[Federal Register Volume 69, Number 1 (Friday, January 2, 2004)]
[Rules and Regulations]
[Pages 12-22]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31614]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 20, 25, and 26

[TD 9102]
RIN 1545-AX96


Definition of Income for Trust Purposes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations revising the 
definition of income under section 643(b) of the Internal Revenue Code. 
The regulations are necessary to reflect changes in the definition of 
trust accounting income under state laws. The final 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. The regulations affect the 
grantors, beneficiaries, and fiduciaries of trusts.

DATES: Effective Date: These regulations are effective January 2, 2004.
    Applicability date: Generally, the final regulations are applicable 
to trusts and estates for taxable years ending after January 2, 2004. 
See revised Sec. Sec.  1.642(c)-2, 1.642(c)-5, and 1.664-3 for special 
dates of applicability affecting those sections.

FOR FURTHER INFORMATION CONTACT: Bradford R. Poston at (202) 622-3060 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On February 15, 2001, proposed regulations (REG-106513-00) were 
published in the Federal Register [66 FR 10396] containing proposed 
amendments to the Income Tax

[[Page 13]]

Regulations [26 CFR part 1], the Estate Tax Regulations [26 CFR part 
20], the Gift Tax Regulations [26 CFR part 25], and the Generation-
Skipping Transfer Tax Regulations [26 CFR part 26] relating to the 
definition of income for trust purposes. A public hearing was held on 
the proposed regulations on June 8, 2001. Written comments were 
received on the proposed regulations. The proposed regulations, with 
certain changes in response to the comments, are adopted as final 
regulations.

