Section 643(b) and Trusts

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Matthew L. Roberts

Matthew L. Roberts

Principal

469.998.8482
mroberts@freemanlaw.com

Mr. Roberts is a Principal of the firm. He devotes a substantial portion of his legal practice to helping his clients successfully navigate and resolve their federal tax disputes, either administratively, or, if necessary, through litigation. As a trusted advisor he has provided legal advice and counsel to hundreds of clients, including individuals and entrepreneurs, non-profits, trusts and estates, partnerships, and corporations.

Having served nearly three years as an attorney-advisor to the Chief Judge of the United States Tax Court in Washington, D.C., Mr. Roberts leverages his unique insight into government processes to offer his clients creative, innovative, and cost-effective solutions to their tax problems. In private practice, he has successfully represented clients in all phases of a federal tax dispute, including IRS audits, appeals, litigation, and collection matters. He also has significant experience representing clients in employment tax audits, voluntary disclosures, FBAR penalties and litigation, trust fund penalties, penalty abatement and waiver requests, and criminal tax matters.

Often times, Mr. Roberts has been engaged to utilize his extensive knowledge of tax controversy matters to assist clients in their transactional matters. For example, he has provided tax advice to businesses on complex tax matters related to domestic and international transactions, formations, acquisitions, dispositions, mergers, spin-offs, liquidations, and partnership divisions.

In addition to federal tax disputes, Mr. Roberts has represented clients in matters relating to white-collar crimes, estate and probate disputes, fiduciary disputes, complex contractual and settlement disputes, business disparagement and defamation claims, and other complex civil litigation matters.

Recently, there seems to be some confusion regarding section 643(b) of the Internal Revenue Code of 1986, as amended (the “Code”), and its application to trusts. Indeed, that provision—particularly to those not well-versed in federal trust taxation—can confound many. This article seeks to dispel some of the complexity surrounding section 643(b).

The Taxation of Trusts Generally

The federal income taxation of trusts and beneficiaries puzzles even tax professionals. Does the trust pay tax? What about the beneficiaries? What is the difference between a grantor trust and a complex trust? The questions can become endless.

I don’t seek to answer all those here. But I will try to provide some background on certain trust concepts so that you are more familiar with them. First, let’s start off with general concepts associated with the taxation of trusts. In Subchapter J of the Code (which addresses the taxation of trusts), it states in the very first provision: “[t]he tax imposed by section 1(e) shall apply to the taxable income of . . . any kind of property held in trust[.]”[i] That same provision further clarifies that this income includes: (i) income accumulated in trust (even contingent income or income for the benefit of unascertainable persons); (ii) income that a trustee is required distribute to the beneficiaries; and (iii) income that the trustee has discretion to retain in trust.[ii] Accordingly, as a general rule, a trust pays income tax on its activities.

Of course, as with many rules in the Code, there are exceptions. For example, Subchapter J can in certain instances subject grantors of so-called grantor trusts to taxation.[iii] And, there are various provisions in Subchapter J that may also make the trust beneficiaries taxable.[iv] Taken together, Subchapter J taxes the grantor, the trust, or the beneficiaries, depending largely on the trust arrangement and governing state law.

Second, let’s also provide some clarity on the distinction between simple and complex trusts and why the distinction can be important. Generally, a trust is a simple trust if it meets all of the following requirements: (i) the trustee is required to distribute all income to the beneficiaries each year; (ii) the terms of the trust do not provide for any amounts to be paid, permanently set aside, or used for certain charitable purposes; and (iii) the trustee does not actually distribute any amounts during the year other than amounts that are required to be distributed annually (i.e., it does not distribute corpus or principal).[v] If a trust fails to meet any one of these three requirements in a tax year, the trust is characterized as a complex trust for federal income tax purposes. The distinction becomes important under Subchapter J because the characterization of the trust can impact the proper party or entity to pay income tax on the trust’s activities.

Section 643(b)

Subchapter J has a litany of definitions, and many of these definitions are found in section 643. Amongst these definitions is a definition for the term “income.”[vi] Specifically, section 643(b) provides:

For purposes of this subpart and subparts B, C, and D, the term ‘income,’ when not preceded by the words ‘taxable,’ ‘distributable net,’ ‘undistributed net,’ or ‘gross,’ means the amount of income of the . . . trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

Section 643(b) is a very old provision—it dates back approximately 70 years to the Internal Revenue Code of 1954, the predecessor of the current Code. It has remained the same since its enactment, and its legislative history states its purpose:

[Section 643](b) provides that the term ‘income’ when used in subparts A, B, C, and D, and when not preceded by the words ‘taxable,’ ‘distributable net,’ ‘undistributed net,’ or ‘gross,’ means the income of the . . . trust as determined under its governing instrument and the applicable local law. This definition eliminates the difficulty occasioned in section 162 of the 1939 Code where the term ‘income’ was used in certain contexts to mean ‘gross income’ and in others to mean income for fiduciary accounting purposes.[vii]

The Significance of Section 643(b)

Given the above legislative history and a full and complete reading of the Code, it is clear that Congress enacted section 643(b) to provide clarity to the various concepts of income found throughout Subchapter J. These include, for example: taxable income, distributable net income, undistributed net income, and gross income. Section 643(b) adds another term—simply, “income,” which refers to fiduciary accounting income of the trust. Although the concept of fiduciary accounting income, or FAI, is itself a complex concept because it depends largely on applicable state law and the trust agreement itself, readers should take away this from this article: to the extent someone is referring to section 643(b) in a trust context, they are really only referring to FAI or the manner in which income is allocated amongst principal and income beneficiaries of the trust.

If you found this article interesting, you may also find the following other trust articles interesting:

Trust & Estate Attorneys

Do you need help with the taxation of a trust? Freeman Law can help you navigate these complex issues. We offer value-driven services and provide practical solutions to complex tax issues. Schedule a consultation today or call (214) 984-3410 to discuss your trust concerns.

 

[i] I.R.C. § 641(a).

[ii] See id.

[iii] I.R.C. § 671-679.

[iv] I.R.C. § 662.

[v] I.R.C. § 651(a).

[vi] See I.R.C. § 643(a) (DNI); § 643(b) (“income”).

[vii] H.R. Rept. No. 1337, 83d Cong., 2d Sess. (Mar. 9, 1954).