[Federal Register Volume 66, Number 32 (Thursday, February 15, 2001)]
[Proposed Rules]
[Pages 10396-10402]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1686]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 20, 25, and 26

[REG-106513-00]
RIN 1545-AX96


Definition of Income for Trust Purposes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations revising the 
definition of income under section 643(b) of the Internal Revenue Code 
to take into account changes in the definition of trust accounting 
income under state laws. The proposed regulations also clarify the 
situations in which capital gains are included in distributable net 
income under section 643(a)(3). Conforming amendments are made to 
regulations affecting ordinary trusts, pooled income funds, charitable 
remainder trusts, trusts that qualify for the gift and estate tax 
marital deduction, and trusts that are exempt from generation-skipping 
transfer taxes. This document also provides notice of a public hearing 
on these proposed regulations.

DATES: Written and electronic comments must be received by May 18, 
2001. Outlines of topics to be discussed at the public hearing 
scheduled for June 8, 2001 must be received by May 18, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-106513-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG-106513-00), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at: http://www.irs.ustreas.gov/tax_regs/regslist.html. 
The public hearing will be held in the IRS Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Bradford Poston at (202) 622-3060 (not a toll-free number); concerning 
submissions of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, Guy R. Traynor, 202-622-
8452 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    Section 643(b) provides a definition of the term income for 
purposes of subparts A through D of part I of subchapter J of the 
Internal Revenue Code (Code) . The term income, when not modified by 
any other term, means the amount of income of the trust or estate 
determined under the terms of the governing instrument and applicable 
local law. Section 1.643(b)-1 further provides that trust provisions 
that depart fundamentally from the concepts of local law in determining 
what constitutes income will not be recognized.
    These statutory and regulatory provisions date back to a time when, 
under state statutes, dividends and interest were considered income and 
were allocated to the income beneficiary while capital gains were 
allocated to the principal of the trust. Changes in the types of 
available investments and in investment philosophies have caused states 
to revise, or to consider revising, these traditional concepts of 
income and principal.
    The prudent investor standard for managing trust assets has been 
enacted by many states and encourages fiduciaries to adopt an 
investment strategy designed to maximize the total return on trust 
assets. Under this investment strategy, trust assets should be invested 
for total positive return, that is, ordinary income plus appreciation, 
in order to maximize the value of the trust. Thus, under certain 
economic circumstances, equities, rather than bonds, would constitute a 
greater portion of the trust assets than they would under traditional 
investment standards.
    One of the concerns with shifting trust investments toward equities 
and away from bonds is the potential adverse impact on the income 
beneficiary. Based on the traditional concepts of income and principal, 
the income beneficiary is entitled only to the dividends and interest 
earned by the trust assets. The dividend return on equities as a 
percentage of their value traditionally has been substantially less 
than the interest return on bonds.
    To ensure that the income beneficiary is not penalized if a trustee 
adopts a total return investment strategy, many states have made, or 
are considering making, revisions to the definitions of

[[Page 10397]]

income and principal. Some state statutes permit the trustee to make an 
equitable adjustment between income and principal if necessary to 
ensure that both the income beneficiary and the remainder beneficiary 
are treated impartially, based on what is fair and reasonable to all of 
the beneficiaries. Thus, a receipt of capital gains that previously 
would have been allocated to principal may be allocated by the trustee 
to income if necessary to treat both parties impartially. Conversely, a 
receipt of dividends or interest that previously would have been 
allocated to income may be allocated by the trustee to principal if 
necessary to treat both parties impartially.
    Other states are proposing legislation that would allow the trustee 
to pay a unitrust amount to the income beneficiary in satisfaction of 
that beneficiary's right to the income from the trust. This unitrust 
amount will be a fixed percentage, sometimes required to be within a 
range set by state statute, of the fair market value of the trust 
assets determined annually.
    Questions have arisen concerning how these state statutory changes 
affect the definition of income provided in section 643(b) and the 
other Code provisions that rely on the section 643(b) definition of 
income. This definition of income affects trusts including, but not 
limited to, ordinary trusts, charitable remainder trusts, pooled income 
funds, and qualified subchapter S trusts.
    In addition, trusts that qualify for the gift or estate tax marital 
deduction must pay to the spouse all the income from the property. All 
the income is considered paid to the spouse if the effect of the trust 
is to give the spouse substantially that degree of beneficial enjoyment 
of the trust property that the principles of trust law accord to a 
person who is unqualifiedly designated as the life beneficiary of a 
trust. Section 25.2523(e)-1(f) of the Gift Tax Regulations and 
Sec. 20.2056(b)-5(f) of the Estate Tax Regulations. Questions have 
arisen whether the spouse is entitled to all the income from the 
property in a state that permits equitable adjustments or unitrust 
payments.
    Similarly, questions have arisen as to whether an otherwise exempt 
trust which uses equitable adjustments or unitrust payments will be 
subject to the generation-skipping transfer tax provisions of chapter 
13 of the Code.

