United States: New Regulations On Definition Of Trust Income And DNI

This article summarizes the provisions of the new IRC § 643 regulations which bring the Code’s definition of income into line with the 41 states which have passed some form of total return legislation. The statutes and the new regulations are sure to provide new opportunities, discretion and some pitfalls for fiduciaries around the country.

Our roundup of fourth quarter decisions includes, from California, a conservatorship case which highlights the modern statutory trend of barring donative transfers by dependent adults to their "care custodians." Cases involving alleged gifts made by the elderly and infirm to their caregivers have plagued our court systems for years. California and other states (like Florida) have responded by passing statutes addressing this problem.

Also, a number of Illinois cases including the Estate of Lane, dealing with the technical requirements of filing a claim. Lane is basically a reprise of the Beider case from ten years ago. The holding of both courts may surprise some readers. Another interesting case is Estate of Ramlose, a guardianship matter involving the Public Guardian’s recovery citation efforts against an individual accused of wrongly converting the ward’s assets. Ramlose deals with due process rights related to freeze orders.

Consistent with this constitutional theme is Estate of Muldrow which examines the equal protection rights of a convicted felon to act as the executor of an estate. Lastly, an update on a case we reported on last year. Estate of Poole discusses a purported biological father’s rights and the interplay of the Illinois Probate Act, the Parentage Act and the Wrongful Death Act when a viable fetus is stillborn following an automobile accident.

On December 30, 2003, the IRS issued final regulations that (1) broaden the definition of trust income and (2) expand the circumstances in which capital gains will be included in distributable net income (DNI). TD 9102. The new regulations are intended to take into account the changes in many states of the definition of trust accounting income to allow trustees to invest for total return. Generally speaking, the changes in the definition of income apply only to trusts in states that have adopted a broader definition of income, while the changes in DNI apply to all trusts. These regulations will be effective for all tax years ending after January 2, 2004.

The income regulations apply to trusts where state statutes (1) give the trustee the discretion to adjust between income and principal to treat beneficiaries fairly or, (2) define income as a unitrust amount. A court order could also meet the "state statute" requirement if the order announces a general principal or rule of law. However, a court order applicable only to the trust before the court will not meet this requirement.

The regulations provide that the trustee can use any definition of income that complies with a state statute that provides for reasonable apportionment between the income and remainder beneficiaries of the trust’s total return for the year, including ordinary and tax-exempt income, capital gains, and appreciation. If income is defined as a unitrust amount, the amount is reasonable if it is between 3% and 5% of the value of the trust assets. Additionally, the value can be determined annually or by averaging the value of the trust assets over a period of years.

The regulations do not restrict trustees to a single definition of income. In fact, the regulations provide that switching between state approved definitions of income (1) will be respected for federal tax purposes, (2) will not be a recognition event and, (3) will not have gift tax consequences. In addition, if the trust is exempt from the generation-skipping transfer tax, a switch in the method of defining income will not result in a loss of exempt status. This applies even to switches that result from a change in the trust’s situs.

Keep in mind that if a trustee switches to a definition of income that is not state authorized, the switch could have detrimental results for the beneficiary. First, the beneficiary could recognize gain on the entire value of the beneficiary’s interest in the trust (a beneficiary’s basis in the trust is zero). Second, either the current beneficiary or the remainder beneficiaries could be treated as making a taxable gift to the other beneficiaries.

The broadened definition of trust income can even be applied to trusts that require all income be paid annually, such as marital trusts. The regulations provide that a marital trust in a state that defines income as a unitrust amount or gives the trustee the discretion to allocate between income and principal will continue to qualify for the marital deduction even if the trustee chooses to adopt the unitrust or allocation method of determining income. However, it is not sufficient for the governing instrument alone to authorize the unitrust payment—state law must allow the allocation and payment of trust earnings.

The new DNI regulations apply to all trusts, even trusts in states that have not adopted regulations to allow trustees to invest for total return. Under the new regulations, capital gains can be included in DNI if the trustee makes the allocation pursuant to (1) a discretionary power under local law or, (2) the governing instrument if not inconsistent with local law. Capital gains will also be included in DNI if distributions are being made pursuant to an ordering clause in a state statute or the governing instrument that provides that distributions must be made in a certain order. For example, an ordering clause might provide that distributions be paid first from ordinary and tax-exempt income, then from capital gains, and then from principal.

In order for capital gains to be included in DNI, the trustee must allocate capital gains to distributions in a reasonable and consistent manner. To support the reasonable and consistent manner of allocation, the trustee must evidence the allocation on the trust’s books, records and tax returns. Regardless of the method of allocation a trustee has used in prior tax years, the trustee can choose whether or not to include capital gains in DNI for the first tax year ending after January 2, 2004 (or in the first tax year after the trustee gains the discretion to include capital gains in DNI). Once a decision is made, the trustee must follow the same practice each subsequent year.