Summary of Comments and Explanation of Revisions

Definition of Income

    The proposed regulations provide that, for purposes of determining 
what constitutes trust accounting income under section 643(b), trust 
provisions that depart fundamentally from the traditional concepts of 
income and principal generally will continue to be disregarded as they 
have been under the existing regulations. One commentator suggested 
that, instead of using traditional concepts of income and principal, 
the benchmark should be whether there is a departure from the duty to 
administer the trust or estate impartially based upon what is fair and 
reasonable to all the parties. One commentator suggested eliminating 
the distinction between trust accounting income and principal. Another 
suggested that the regulations clarify the consequences of a 
fundamental departure from traditional concepts of income and 
principal.
    Income under section 643(b) is the amount of income determined 
under the terms of the governing instrument and applicable local law. 
This concept of income is used as the measure of the amount that must 
be distributed from a trust in order for the trust to qualify for 
certain treatment under various provisions of the Internal Revenue 
Code. Trusts classified as simple trusts, pooled income funds, net 
income charitable remainder unitrusts, and qualified subchapter S 
trusts (QSSTs) are required to make distributions measured at least in 
part by the amount of trust accounting income. A similar concept 
applies to trusts that qualify for the gift and estate tax marital 
deductions. Because section 643(b) requires a determination of trust 
accounting income, it is not possible to ignore any distinctions 
between trust accounting income and principal as suggested by a 
commentator.
    A trust instrument may provide for any amount to be distributed to 
beneficiaries currently. Trust provisions that measure the amount of 
the distribution by reference to income but define income differently 
from the state statutory definition of income generally will be 
recognized for state law purposes. However, Internal Revenue Code 
provisions that require the current distribution of income to qualify 
the trust for certain federal tax treatment are based on the assumption 
that the income beneficiary will receive what is traditionally 
considered to be income. In some situations, such as with QSSTs and 
marital deduction trusts for spouses who are U.S. citizens, the income 
beneficiary is permitted to also receive principal distributions as 
long as all the income is currently distributed. In other situations, 
as with pooled income funds and net income charitable remainder 
unitrusts, only the income may be distributed. In all these situations, 
the determination of income is critical. Thus, the definition of income 
under the terms of the governing instrument and applicable local law 
must not depart fundamentally from traditional concepts of income and 
principal, if the desired federal tax treatment is to be secured.
    The IRS and the Treasury Department recognize that state statutes 
are in the process of changing traditional concepts of income and 
principal in response to investment strategies that seek total positive 
return on trust assets. These statutes are designed to ensure that, 
when a trust invests in assets that may generate little traditional 
income (including dividends, interest, and rents), the income and 
remainder beneficiaries are allocated reasonable amounts of the total 
return of the trust (including both traditional income and capital 
appreciation of trust assets) so that both classes of beneficiaries are 
treated impartially. Some statutes permit the trustee to pay to the 
person entitled to the income a unitrust amount based on a fixed 
percentage of the fair market value of the trust assets. Other statutes 
permit the trustee the discretion to make adjustments between income 
and principal to treat the beneficiaries impartially. Under the 
proposed regulations, a trust's definition of income in conformance 
with applicable state statutes will be respected for federal tax 
purposes when the state statutes provide for a reasonable apportionment 
of the total return of the trust.
    Some commentators suggested that, even in those states that have 
not enacted legislation specifically authorizing powers to adjust or a 
unitrust definition of income, trust instruments containing such 
provisions should be respected as defining income for purposes of 
section 643(b). Under a unitrust or power to adjust, items 
traditionally allocable to principal (such as gains from the sale or 
exchange of trust assets) may, under certain circumstances, be 
allocated to income, and items traditionally allocable to income (such 
as dividends, interest, and rents) may, under certain circumstances, be 
allocated to principal. The proposed regulations already recognize that 
gains from the sale or exchange of trust assets may, under certain 
circumstances, be allocated to income under the terms of the governing 
instrument. However, Sec.  1.643(b)-1 has always provided that the 
allocation to principal, under the terms of the governing instrument, 
of items that traditionally would be allocable to income will not be 
respected for purposes of section 643(b), and this position is 
maintained in the final regulations. Accordingly, the IRS and the 
Treasury Department believe that an allocation to principal of 
traditional income items should be respected for Federal tax purposes 
only if applicable state law has specifically authorized such an 
allocation in certain limited circumstances, such as when necessary to 
ensure impartiality regarding a trust investing for total return. Under 
the regulations, a state statute specifically authorizing certain 
unitrust payments in satisfaction of an income interest or certain 
powers to adjust would satisfy that requirement. Further, the IRS and 
the Treasury Department acknowledge that other actions may constitute 
applicable state law, such as a decision by the highest court of the 
state announcing a general principle or rule of law that would apply to 
all trusts administered under the laws of that state. However, a court 
order applicable only to the trust before the court would not 
constitute applicable state law for this purpose.
    Two commentators suggested that the permissible range of unitrust 
percentages should include any percentage permitted by state statutes. 
The IRS and the Treasury Department believe that when establishing a 
unitrust percentage that attempts to yield the equivalent of income 
over a long period of time that may encompass wide variations in 
economic conditions, a range of 3% to 5% will be considered a 
reasonable apportionment of a trust's total return. In response to one 
comment, the range of unitrust percentages has been adjusted in the 
final regulations to include, rather than exclude, unitrust percentages 
of 3% and 5%. Also in response to comments, the final regulations state 
that the periodic redetermination of the fair market value of the trust 
assets may be done as of a

[[Page 14]]