Explanation of Provisions

Definition of Income

    The proposed regulations will amend the definition of income under 
Sec. 1.643(b)-1 to take into account certain state statutory changes to 
the concepts of income and principal. Under the proposed regulations, 
trust provisions that depart fundamentally from traditional concepts of 
income and principal (that is, allocating ordinary income to income and 
capital gains to principal) will generally continue to be disregarded, 
as they are under the current regulations. However, amounts allocated 
between income and principal pursuant to applicable state law will be 
respected if state law provides for a reasonable apportionment between 
the income and remainder beneficiaries of the total return of the trust 
for the year, taking into account ordinary income, capital gains, and, 
in some situations, unrealized appreciation. For example, a state law 
that provides for the income beneficiary to receive each year a 
unitrust amount of between 3% and 5% of the annual fair market value of 
the trust assets is a reasonable apportionment of the total return of 
the trust. Similarly, a state law that permits the trustee to make 
equitable adjustments between income and principal to fulfill the 
trustee's duty of impartiality between the income and remainder 
beneficiaries is a reasonable apportionment of the total return of the 
trust.
    In addition, an allocation of capital gains to income will be 
respected under certain circumstances. Such an allocation will be 
respected if directed by the terms of the governing instrument and 
applicable local law. Similarly, if a trustee, pursuant to a 
discretionary power granted to the trustee by local law or by the 
governing instrument (if not inconsistent with local law), allocates 
capital gains to income, the allocation will be respected, provided the 
power is exercised in a reasonable and consistent manner.
    The proposed changes to the regulations will permit trustees to 
implement a total return investment strategy and to follow the 
applicable state statutes designed to treat the income and remainder 
beneficiaries impartially. At the same time, the limitations imposed by 
the proposed regulations ensure that the Code provisions relying on the 
definition of income under section 643(b) are not undermined by an 
unlimited ability of the trustee to allocate between income and 
principal.

Pooled Income Funds

    A special rule is proposed to be added to the regulations covering 
pooled income funds to address the problems arising from the potential 
application of the new state statutes to these funds. A pooled income 
fund as defined in section 642(c)(5) is a split-interest trust created 
and maintained by certain types of charitable organizations. 
Noncharitable beneficiaries receive the income from the commingled fund 
during their lives and the charitable organization receives the 
remainder interests. The income that is to be paid to the noncharitable 
beneficiaries is income as defined in section 643(b). Sec. 1.642(c)-
5(i).
    A pooled income fund is a trust subject to taxation under section 
641. It is entitled to a distribution deduction under section 661 for 
income distributed to the noncharitable beneficiaries. In addition, it 
receives a charitable deduction under section 642(c)(3) for any amount 
of net long-term capital gain which pursuant to the terms of the 
governing instrument is permanently set aside for charitable purposes. 
A pooled income fund is taxed on any net short-term capital gain that 
is not required to be distributed to the income beneficiaries pursuant 
to the terms of the governing instrument and applicable local law.
    Under traditional principles of income and principal, ordinary 
income would be paid to the income beneficiaries. Any net long-term 
capital gain would be allocated to principal to be held for the 
ultimate benefit of the charitable remainderman and therefore would 
qualify for the charitable deduction under section 642(c)(3).
    If a pooled income fund were to pay the income beneficiaries a 
unitrust amount in satisfaction of their right to income, as provided 
by proposed state statutes, long-term capital gains would no longer 
qualify for the charitable deduction. Any net long-term capital gain 
not required to be distributed during the current year would be added 
to principal. However, the amount of the gain would not be permanently 
set aside for charitable purposes because this amount may be used in 
the future to make the unitrust payment to the income beneficiaries. A 
similar situation arises if the trustee is permitted under state law to 
make equitable adjustments with respect to unrealized appreciation in 
the value of the trust assets. A portion of any subsequently realized 
capital gain may already have been treated as distributed to the income 
beneficiaries in accordance with an equitable adjustment distribution.
    The proposed regulations will amend Sec. 1.642(c)-2(c) to address 
these issues for pooled income funds. Thus, no net long-term capital 
gain qualifies for the charitable deduction if, under the terms of the 
governing instrument and applicable state law, income may be a

[[Page 10398]]

unitrust amount or may include an equitable adjustment with respect to 
unrealized appreciation in the value of the trust assets.