Trustees should review current state law to determine if (1) it gives trustees the discretion to allocate capital gains to income or at least does not prohibit such an allocation and, (2) if the trust agreement allows the inclusion of capital gains in distributions. If the distribution of capital gains is allowed, the trustee will want to carefully consider whether or not to include capital gains in DNI. The method of reporting capital gains on 2004 fiduciary income tax returns will establish the "pattern" for future distributions, so a decision on the inclusion of capital gain in distributions should be made prior to that time. Trustees of more than one trust should keep in mind that, although a trustee’s allocation of capital gains must be consistent on each trust, a trustee of several trusts can act differently for each trust.

In Conservatorship of Estate of Davidson, 113 Cal. App. 4th 1035, 6 Cal.Rptr.3d 702 (1st Dist., 11/26/03), the Contestant filed a petition to invalidate a trust and pour-over will claiming undue influence and citing a California statute barring a care custodian from receiving a gift from a dependent adult. The Court of Appeals upheld the prior ruling, finding that there was no undue influence and no evidence supporting the application of the care custodian statute.

California, joining a growing number of states, has a statute that effectively bars donative transfers to "care custodians" of dependent adults. However, the statute does not bar donative transfers to individuals who care for dependent adults as a direct result of preexisting genuinely personal relationships, rather than any professional or occupational connection with health or social services, unless it can be shown that the donative transfer was the result of undue influence, fraud or duress.

The Court cited various factors to look for in determining whether a person was a "care custodian" under the statute including the length of time the individuals had a personal relationship before assuming the roles of caregiver and dependent, closeness, authenticity of personal relationship, and whether money was paid for the care. In this case, extensive evidence supported the fact that the alleged "care custodian" was in fact a longtime, personal friend of the dependent adult, with a close, almost familial relationship. In addition, evidence showed that the alleged care custodian never received payment for his services, but instead was reimbursed only for out of pocket expenses.

The Court also dismissed the claims of undue influence finding that clear and convincing evidence was presented, including a clinical evaluation while the dependent adult was still alive, an independent evaluation of her medical records, and extensive testimony of friends and neighbor, showing that the dependent adult freely, voluntarily and independently executed the trust and Will free of any undue influence.

In In re Estate of Lane, 2003 WL 23019413 (4th Dist., 12/18/03), the decedent and his wife entered into a 1999 indemnification agreement with the Joel Schneider 1996 Trust. The indemnification agreement was later assigned to Qik N EZ Properties. The decedent died in 2002, his wife was appointed executor of his estate, and notice was properly published. Counsel for Qik N EZ wrote to the widow about the indemnification agreement, however the letter was addressed to the widow personally and made no mention of the decedent or his estate except to note that the decedent was a signatory on the indemnification agreement. The widow/executor’s attorney informed Qik N EZ about the decedent’s death as well as the fact that Qik N EZ was free to file a claim in the probate proceeding. Qik N EZ did not file a claim but rather sent further correspondence stating that the widow needed to address the indemnification agreement. Subsequent correspondence did make reference to the estate but continued to also address the widow individually. Qik N EZ alleged that these letters constituted a claim filed with the estate’s representative.

The lower court dismissed the claim. In affirming the lower court’s holding, the appellate court noted that Illinois law does not require "technical legal form" in order to constitute a valid claim, however it must be sufficient to notify the representative of the nature of the claim. The first letter sent to the widow was not a valid claim as it was addressed to her in her individual capacity. When informed of the decedent’s death, Qik N EZ chose not to file a formal claim despite being advised of its right to do so by the widow/executor’s attorney. Instead, the court reasoned, Qik N EZ continued to write letters to the widow individually as if the existence of the probate estate did not affect their dealings.

In rationalizing its holding, the appellate court referenced Estate of Beider, 645 N.E.2d 553, 268 Ill.App.3d 1094 (1st Dist. 1994) in which the court held that letters addressed personally to the decedent rather than to his estate were insufficient to state a claim against the estate. The Beider holding was based upon a Minnesota case, Harter v. Lenmark. Harter held that an administrator’s knowledge of a potential claim against an estate is not enough – rather, the claim must be clearly and intentionally directed to the estate. The Beider court used the holding in Harter to formulate the rule that, to be a valid claim, a letter must: (1) be addressed directly to the estate or its administrator is his or her representative capacity; (2) state an unequivocal intention to pursue a claim against the estate; (3) state the basis for the claim; and, (4) identify the creditor.