particular date each year or as an average determined on a multiple 
year basis.
    The proposed regulations state that traditionally ordinary income 
is allocated to income and capital gains are allocated to principal. 
One commentator pointed out that ordinary income and capital gains are 
tax concepts and not concepts that have any meaning for purposes of 
trust accounting income. The final regulations have been revised to 
state that traditionally items such as dividends, interest, and rents 
are allocated to income and the proceeds from the sale or exchange of 
trust assets are allocated to principal.
    The proposed regulations refer to a power to make equitable 
adjustments between income and principal and describe the circumstances 
under which these adjustments currently are permitted under state law 
and will be respected for Federal tax purposes. Specifically, state 
statutes permit adjustments when trust assets are invested under the 
state's prudent investor standard, the trust instrument refers to 
income in describing the amount that may or must be paid to a 
beneficiary, and the trustee, after applying the state statutory rules 
regarding the allocation of receipts and disbursements between income 
and principal, is unable to administer the trust impartially. One 
commentator requested clarification of the requirements a trustee must 
satisfy to make an adjustment that will be respected for Federal tax 
purposes. Those requirements are a matter of local law and may differ 
from state to state; the trustee must meet whatever requirements are 
imposed by applicable local law on the exercise of this power. One 
commentator pointed out that state statutes do not include the term 
equitable in referring to this power and suggested deleting that term. 
One commentator suggested adding ``generally'' to the statement 
concerning the circumstances in which these adjustments are permitted 
because some states may permit these adjustments without enacting a 
prudent investor standard. These two suggestions are adopted in the 
final regulations.
    One commentator suggested clarifying that the definition of income 
in the regulations also applies to spray and sprinkle trusts. The final 
regulations provide that allocations apportioning the total return of 
the trust pursuant to the state statute will be respected regardless of 
whether the trust has one or more income beneficiaries and irrespective 
of whether income must or may be paid out each year. The commentator 
also suggested that allocations pursuant to one apportionment method 
should be respected even if a different apportionment method was used 
in prior years. The final regulations provide that, as long as the 
trust complies with the requirements of state statutes for switching 
between methods authorized by the statute, then, when the trust 
switches between permitted methods: (i) The method used in any year 
will be respected for Federal tax purposes; (ii) the switch will not 
constitute a recognition event under section 1001; and (iii) neither 
the grantor nor any beneficiary will have any gift tax consequences. 
This provision does not apply to switches between methods not 
specifically authorized by state statute.
    It has been questioned whether the changes to Sec.  1.643(b)-1 
affect the amount of income required to be distributed by QSSTs. 
Section 1.1361-1(j) provides that QSSTs are required to distribute 
income as defined in Sec.  1.643(b)-1. Therefore, no amendment to the 
QSST regulations is necessary for the new provisions of Sec.  1.643(b)-
1 to be applicable to QSSTs.
    The proposed regulations provide that an allocation of capital 
gains to income will be respected if made either (i) pursuant to the 
terms of the governing instrument and applicable local law, or (ii) 
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. One commentator 
suggested that in the phrase ``pursuant to the terms of the governing 
instrument and applicable local law,'' the term ``and'' be replaced 
with ``or.'' The phrase with the term ``and'' is consistent with the 
statutory language of section 643(b), and, therefore, no change has 
been made.
    One commentator suggested that a discretionary power to allocate 
capital gains to income should not have to be exercised consistently. 
The exercise of the power generally affects the actual amount that may 
or must be distributed to the income beneficiaries and affects whether 
the trust or the beneficiary will be taxed on the capital gains. Thus, 
the IRS and the Treasury Department agree that the power does not have 
to be exercised consistently, as long as it is exercised reasonably and 
impartially. However, if the amount of income is determined by a 
unitrust amount, the exercise of this discretionary power has no effect 
on the amount of the distribution, but does affect whether the 
beneficiary or the trust is taxed on the capital gains. Under these 
circumstances, a discretionary power must be exercised consistently. 
One commentator suggested changing the phrase ``if not inconsistent 
with local law'' because powers to allocate capital gains to income 
will almost always be inconsistent with the default provisions of state 
law. Accordingly, the phrase has been changed to ``if not prohibited by 
local law.''

Pooled Income Funds

    Several commentators were concerned about the provision in the 
proposed regulations that long-term capital gain does not qualify for 
the income tax charitable deduction available to pooled income funds 
(PIFs), if the amount of income payable to the noncharitable 
beneficiaries may be either a unitrust amount or an amount that could 
include unrealized appreciation in the value of trust assets pursuant 
to the exercise of a trustee's power to adjust. One commentator 
suggested that, if income is defined as a unitrust amount or is subject 
to the trustee's power of adjustment, the provision in the proposed 
regulation invalidly limits the amount that can be paid to the 
noncharitable beneficiaries of the PIF.
    This regulatory provision places no prohibition on paying to the 
noncharitable beneficiaries an amount of income determined under the 
governing instrument and applicable local law, even if that income is a 
unitrust amount or is determined pursuant to a power of adjustment that 
takes into account unrealized appreciation. Rather, this regulatory 
provision addresses whether long-term capital gains recognized during a 
year but not distributed during that year are permanently set aside for 
a charitable purpose as required by section 642(c)(3) to allow the PIF 
to claim a charitable deduction for these amounts. If income is defined 
as a unitrust amount, a future payment of income to the noncharitable 
beneficiaries may be attributable to long-term capital gains realized, 
but not distributed, in the current year. If income is determined 
pursuant to a power of adjustment that takes into account unrealized 
appreciation, a portion of the capital gain recognized during a year 
may be attributable to appreciation that was the basis for a 
distribution to the noncharitable beneficiaries in a prior year. In 
both situations, the long-term capital gains are not permanently set 
aside for charitable purposes and therefore do not qualify for the 
charitable deduction in computing the PIF's income tax liability.