Charitable Remainder Unitrusts

    A charitable remainder unitrust is a split-interest trust that 
provides for a specified distribution to one or more noncharitable 
beneficiaries for life or a term of years, with an irrevocable 
remainder interest held for the benefit of a charitable organization. 
Under section 664(d)(2), the amount distributed to the noncharitable 
beneficiaries is a fixed percentage (not less than 5% and not more than 
50%) of the annual fair market value of the trust assets. 
Alternatively, under section 664(d)(3), the unitrust amount may be the 
lesser of this fixed percentage amount or trust income (with or without 
a make-up amount). For this purpose, trust income means income as 
defined under section 643(b) and the applicable regulations. 
Sec. 1.664-3(a)(1)(i)(b).
    Under proposed state statutes, trust income could be a fixed 
percentage of the annual fair market value of the trust assets, and the 
fixed percentage may be less than 5%. A net income charitable remainder 
unitrust using such a state statutory definition of income would in 
substance be a fixed percentage unitrust with a percentage less than 
the 5% required by section 664(d)(2). Therefore, the proposed 
regulations will amend Sec. 1.664-3(a)(1)(i)(b) to provide that income 
under the terms of the governing instrument and applicable local law 
may not be determined by reference to a fixed percentage of the annual 
fair market value of the trust property. If the applicable state law 
defines income as a unitrust amount, the governing instrument of a net 
income charitable remainder unitrust must provide its own definition of 
trust income. In addition, the proposed regulations will provide that 
capital gains attributable to appreciation in the value of assets after 
the date contributed to the trust or purchased by the trust may be 
allocated to income under the terms of the governing instrument and 
applicable local law. Such an allocation, however, may not be 
discretionary with the trustee. The section 664 regulations already 
prohibit the allocation of pre-contribution gains to income.

Capital Gains and Distributable Net Income

    Section 643(a)(3) provides that gains from the sale or exchange of 
capital assets are excluded from distributable net income to the extent 
that these gains are allocated to corpus and they are not either paid, 
credited, or required to be distributed, to a beneficiary during the 
year, or paid, permanently set aside, or to be used for a charitable 
purpose. The circumstances in which capital gains are considered paid 
or credited to a beneficiary during the year, and therefore included in 
distributable net income, are not entirely clear. In addition, the 
revisions to state law definitions of income have precipitated 
additional questions in this area. The question arises, for example, 
whether realized capital gains are included in the unitrust amount 
distributed to the income beneficiary under local law, if the unitrust 
amount exceeds the trust's ordinary income.
    The proposed regulations will amend Sec. 1.643(a)-3(a) to clarify 
the circumstances in which capital gains are includible in 
distributable net income for the year. In general, capital gains are 
included in distributable net income to the extent they are, pursuant 
to the terms of the governing instrument or local law, or pursuant to a 
reasonable and consistent exercise of discretion by the fiduciary (in 
accordance with a power granted to the fiduciary by the governing 
instrument or local law): allocated to income; allocated to corpus but 
treated by the fiduciary on the trust's books, records, and tax returns 
as part of a distribution to a beneficiary; or allocated to corpus but 
utilized by the fiduciary in determining the amount which is 
distributed or required to be distributed to a beneficiary. As is the 
case under the current regulations, capital gains that are paid, 
permanently set aside, or to be used for the purposes specified in 
section 642(c) are included in the distributable net income. Capital 
losses are netted at the trust level against any capital gains, except 
for a capital gain that is utilized in determining the amount that is 
distributed or required to be distributed to a particular beneficiary.
    Under the proposed regulations, capital gains will be included in 
distributable net income under certain circumstances that are directed 
by the terms of the governing instrument and applicable local law. 
Thus, any capital gain that is included in the section 643(b) 
definition of income is included in distributable net income. 
Similarly, any capital gain that is used to determine the amount or the 
timing of a distribution to a beneficiary is included in distributable 
net income.
    Capital gains are also included in distributable net income if the 
fiduciary, pursuant to a discretionary power granted by local law or by 
the governing instrument (if not inconsistent with local law), treats 
the capital gains as distributed to a beneficiary, provided the power 
is exercised in a reasonable and consistent manner. Thus, if a trustee 
exercises a discretionary power by consistently treating any 
distribution in excess of ordinary income as being made from realized 
capital gains, any capital gain so distributed is included in 
distributable net income.
    The provisions of sections 643(b) and 643(a)(3) are further 
intertwined when consideration is given to the new state statutory 
provisions defining income. If, under the terms of the governing 
instrument or applicable local law, realized capital gains are treated 
as income to the extent the unitrust amount or the equitable adjustment 
amount exceeds ordinary income, capital gains so treated are included 
in distributable net income. A similar result is achieved for capital 
gains consistently allocated to income by the fiduciary pursuant to a 
discretionary power. In any other situation, capital gains will be 
excluded from distributable net income and will be taxed to the trust.

Distributions in Kind

    The proposed regulations will clarify the consequences of certain 
distributions of property in kind for purposes of the distribution 
deductions under sections 651 and 661. Thus, if property is distributed 
to a beneficiary in satisfaction of the beneficiary's right to income, 
the trust will be treated as having sold the property for its fair 
market value on the date of distribution.

