Have you ever wished for the benefit of hindsight when preparing to file taxes? For fiduciaries, taxes can be especially tricky, because there may be income and expenses to manage on the trust and beneficiary level. Both expenses and income can change from beginning of the year projections. Maybe a beneficiary needed emergency medical care, or perhaps projected income was more than expected due to changes in financial markets and an increase in interest rates. With trust tax brackets being extremely compressed, is there anything a fiduciary can do? Surprisingly, the IRS understands this predicament and actually gives a way for fiduciaries to be more tax efficient through Section 663(b) of the Internal Revenue Code – the trust distributions 65-day rule.
For estates and trusts, Section 663(b)(1) states that distributions made during the first 65 days of any taxable year can be credited on the last day of the preceding year. The ability to assign distributions to a prior year is extremely helpful for a fiduciary, especially those who are trustees of irrevocable trusts, where the beneficiary does not have a means of earning their own income. This is because tax brackets for estates and non-grantor trusts are extremely compressed when compared to the tax brackets of the beneficiary.
|2023 Tax Year|
|Taxable Income Between||Single Filer Tax Bracket||Trust and Estates Tax Bracket|
|0 to $2,900||10%||10%|
|$2,901 to $10,550||10%||24%|
|$10,551 to $11,000||10%||35%|
|$11,001 to $14,450||12%||35%|
|$14,451 to $44,725||12%||37%|
|$44,726 to $95,375||22%||37%|
|$95,376 to $182,100||24%||37%|
|$182,101 to $231,250||32%||37%|
|$231,251 to $578,125||35%||37%|
Section 663(b) allows the fiduciary to more easily shift the taxation of income earned by the trust or estate to the beneficiary. This is because the 65-day window normally allows a fiduciary enough time to receive corresponding 1099s that will show how much income was received by the trust from the prior year’s investments.
This can be extremely helpful in calculating the total amount of distributable net income (DNI) that the trust could distribute. It is common for non-grantor trusts to seek to distribute as much of the DNI as the trust terms allow, as any income distributed to the beneficiary from DNI can then be deducted against the trust’s income tax (Section 661). If the fiduciary decides to make distributions during the 65-day period and have it count for the prior year, then the CPA will want to make sure line 6 at the bottom of page 3 of the 1041 has been selected.
Section 663(b) is even more useful when a non-grantor trust gives the trustee discretion to allocate and distribute capital gains as income. Trustees should review the trust document to determine they are given this authority; they should also review state laws (e.g. in California Probate Code 16335 and 16336) and consult with their attorney. Fiduciaries that are given this authority can more easily shift the taxation of capital gains from the trust bracket to the beneficiary.
Given that many mutual funds wait to distribute capital gains until the end of the year, the trust distributions 65-day rule can help save thousands in taxes. For short term capital gains that are taxed at ordinary income tax rates, there is a high likelihood the beneficiary’s tax bracket is lower than the trust’s bracket. Savings in taxes could even occur for long-term capital gain tax rates, as there is a 3.8% medicare surtax at the highest rates.
65-Day Rule Example
To give an example, suppose an irrevocable spendthrift trust was established for a beneficiary. The beneficiary is unable to work due to a disability and has no income. The trust makes a $1,000 monthly distribution to support the beneficiary. However, when the 1099 comes, it turns out the trust has generated $25,000 in income and $10,000 in long term capital gains due to a mutual fund long-term capital gain distribution. If the fiduciary did not use Section 663(b), then the amount of ordinary income taxed to trust would be $13,000 ($25,000 – $12,000 DNI deduction). The long-term capital gains would be taxed at the trust bracket rate, in this case 15%. Total tax would be around $8,500.
Conversely, let’s say the fiduciary did choose the election available in Section 663(b). In this hypothetical example, the trust document allows for assigning capital gains to income, and so the trustee allocates the full $35,000 as distributable income to the beneficiary. The beneficiary’s distributions would be taxed as follows:
- $25,000 received as income would be taxed at the beneficiary’s ordinary income rate;
- $10,000 would be taxed at the long-term capital gains rate (0% according to the long-term capital gains bracket ).
- Total tax would be an estimated $1,110.
There are a couple of things for the fiduciary to remember in the allocation of capital gains to income. Although a trust may give fiduciary discretion related to capital gains and income, the fiduciary may also need to take into account the impact distributing capital gains can have on both income beneficiary and remainder beneficiary. This is because remainder beneficiaries are entitled to the corpus. Without careful consideration of the impact to all beneficiaries, a distribution of capital gains to the income beneficiary could potentially harm the remainder beneficiary.
When considering your tax strategy there are most likely opportunities to save on taxes by utilizing the trust distributions 65-day rule. However, to fully take advantage, the fiduciary should:
- Closely read the trust document and determine income distribution requirements stated by the trust
- Determine if the trust gives discretionary authority for categorizing capital gains as income
- Determine how state law applies to administration of the trust and assignment of capital gains as income
- Review the 1099 to see how much remaining distributable net income may be distributed
- Determine whether distributing the additional income (i.e., interest, dividends, and/or capital gains) to the beneficiary is tax advantageous
- Consult with both their CPA, attorney, and investment advisor to confirm best course of action
- Confirm CPA makes the appropriate 663(b) election (line 6 under other information at bottom of page 3 on Form 1041).
March 6, 2023 marks the last day to tag a distribution to the previous year, so fiduciaries should consult with their CPA, attorney, and investment advisor now to ensure you meet the deadline.
Prudent Investors is a highly knowledgeable and experienced investment advisor providing portfolio management and financial planning services under a fiduciary standard of care. We work closely with our clients’ attorneys, CPAs, caregivers, and other professionals to ensure all investment plans are well prepared, expertly strategized, and provide the most value possible. If you’re looking to partner with an investment advisor who treats your client or loved one’s investments as their own, we welcome you to connect with our team to schedule a no-obligation consultation.
This blog is general communication being provided for informational purposes only. This information is in no way a solicitation or offer to sell securities or investment advisory services. It is educational in nature and not to be taken as advice or a recommendation for any specific investment product or investment strategy. This does not contain sufficient information to support an investment decision. Any investment or investment strategy mentioned may not be suitable for all investors or in their best interest. Statistical information, quotes, charts, references to articles or any other quoted statement or statements regarding market or other financial information is obtained from sources which we believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. All rights are reserved. No part of this blog including text, graphics, et al, may be reproduced or copied in any format, electronic, print, et al, without written consent from Prudent Investors. Prudent Investors does not provide legal or tax advice. Please consult with your investment advisor, attorney or tax professional before making any investment decisions. Investment advice offered through Prudent investors Network, Inc., an SEC registered investment adviser.