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by Steven B. Gorin, Esq.
Thompson Coburn LLP
St. Louis, MO
At the request of the American Bar Association's Real Property, Trust & Estate Law Section (the “Section”) and the American College of Trust & Estate Counsel, the Uniform Law Commission has revised sections 409 and 505 of the Uniform Principal and Income Act (“UPIA”).
UPIA Section 409
Revenue Ruling 2006-26 (the “Ruling”) provides a safe harbor for IRAs and defined contribution retirement plans (either of which was referred to as a “fund”) that are payable to a marital deduction trust to qualify for the marital deduction, but only if the trust satisfies two requirements. First, the surviving spouse must be entitled to withdraw the fund's income. Second, the fund's income must be determined as if the fund itself were a trust. The Ruling criticized UPIA section 409 for the way it determined the marital trust's income (which criticism could also apply to some states that have not adopted UPIA section 409). In response to the Ruling's criticism of section 409, the Uniform Law Commission has amended that provision to make it comply with the Ruling's safe harbor requirements. The Section has formally requested that the IRS modify the Ruling to provide that the new version of UPIA Section 409 satisfies the Ruling's safe harbor.
UPIA Section 505
It is not uncommon for trusts that are required to pay income to a beneficiary to own an interest in a partnership (including an LLC) or other entity where the owners are taxed on the entity's income whether or not the owners receive the income. Many such entities distribute to their owners only enough income to enable the owners to pay their tax obligations and reinvest the rest of the income in business operations.
This strategy works well when the owners are individuals, but it can cause problems when the owners are mandatory income trusts, as described below. Suppose a trust has a 40% combined federal and state income tax rate and receives a Schedule K-1 reporting $100x of the entity's income. The entity distributes $40x to the trust to fund the tax obligation. If the trust is required to distribute the full $40x to the beneficiary, the trust will be taxed on $60x of income ($100x minus the $40x that was distributable to the beneficiary), but the trustee will have no money remaining to pay its income taxes. The beneficiary would be liable for the taxes on the $40x distribution. How should the trust and beneficiary share the money that the entity distributed to pay its owners' taxes?
Before amendment, UPIA section 505 provided rules for calculating how much the trust needs to distribute and how much it can use to pay taxes. The language was ambiguous and led to litigation. The proposed change clarifies that the trust will keep enough money to pay its taxes and distribute the balance of the income to the mandatory income beneficiary.
The individual at the Uniform Law Commission who tracks enactments and can help those interested in having their states enact these changes is:
Kieran P. Marion, Legislative Counsel
Uniform Law Commission (NCCUSL)
111 N. Wabash Avenue, #1010
Chicago, IL 60602
The ABA Advisor who worked on these amendments from start until finish is the author of this column, Steven B. Gorin. He is continuing to work with the Joint Editorial Board for Uniform Trust & Estate Laws on possibly extending the changes to UPIA section 409 so that they apply in all situations involving retirement plans, annuities, and similar funds, not just where funds are payable to a marital trust.
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