Trusts Qualifying for Gift and Estate Tax Marital Deduction

    Certain transfers of property in trust for the benefit of the 
spouse qualify for the marital deduction for gift and estate tax 
purposes. These transfers include a life estate with a general power of 
appointment described in sections 2523(e) and 2056(b)(5) and qualified 
terminal interest property described in sections 2523(f) and 
2056(b)(7). One of the requirements of these provisions is that the 
spouse must be entitled for life to all the income from the trust 
property. The rules for determining whether the spouse is entitled to 
all the income from either a life estate with a general power of 
appointment trust or a qualified terminable interest trust are set 
forth in Sec. 20.2056(b)-5(f) of the Estate Tax Regulations and 
Sec. 25.2523(e)-1(f) of the Gift Tax Regulations. These rules provide 
that if an interest is transferred in trust, the spouse is entitled for 
life to all the income from the entire interest or a specific portion 
of the entire interest if the effect of the trust is to give the spouse 
substantially that degree of beneficial enjoyment of the trust

[[Page 10399]]

property during the spouse's life which the principles of the law of 
trusts accord a person who is unqualifiedly designated as the life 
beneficiary of a trust.
    The proposed regulations will provide that a spouse's interest 
satisfies the income standard set forth in Secs. 20.2056(b)-5(f) and 
25.2523(e)-1(f) if the spouse is entitled to income as defined under a 
state statute that provides for a reasonable apportionment between the 
income and remainder beneficiaries of the total return of the trust and 
that meets the requirements of Sec. 1.643(b)-1(a). As the examples 
under Sec. 1.643(b)-1(a) make clear, reasonable apportionment can be 
accomplished through a unitrust definition of income or by giving the 
trustee the power to make equitable adjustments between income and 
principal. In addition, a conforming amendment is made to 
Sec. 20.2056A-5(c)(2) providing rules regarding distributions of income 
from a qualified domestic trust.

Trusts Exempt From Generation-Skipping Transfer Tax

    In general, under the effective date rules accompanying the 
generation-skipping transfer (GST) tax statutory provisions, a trust 
that was irrevocable on September 25, 1985, is not subject to the GST 
tax provisions, unless a GST transfer is made out of corpus added to 
the trust after that date. Section 1433(b)(2)(A) of the Tax Reform Act 
of 1986 (TRA), Public Law 99-514 (100 Stat. 2085, 2731), 1986-3 (Vol. 
1) C.B. 1, 634. The regulations provide guidance on when certain 
changes made to the terms of an exempt trust will not be treated as 
causing the trust to lose its exempt or grandfathered status. One safe-
harbor in Sec. 26.2601-1(b)(4)(i)(D) is for modifications that will not 
shift a beneficial interest in the trust to a lower generation 
beneficiary or increase the amount of a GST transfer.
    Under the proposed regulations, the administration of a pre-
September 25, 1985 trust in conformance with a state law that defines 
income as a unitrust amount, or permits equitable adjustments between 
income and principal to ensure impartiality, and that meets the 
requirements of Sec. 1.643(b)-1(a) will not be treated as a 
modification that shifts a beneficial interest to a lower generation 
beneficiary, or increases the amount of a generation-skipping transfer.

Proposed Effective Date

    The regulations are proposed to apply to trusts and estates for 
taxable years that begin on or after the date that final regulations 
are published in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) and comments sent via the 
Internet that are submitted timely to the IRS. The IRS and Treasury 
request comments on the clarity of the proposed regulations and how 
they may be made easier to understand. All comments will be available 
for public inspection and copying. A public hearing has been scheduled 
for June 8, 2001, in the IRS Auditorium, Internal Revenue Service, 1111 
Constitution Avenue, NW., Washington, DC. Owing to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. Because of access 
restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 15 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments and an outline of the topics to be discussed and 
the time to be devoted to each topic (preferably a signed original and 
eight (8) copies) by May 18, 2001. A period of 10 minutes will be 
allotted to each person making comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    Various personnel from offices of the IRS and the Treasury 
Department participated in the development of these proposed 
regulations.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 20

    Estate taxes, Reporting and recordkeeping requirements.

26 CFR Part 25

    Gift taxes, Reporting and recordkeeping requirements.

26 CFR Part 26

    Estate taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1, 20, 25, and 26 are proposed to be 
amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Par. 2. In Sec. 1.642(c)-2, paragraph (c) is amended by adding a 
sentence after the first sentence to read as follows:


Sec. 1.642(c)-2  Unlimited deduction for amounts permanently set aside 
for a charitable purpose.

* * * * *
    (c) * * * No amount of net long-term capital gain shall be 
considered permanently set aside for charitable purposes if it is 
possible, under the terms of the fund's governing instrument or 
applicable local law, that the income beneficiaries' right to income 
may, at any time, be satisfied by the payment of either an amount equal 
to a fixed percentage of the annual fair market value of the trust 
property or any amount based on unrealized appreciation in the value of 
the trust property. * * *
* * * * *
    Par. 3. Section 1.643(a)-3 is revised to read as follows:


Sec. 1.643(a)-3  Capital gains and losses.

