts. Their attorney proposes retitling so that on the first death an amount equal to the deceased spouse remaining federal estate tax exclusion funds a CREDIT SHELTER (bypass) trust paying income to the survivor for life, with the remainder to their children. Compared with leaving everything outright to the survivor and relying on portability, the bypass trust:

1. A.Produces a second basis step-up at the survivor death that portability does not provideExactly backwards. Bypass trust assets are not in the survivor estate, so they receive no second step-up.
2. B.Keeps the sheltered assets and their future appreciation out of the survivor estate and locks in who ultimately receives them, at the cost of forgoing a second basis step-up and adding trust administrationCorrect. Growth is sheltered and the remainder is protected; the price is basis and complexity.
3. C.Eliminates income tax on the trust investment income, because a credit shelter trust is a tax-exempt entityThe trust is a taxable entity. Undistributed income is taxed to the trust, and trust brackets compress very quickly.
4. D.Is unnecessary in every case, because portability preserves the deceased spouse unused exclusion automatically with no filing requiredPortability must be elected on a timely filed estate tax return, and it does not shelter post-death appreciation or control the remainder beneficiaries.

Why: A funded bypass trust removes the sheltered assets AND all their subsequent appreciation from the surviving spouse taxable estate, and it fixes the ultimate remainder beneficiaries so that a remarriage or a later will cannot redirect them. Those are its two real advantages over portability. The costs are that the trust assets receive no second basis step-up at the survivor death, that the trust must be administered and file its own returns, and that trust income retained inside the trust reaches the top bracket at a very low income level.

The Halvard Family Trust is an irrevocable, non-grantor trust. This year it earns $60,000 of taxable interest and dividends. The trustee distributes $45,000 to the income beneficiary and accumulates the remaining $15,000 inside the trust. Which statement about the income taxation is correct?

1. A.All $60,000 is taxed to the beneficiary, because a trust is a pure conduit in the same way a mutual fund is.Incorrect. Only distributed income passes through. Accumulated income remains taxable to the trust.
2. B.The $15,000 accumulated is taxed to the grantor, because accumulated income is always attributed back to the person who created the trust.Incorrect. That result belongs to a grantor trust. The stem specifies a non-grantor trust, so the trust itself pays.
3. C.All $60,000 is taxed to the trust, because an irrevocable trust is a separate taxpayer and distributions are not deductible to it.Incorrect. A non-grantor trust receives a distribution deduction, which is exactly what shifts the tax to the beneficiary.
4. D.The $45,000 distributed is carried out and taxed to the beneficiary, while the $15,000 accumulated is taxed to the trust at compressed trust brackets that reach the top rate at a very low income level.Correct. Distributions carry income out to beneficiaries; retained income is taxed to the trust at steeply compressed rates.

Why: A non-grantor trust is a separate taxpayer, but it gets a deduction for income it distributes, so distributed income is carried out to the beneficiary and reported on her personal return at her own rates. Income the trustee accumulates stays with the trust and is taxed to the trust. That matters because trust tax brackets are severely compressed: a trust reaches the top marginal rate at a level of income that would barely register on an individual return. This asymmetry is why trustees and advisers pay close attention to distribution decisions before year end.

The Beltran Family Trust is an irrevocable nongrantor trust. This year it earns 50,000 dollars of taxable interest and dividends and distributes 30,000 dollars of that income to its sole adult beneficiary, retaining the rest. How is the income taxed?

1. A.The beneficiary reports the 30,000 dollars distributed, and the trust is taxed on the retained 20,000 dollars under the compressed trust rate scheduleCorrect. The distribution deduction, limited by distributable net income, shifts the distributed income to the beneficiary.
2. B.The distribution is a tax-free return of trust principal to the beneficiaryDistributions are treated as carrying out income first, up to distributable net income.
3. C.The trust is taxed on the entire 50,000 dollars because it is an irrevocable nongrantor trustDistributions carry income out to the beneficiary and generate a deduction for the trust.
4. D.The beneficiary is taxed on the entire 50,000 dollars because she is the sole beneficiaryOnly the amount actually distributed, capped by distributable net income, is taxed to her.

Why: A nongrantor trust is a conduit only to the extent it distributes. The trust takes a distribution deduction for amounts paid out, capped by distributable net income, so the beneficiary reports the 30,000 dollars on her own return and the income keeps its character as interest or as qualified dividends in her hands. The 20,000 dollars the trust retains is taxed to the trust itself, under a highly compressed rate schedule that reaches the top bracket at a very low level of income. That compression is why trustees so often distribute income rather than accumulate it.