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Tax News You Can Use

The 65-Day Rule & Its Impact on Trust Income Taxes

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Tax News You Can Use | For Professional Advisors

 

Jane G. Ditelberg

Jane G. Ditelberg

Director of Tax Planning, The Northern Trust Institute

The books are closed on 2023 – or are they? How the 65-day rule applies to income distributions from estates and trusts.

Most taxpayers are on a calendar year reporting basis for income tax purposes. This means that their tax year runs from January 1 to December 31. And for calendar year taxpayers, the third week of January 2024 is clearly not part of 2023. However, there is one area of tax where the first 65 days of 2024 can be treated as part of 2023. The Internal Revenue Code permits estates and certain trusts to elect to treat income distributions, as well as principal distributions that will carry out taxable income, made to beneficiaries on or before March 5, 20241, as having been made on December 31, 2023 for income tax purposes2. This election is referred to as the 65-day distribution election.

How is tax usually paid on income earned by an estate or trust?

This is challenging to summarize. In short, and greatly simplified, trusts (and estates)3 are taxed like individuals, except for the deduction trusts take for distributions made to beneficiaries. It is in this way, that trusts are like a conduit. In general, income retained inside the trust is taxed to the trust. Income (generally excluding capital gains) deemed available for distribution under the terms of the trust and applicable state law (distributable net income or DNI) that is, in fact, distributed to the beneficiary is deductible by the trust on its return. This income is reported to the beneficiary on a form K-1, and then the beneficiary reports the income and pays the tax. This avoids double taxation of the same income.

The trustee of a trust may have the discretion to make distributions to one or more beneficiaries. It is in this context that the 65-day distribution election may be relevant for non-grantor trusts. This election is not applicable to grantor trusts (where the powers retained by the person who created the trust results in the trust’s income being taxed directly to the grantor), or simple trusts that must pay all of the DNI (and only the DNI) out to the beneficiary.

When does taxing the income to the beneficiary result in lower total tax paid?

For many trusts, distributing all the trust’s DNI to the beneficiary is a way to reduce the overall tax burden on the trust. This is because the income tax brackets for estates and trusts are compressed. For 2023, a trust with income in excess of $14,450 is subject to tax at the highest marginal rate of 37%, while a single taxpayer must have income of more than $578,000 to reach that bracket. Furthermore, the 3.8% net investment income tax (NIIT) hits trust income in excess of $14,450, while that tax kicks in for single taxpayers making over $200,000.

How can the 65-day distribution election reduce overall income tax due?

The 65-day distribution election allows the trustee to complete an accounting for all items of income that are booked at the end of the year before determining the amount that should be distributed to the beneficiary to minimize the taxes due. This can be helpful in reducing the applicable rate by taxing it to the beneficiary. The election is effective for a single tax year so this is an assessment that should be made annually.

Example: Suppose a trust earned taxable DNI4 of $65,000 between January 1, 2023 and December 31, 2023, but $50,000 of that was received by the trust on December 30, 2023, and there was not time to process a distribution of that receipt to the beneficiary until January 15, 2024. Pat is the beneficiary of the trust and under the terms of the trust, the trustee may make distributions to Pat in the trustee's discretion5 for their best interests. Assuming Pat is single, takes the standard deduction, and has $150,000 in net income taxable at ordinary rates6 for 2023 exclusive of trust distributions, the following chart compares the federal income taxes due:

How does an executor or trustee make a 65-day distribution election?

There are two steps to eligibility for this particular tax treatment. The first is that the income has to actually be distributed to the beneficiary in the first 65 days of the new year (for leap years like 2024, that is by March 5). The second part is affirmatively making the election on the trusts or estate’s income tax return (form 1041) which must be timely filed, including extensions. This election is made by checking the box for question 6 under “other information” found on page three of the current version of form 1041. Once the election is made, it is irrevocable.

Are there other factors to consider?

From a tax standpoint, it is important to consider not only federal tax consequences but also state tax consequences for both the trust and the beneficiary. If the trust is in the 37% bracket and the beneficiary is in the 32% bracket, but the beneficiary is subject to a 6% state income tax that the trust is not subject to due to its domicile, then the election may make less sense.

It is also possible that at the time the decision to distribute would have to be made, neither the trust nor the beneficiary may know what tax bracket they will be in if much of their income comes from private investments or hedge funds that do not provide tax information until later than March 5.

The beneficiary may face other consequences from having higher income. For example, an individual’s level of adjusted gross income could impact their Medicare Parts B and D premiums, their eligibility for certain deductions or credits, or their eligibility to make Roth IRA contributions. It is important for the trustee to understand the beneficiary’s full income tax picture before determining whether or not to make the election.

In addition, the tax considerations fall into the “all else being equal” department of decisions. Fiduciaries are bound by the terms of the trust agreements and their fiduciary duties to the beneficiaries. While paying the fewest tax dollars is generally a positive, the trustee’s distribution discretion has to be broad enough to encompass the distribution and there must not be other fiduciary factors weighing against making the distribution.

If you have questions about making a 65-day distribution election for fiduciary income tax purposes, please contact your Northern Trust Advisor.

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  1. March 5 is the date in a leap year like 2024. For non-leap years, it is March 6. Note that this date does not shift if the 5th or the 6th falls on a weekend or holiday – the distribution has to be made by that day regardless so in some years the distribution deadline is effectively earlier to complete the transaction before the deadline.
  2. Note that this does not shift any other tax consequences. For example, if the distribution is made from a trust that is not exempt from the GST tax to a beneficiary who is more than one generation younger than the grantor of the trust, the distribution will generate a 40% GST tax. The GST tax will be due in the calendar year in which the distribution is made, even if for income tax purposes, the distribution is treated as made on December 31 of the preceding calendar year.
  3. Estates are taxed the same way; but for the sake of simplicity, we will refer here to trusts.
  4. Assumes no tax-exempt income, no 199A income and all income taxed at ordinary rates.
  5. If the trustee was required to distribute the income to Pat, then Pat would be taxed on the income regardless of when it was distributed.
  6. Assumes no tax-exempt income and no 199A income.

Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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