    (a) In general. Except as provided in Sec. 1.643(a)-6 and in 
paragraph (b) of this section, gains from the sale or exchange

[[Page 10400]]

of capital assets are ordinarily excluded from distributable net income 
and are not ordinarily considered as paid, credited, or required to be 
distributed to any beneficiary.
    (b) Capital gains included in distributable net income. Gains from 
the sale or exchange of capital assets are included in distributable 
net income to the extent they are, pursuant to the terms of the 
governing instrument and applicable local law, or pursuant to a 
reasonable and consistent exercise of discretion by the fiduciary (in 
accordance with a power granted to the fiduciary by local law or by the 
governing instrument, if not inconsistent with local law)--
    (1) Allocated to income;
    (2) Allocated to corpus but treated by the fiduciary on the trust's 
books, records, and tax returns as part of a distribution to a 
beneficiary; or
    (3) Allocated to corpus but utilized by the fiduciary in 
determining the amount which is distributed or required to be 
distributed to a beneficiary.
    (c) Charitable contributions included in distributable net income. 
If capital gains are paid, permanently set aside, or to be used for the 
purposes specified in section 642(c), so that a charitable deduction is 
allowed under that section in respect of the gains, they must be 
included in the computation of distributable net income.
    (d) Capital losses. Losses from the sale or exchange of capital 
assets shall first be netted at the trust level against any gains from 
the sale or exchange of capital assets, except for a capital gain that 
is utilized under paragraph (b)(3) of this section in determining the 
amount that is distributed or required to be distributed to a 
particular beneficiary. See Sec. 1.642(h)-1 with respect to capital 
loss carryovers in the year of final termination of an estate or trust.
    (e) Examples. The following examples illustrate the rules of this 
section:
    Example 1. Under the terms of Trust's governing instrument, all 
income is to be paid to A for life. Trustee is given discretionary 
powers to invade principal for A's benefit and to deem discretionary 
distributions to be made from capital gains realized during the 
year. During Trust's first taxable year, Trust has $5,000 of 
dividend income and $10,000 of capital gain from the sale of 
securities. Pursuant to the terms of the governing instrument and 
applicable local law, Trustee allocates the $10,000 capital gain to 
principal. During the year, Trustee distributes to A $5,000, 
representing A's right to trust income. In addition, Trustee 
distributes to A $12,000, pursuant to the discretionary power to 
distribute principal. Trustee does not exercise the discretionary 
power to deem the discretionary distributions of principal as being 
paid from capital gains realized during the year. Therefore, the 
capital gains realized during the year are not included in 
distributable net income and the $10,000 of capital gain is taxed to 
the trust.
    Example 2. The facts are the same as in Example 1, except that 
Trustee intends to follow a regular practice of treating 
discretionary distributions as being paid first from any net capital 
gains realized by Trust during the year. Trustee evidences this 
treatment by including the $10,000 capital gain in distributable net 
income on Trust's federal income tax return so that it is taxed to 
A. This treatment of the capital gains is a reasonable exercise of 
Trustee's discretion. In future years Trustee must treat all 
discretionary distributions as being made first from any realized 
capital gains.
    Example 3. The facts are the same as in Example 1, except that 
pursuant to the terms of the governing instrument (in a provision 
not inconsistent with applicable local law), capital gains realized 
by Trust are allocated to income. Because the capital gains are 
allocated to income pursuant to the terms of the governing 
instrument, the $10,000 capital gain is included in Trust's 
distributable net income for the taxable year.
    Example 4. The facts are the same as in Example 1, except that 
Trustee decides that discretionary distributions will be made only 
to the extent Trust has realized capital gains during the year and 
thus the discretionary distribution to A is $10,000, rather than 
$12,000. Because Trustee will consistently use the amount of any 
realized capital gain to determine the amount of the discretionary 
distribution to the beneficiary, the $10,000 capital gain is 
included in Trust's distributable net income for the taxable year.
    Example 5. Trust's assets consist of Blackacre and other 
property. Under the terms of Trust's governing instrument, Trustee 
is directed to hold Blackacre for ten years and then sell it and 
distribute all the sales proceeds to A. Because Trustee uses the 
amount of the sales proceeds that includes any realized capital gain 
to determine the amount required to be distributed to A, any capital 
gain realized from the sale of Blackacre is included in Trust's 
distributable net income for the taxable year.
    Example 6. Under the terms of Trust's governing instrument, all 
income is to be paid to A during the Trust's term. When A reaches 
35, Trust is to terminate and all the principal is to be distributed 
to A. All capital gains realized in the year of termination are 
included in distributable net income. See Sec. 1.641(b)-3 for the 
determination of the year of final termination and the taxability of 
capital gains realized after the terminating event and before final 
distribution.
    Example 7. The facts are the same as Example 6, except Trustee 
is directed to distribute only one-half of the principal to A when A 
reaches 35. Trust assets consist entirely of stock in corporation M. 
If Trustee sells one-half of the stock and distributes the sales 
proceeds to A, all the capital gain attributable to that sale is 
included in distributable net income. If Trustee sells all the stock 
and distributes one-half of the sales proceeds to A, one-half of the 
capital gain attributable to that sale is included in distributable 
net income.
    Example 8. The facts are the same as Example 6, except Trustee 
is directed to pay B $10,000 before distributing the remainder of 
Trust assets to A. No portion of the capital gains is allocable to B 
because the distribution to B is a gift of a specific sum of money 
within the meaning of section 663(a)(1).
    Example 9. State law provides that a trustee may make an 
election to pay an income beneficiary an amount equal to four 
percent of the annual fair market value of the trust assets in full 
satisfaction of that beneficiary's right to income. State law 
provides that this unitrust amount shall be considered paid first 
from ordinary income, then from net short-term capital gain, then 
from net long-term capital gain, and finally from return of 
principal. Trust's governing instrument provides that A is to 
receive each year income as defined under State law. Trustee makes 
the unitrust election under State law. At the beginning of the 
taxable year, Trust assets are valued at $500,000. During the year, 
Trust receives $5,000 of dividend income and realizes $80,000 of net 
long-term gain from the sale of capital assets. Trustee distributes 
to A $20,000 (4% of $500,000) in satisfaction of A's right to 
income. Net long-term capital gain in the amount of $15,000 is 
allocated to income pursuant to the State law ordering rule and is 
included in distributable net income for the taxable year.
    Example 10. The facts are the same as in Example 9, except that 
neither State law nor Trust's governing instrument has an ordering 
rule for the character of the unitrust amount, but leaves such a 
decision to the discretion of Trustee. Trustee intends to follow a 
regular practice of treating principal as distributed to the 
beneficiary to the extent that the unitrust amount exceeds Trust's 
ordinary income. Trustee evidences this treatment by not including 
any capital gains in distributable net income on Trust's Federal 
income tax return so that the entire $80,000 capital gain is taxed 
to Trust. This treatment of the capital gains is a reasonable 
exercise of Trustee's discretion. In future years Trustee must 
consistently follow this treatment with respect to all realized 
capital gains.
    Example 11. The facts are the same as in Example 9, except that 
neither State law nor Trust's governing instrument has an ordering 
rule for the character of the unitrust amount, but leaves such a 
decision to the discretion of Trustee. Trustee intends to follow a 
regular practice of treating net capital gains as distributed to the 
beneficiary to the extent the unitrust amount exceeds Trust's 
ordinary income. Trustee evidences this treatment by including 
$15,000 of the capital gain in distributable net income on Trust's 
Federal income tax return. This treatment of the capital gains is a 
reasonable exercise of Trustee's discretion. In future years Trustee 
must consistently treat realized capital gain, if any, as 
distributed to the beneficiary to the extent that the unitrust 
amount exceeds ordinary income.