In affirming the lower court’s holding that Qik N EZ did not present a valid claim, the Lane court compared the facts at issue to Harter: the letters sent by Qik N EZ were sent to the widow in her individual capacity and didn’t present any evidence that Qik N EZ intended to pursue a claim against the estate.

The In re Estate of Ramlose, 801 N.E.2d 76, 279 Ill.Dec. 784 (1st Dist. 11/19/03) case arose from allegations of impropriety levied against an individual trustee. Elmer Haneberg was trustee of a trust for Alexander Ramlose’s benefit. Ramlose (age 95) initially filed an accounting action alleging that Haneberg had engaged in deceitful and self-dealing behaviors. During the course of the proceeding, Ramlose was adjudicated mentally disabled, and the Public Guardian took over the case on his behalf demanding an accounting and production of trust administration documents. The Guardian later added a request which was granted by the lower court that Haneberg be removed as trustee. Haneberg continued to refuse to produce the trust administration documents or an accounting. Based upon further information supporting the self-dealing allegations, the Guardian filed a recovery citation against Haneberg. Haneberg denied all allegations. After considerable legal wrangling between the Guardian and Haneberg over various issues (including Haneberg’s refusal to sit for his deposition resulting in the court holding him in contempt), the Guardian persuaded the lower court to enter an order freezing bank accounts held in the names of Haneberg, his wife, mother and his children’s trust. The freeze order also froze all time share property held by Haneberg, including properties in Wisconsin and Utah, and all other real property in which Haneberg had an interest. Haneberg filed a motion to vacate the freeze order which the lower court denied. Haneberg appealed various issues including the propriety of the freeze order (the only issue relevant to this article).

The appellate court reversed the lower court’s decision regarding the freeze order for violating Haneberg’s due process rights. The Court stated that, by entering the order, the lower court essentially determined that the assets named in the order had been illegally acquired through funds belonging to the Ramlose Trust and were in danger of dissipation, however the order encompassed assets that were not even listed in the Guardian’s recovery citation. The court held that due process required the lower court to, at a minimum, conduct a hearing in order to establish a nexus between the trust funds and the assets belonging to Haneberg and his family. The appellate court criticized the lower court for entering such a broad order without sufficient evidentiary support, particularly regarding assets frozen by the order that belonged to Haneberg’s wife, mother and children.

In In re Estate of Poole, 799 N.E.2d 250, 207 Ill.2d 393 (Ill., 10/17/03), the purported father of a stillborn child petitioned to revoke letters of administration issued to the child’s maternal grandmother. The circuit court denied his petition citing that he lacked standing. The appellate court then reversed, and the Supreme Court affirmed the decision, holding that the father of a stillborn child had priority over the child’s maternal grandmother to act as the administrator of such child’s estate. In addition, the Court held that the father could establish parentage under the Illinois Parentage Act and could inherit through the child as an heir at law if parentage was proven.

The Court partially based its holding upon the Illinois Probate Act, 755 ILCS 5/9-3, which provides that "parents" shall act as administrators of a deceased child’s estate. Respondent grandmother argued that the purported father could not be the administrator because an illegitimate father could not establish paternity of a stillborn child. The Court disagreed and looked to the Illinois Parentage Act which applies to any civil action where parentage is an issue. The Court reasoned that if the alleged father could establish a parent/child relationship under the Parentage Act, he would be deemed to be a "parent" and would have precedence as the administrator of his child’s estate. Section 7 of the Parentage Act allows for a man alleging himself to be the father of a child or expected child to establish paternity. The Court determined that a stillbirth is, by definition, a birth and the father could try to establish paternity. Following that reasoning, the Court remanded the case for rehearing where the purported father would have a chance to establish paternity pursuant to Section 7 of the Parentage Act.

In Estate of Muldrow, 799 N.E.2d 497, 343 Ill.App.3d 1148 (1st Dist., 10/10/03), the First District Appellate Court upheld the constitutionality of Section 5/6-13(a) of the Illinois Probate Act which states that anyone convicted of a felony is not eligible to serve as executor of an estate. Petitioner filed a motion to disqualify his brother, a convicted felon, from serving as co-executor. His motion was denied and he appealed. The appellate court reversed, finding that the provision in the Probate Code did not violate equal protection. The Court reasoned that the test was to determine whether the statutory classification (excluding convicted felons from serving as executors) was rationally related to a legitimate government interest. The Court found that a rational basis existed in classifying convicted felons because executors are entrusted with safeguarding and distributing property to others in accordance with the law, and convicted felons had demonstrated an inability to act within the confines of the law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.