    Par. 4. Section 1.643(b)-1 is revised to read as follows:

[[Page 10401]]

Sec. 1.643(b)-1  Definition of income.

    For purposes of subparts A through D, part I, subchapter J, chapter 
1 of the Internal Revenue Code, income, when not preceded by the words 
``taxable,'' ``distributable net,'' ``undistributed net,'' or 
``gross,'' means the amount of income of an estate or trust for the 
taxable year determined under the terms of the governing instrument and 
applicable local law. Trust provisions that depart fundamentally from 
traditional principles of income and principal, that is, allocating 
ordinary income to income and capital gains to principal, will 
generally not be recognized. However, amounts allocated between income 
and principal pursuant to applicable local law will be respected if 
local law provides for a reasonable apportionment between the income 
and remainder beneficiaries of the total return of the trust for the 
year, including ordinary income, capital gains, and appreciation. For 
example, a state law that provides for the income beneficiary to 
receive each year a unitrust amount of between 3% and 5% of the annual 
fair market value of the trust assets is a reasonable apportionment of 
the total return of the trust. Similarly, a state law that permits the 
trustee to make equitable adjustments between income and principal to 
fulfill the trustee's duty of impartiality between the income and 
remainder beneficiaries is generally a reasonable apportionment of the 
total return of the trust. These adjustments are permitted when the 
trustee invests and manages the trust assets under the state's prudent 
investor standard, the trust describes the amount that shall or must be 
distributed to a beneficiary by referring to the trust's income, and 
the trustee after applying the state statutory rules regarding 
allocation of income and principal is unable to administer the trust 
impartially. In addition, an allocation of capital gains to income will 
be respected if the allocation is made either pursuant to the terms of 
the governing instrument and local law, or pursuant to a reasonable and 
consistent exercise of a discretionary power granted to the fiduciary 
by local law or by the governing instrument, if not inconsistent with 
local law.
    Par. 5. In Sec. 1.651(a)-2, paragraph (d) is added to read as 
follows:


Sec. 1.651(a)-2  Income required to be distributed currently.

* * * * *
    (d) If a trust distributes property in kind as part of its 
requirement to distribute currently all the income as defined under 
section 643(b) and the applicable regulations, the trust shall be 
treated as having sold the property for its fair market value on the 
date of distribution. If no amount in excess of the amount of income as 
defined under section 643(b) and the applicable regulations is 
distributed by the trust during the year, the trust will qualify for 
treatment under section 651 even though property in kind was 
distributed as part of a distribution of all such income.
    Par. 6. In Sec. 1.661(a)-2, paragraph (f) is revised to read as 
follows:


Sec. 1.661(a)-2  Deduction for distributions to beneficiaries.

* * * * *
    (f) Gain or loss is realized by the trust or estate (or the other 
beneficiaries) by reason of a distribution of property in kind if the 
distribution is in satisfaction of a right to receive a distribution of 
a specific dollar amount, of specific property other than that 
distributed, or of income as defined under section 643(b) and the 
applicable regulations, if income is required to be distributed 
currently. In addition, gain or loss is realized if the trustee or 
executor makes the election to recognize gain or loss under section 
643(e).
    Par. 7. In Sec. 1.664-3, paragraph (a)(1)(i)(b)(3) is revised to 
read as follows:


Sec. 1.664-3  Charitable remainder unitrust.

    (a) * * *
    (1) * * *
    (i) * * *
    (b) * * *
    (3) For purposes of this paragraph (a)(1)(i)(b), trust income 
generally means income as defined under section 643(b) and the 
applicable regulations. However, trust income may not be determined by 
reference to a fixed percentage of the annual fair market value of the 
trust property. If applicable state law provides that income is a 
unitrust amount, the trust's governing instrument must contain its own 
definition of trust income. In addition, capital gain attributable to 
appreciation in the value of a trust asset after the date it was 
contributed to the trust or purchased by the trust may be allocated to 
income pursuant to applicable local law and the terms of the governing 
instrument but not pursuant to a discretionary power granted the 
trustee.
* * * * *

PART 20--ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 
1954

    Par. 8. The authority citation for part 20 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 9. Section 20.2056(b)-5 is amended by adding a new sentence to 
the end of paragraph (f)(1) to read as follows:


Sec. 20.2056(b)-5  Marital deduction; life estate with power of 
appointment in surviving spouse.

* * * * *
    (f) * * * (1) * * * In addition, the surviving spouse's interest 
shall meet the condition set forth in paragraph (a)(1) of this section, 
if the spouse is entitled to income as defined by a state statute that 
provides for a reasonable apportionment between the income and 
remainder beneficiaries of the total return of the trust and that meets 
the requirements of Sec. 1.643(b)-1 of the chapter.
* * * * *
    Par. 10. Section 20.2056(b)-7 is amended by adding a new sentence 
to the end of paragraph (d)(1) to read as follows:


Sec. 20.2056(b)-7  Election with respect to life estate for surviving 
spouse.

* * * * *
    (d) * * * (1) * * * A power under applicable state law that permits 
the trustee to adjust between income and principal to fulfill the 
trustee's duty of impartiality between the income and remainder 
beneficiaries that meets the requirements of Sec. 1.643(b)-1 of this 
chapter will not be considered a power to appoint trust property to a 
person other than the surviving spouse.
* * * * *
    Par. 11. Section 20.2056(b)-10 is amended by adding a new sentence 
at the end of the section to read as follows:


Sec. 20.2056(b)-10  Effective dates.

    * * * In addition, the rule in the last sentence of 
Sec. 20.2056(b)-5(f)(1) and the rule in the last sentence of 
Sec. 20.2056(b)-7(d)(1) regarding the spouse's right to income if the 
state statute provides for the reasonable apportionment between the 
income and remainder beneficiaries of the total return of the trust are 
applicable with respect to trusts for taxable years that begin on or 
after the date that final regulations are published in the Federal 
Register.
    Par. 12. Section 20.2056A-5 is amended by adding a new sentence in 
paragraph (c)(2) after the third sentence to read as follows:


Sec. 20.2056A-5  Imposition of section 2056A estate tax.

* * * * *
    (c) * * *
    (2) * * * However, distributions made to the surviving spouse as 
the income beneficiary in conformance with

[[Page 10402]]

applicable state law that defines the term income as a unitrust amount, 
or permits the trustee to adjust between principal and income to 
fulfill the trustee's duty of impartiality between income and principal 
beneficiaries, will be considered distributions of trust income, if the 
state statute provides for a reasonable apportionment between the 
income and remainder beneficiaries of the total return of the trust and 
meets the requirements of Sec. 1.643(b)-1 of this chapter. * * *
* * * * *
    Par. 13. Section 20.2056A-13 is revised to read as follows:


Sec. 20.2056A-13  Effective dates.

    Except as provided in this section, the provisions of 
Secs. 20.2056A-1 through 20.2056A-12 are applicable with respect to 
estates of decedents dying after August 22, 1995. The rule in the 
fourth sentence of Sec. 20.2056A-5(c) regarding unitrusts and 
distributions of income to the surviving spouse in conformance with 
applicable state law that provides for the reasonable apportionment 
between the income and remainder beneficiaries of the total return of 
the trust is applicable with respect to trusts for taxable years that 
begin on or after the date that final regulations are published in the 
Federal Register.

PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

    Par. 14. The authority citation for part 25 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 15. Section 25.2523(e)-1 is amended by adding a new sentence 
to the end of paragraph (f)(1) to read as follows:


Sec. 25.2523(e)-1  Marital deduction; life estate with power of 
appointment in donee spouse.

* * * * *
    (f) * * * (1) * * * In addition, the spouse's interest shall meet 
the condition set forth in paragraph (a)(1) of this section, if the 
spouse is entitled to income as defined by a state statute that 
provides for a reasonable apportionment between the income and 
remainder beneficiaries of the total return of the trust and that meets 
the requirements of Sec. 1.643(b)-1(a) of this chapter.
* * * * *
    Par. 16. Section 25.2523(h)-2 is amended by adding a new sentence 
to the end of the section to read as follows:


Sec. 25.2523(h)-2  Effective dates.

    * * * In addition, the rule in the fourth sentence of 
Sec. 25.2523(e)-1(f)(1) regarding the spouse's right to income if the 
state statute provides for reasonable apportionment between the income 
and remainder beneficiaries of the total return of the trust is 
applicable with respect to trusts and estates for taxable years that 
begin on or after the date the final regulations are published in the 
Federal Register.

PART 26--GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE TAX 
REFORM ACT OF 1986

    Par. 17. The authority citation for part 26 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 18. Section 26.2601-1 is amended as follows:
    1. Paragraph (b)(4)(i)(D)(2) is amended by adding a new sentence to 
the end of the paragraph.
    2. Paragraph (b)(4)(i)(E) is amended by adding Examples 11 and 12.
    3. Paragraph (b)(4)(ii) is revised to read as follows.
    The additions and revisions read as follows:


Sec. 26.2601-1  Effective dates.

* * * * *
    (b) * * *
    (4) * * *
    (i) * * *
    (D) * * *
    (2) * * * In addition, administration of a trust in conformance 
with applicable state law that defines the term income as a unitrust 
amount, or permits the trustee to adjust between principal and income 
to fulfill the trustee's duty of impartiality between income and 
principal beneficiaries, will not be considered to shift a beneficial 
interest in the trust, if the state statute provides for a reasonable 
apportionment between the income and remainder beneficiaries of the 
total return of the trust and meets the requirements of Sec. 1.643(b)-1 
of this chapter.
    (E) * * *

    Example 11. Conversion of income interest to unitrust interest 
under state statute. In 1980, Grantor, a resident of State X, 
established an irrevocable trust for the benefit of Grantor's child, 
A, and A's issue. The trust provides that trust income is payable to 
A for life and upon A's death the remainder is to pass to A's issue, 
per stirpes. In 2002, State X amends its income and principal 
statute to define ``income'' as a unitrust amount of 4% of the fair 
market value of the trust assets valued annually. For a trust 
established prior to 2002, the statute provides that the new 
definition of income will apply only if all the beneficiaries who 
have an interest in the trust consent to the change within two years 
after the effective date of the statute. The statute provides 
specific procedures to establish the consent of the beneficiaries. A 
and A's issue consent to the change in the definition of income 
within the time period, and in accordance with the procedures, 
prescribed by the state statute. The administration of the trust, in 
accordance with the state statute defining income to be a 4% 
unitrust amount, will not be considered to shift any beneficial 
interest in the trust. Therefore, the trust will not be subject to 
the provisions of chapter 13 of the Internal Revenue Code.
    Example 12. Equitable adjustments under state statute. The facts 
are the same as in Example 11, except that in 2002, State X amends 
its income and principal statute to permit the trustee to make 
equitable adjustments between income and principal when the trustee 
invests and manages the trust assets under the state's prudent 
investor standard, the trust describes the amount that shall or must 
be distributed to a beneficiary by referring to the trust's income, 
and the trustee after applying the state statutory rules regarding 
allocation of income and principal is unable to administer the trust 
impartially. The provision permitting the trustees to make these 
equitable adjustments is effective in 2002 for trusts created at any 
time. The trustee invests and manages the trust assets under the 
state's prudent investor standard, and pursuant to authorization in 
the state statute, the trustee allocates receipts between the income 
and principal accounts in a manner to ensure the impartial 
administration of the trust. The administration of the trust in 
accordance with the state statute will not be considered to shift 
any beneficial interest in the trust. Therefore, the trust will not 
be subject to the provisions of chapter 13 of the Internal Revenue 
Code.

    (ii) Effective dates. The rules in this paragraph (b)(4) are 
applicable on and after December 20, 2000. However, the rule in the 
last sentence of paragraph (b)(4)(i)(D)(2) of this section regarding 
the administration of a trust in conformance with applicable state law 
providing for a reasonable apportionment between the income and 
remainder beneficiaries of the total return of the trust is applicable 
with respect to trusts for taxable years that begin on or after the 
date that final regulations are published in the Federal Register.
* * * * *

Bob Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-1686 Filed 2-14-01; 8:45 am]
BILLING CODE 4830-01-P