[[Page 15]]

    Some commentators were concerned that PIFs need to be able to 
distribute more than the traditional amounts of income to remain useful 
vehicles for charitable giving. They suggest that PIFs should be able 
to define trust accounting income as traditional income plus any 
realized capital gains for the year but the total amount defined as 
income cannot exceed a specified percentage. Thus, the annual payout 
would be the lesser of a unitrust amount or trust accounting income 
defined to include gains from the appreciation of assets sold by the 
trust during the year.
    Distinct statutory provisions govern PIFs and charitable remainder 
unitrusts (CRUTs). The provisions applicable to each type of trust are 
specifically designed to achieve statutory objectives based on the 
nature of the charitable and noncharitable interests in each type of 
trust. The commentators' suggestion is, in effect, to permit PIFs to 
operate in the same manner as a net income CRUT, but without applying 
any of the other CRUT requirements to these funds. There is no 
authority for incorporating certain provisions applicable to CRUTs into 
the provisions applicable to PIFs.
    Nevertheless, the power to adjust authorized by many state statutes 
currently applies to PIFs administered in those states. If permitted 
under the terms of the governing instrument and state statutes, a 
trustee may use the power to make adjustments by allocating to income a 
portion of the sales proceeds from trust assets in order to treat the 
income and remainder beneficiaries impartially. The proper exercise of 
a power to adjust may provide the income beneficiaries with amounts in 
excess of the amount of traditional income. The final regulations 
provide that, for a PIF, the amount of proceeds from the sale of assets 
that may be allocated to income pursuant to a power to adjust is 
limited to the amount by which those proceeds exceed the fair market 
value of those assets as of the date those assets were contributed to 
or purchased by the PIF. This provision ensures that amounts 
attributable to the fair market value of assets on the date contributed 
to the PIF cannot be reallocated to income under a power to adjust. In 
addition, long-term capital gains from the sale or exchange of trust 
assets do not qualify for the charitable deduction under section 
642(c)(3) to the extent that any sales proceeds are distributed to the 
income beneficiaries.
    One commentator suggested that the ``or'' in the phrase ``under the 
terms of the governing instrument or applicable local law'' should be 
changed to ``and'' to be consistent with the statutory definition of 
income under section 643(b). This change has been made.

Charitable Remainder Trusts

    Several commentators were concerned about the requirement in the 
proposed regulations that net income CRUTs under sections 664(d)(2) and 
664(d)(3) contain their own definition of income if applicable state 
law provides that income is a unitrust amount. The purpose of this 
proposed requirement was to avert potential problems with qualification 
of a net income CRUT in a state that defines income as a unitrust 
amount. Some commentators pointed out that state statutes provide 
alternative definitions of income and all that should be necessary is 
that the trust use a definition of income, whether contained in the 
terms of the governing instrument or applicable local law, that is not 
a unitrust amount. Therefore, the requirement that the trust contain 
its own definition of income has been eliminated from the final 
regulations.
    Several commentators were concerned about the provision in the 
proposed regulations that the allocation of post-contribution capital 
gain to income, if permitted under the terms of the governing 
instrument and applicable local law, may not be discretionary with the 
trustee. Some suggested eliminating the prohibition on discretionary 
powers held by the trustee. Some suggested that a discretionary power 
should be permitted if held by an independent trustee. Some requested 
clarification that this prohibition does not apply to a trustee's power 
to allocate receipts to income or principal pursuant to state law.
    The provision in the proposed regulations has no effect on the 
determination of trust accounting income under applicable state law 
that grants the trustee a power to reasonably apportion the total 
return of the trust. The provision is directed at discretion given the 
trustee under the terms of the governing instrument to allocate capital 
gains to income in some years and not others. Allowing the trustee this 
type of discretion is inconsistent with the requirements for net income 
CRUTs as explained in the legislative history. The settlor has the 
option of providing in the trust that the trustee is to distribute the 
lesser of the stated percentage payout or trust income. However, this 
option must be adopted in the trust instrument and not left to the 
discretion of the trustee. See H.R. Conf. Rep. No. 91-782, at 296 
(1969), reprinted in 1969-3 C.B. 644, 655. A power to allocate capital 
gains to income in some years and not others in the trustee's sole 
discretion is similar to having the discretionary ability to pay out 
either the trust income or the stated percentage payout each year, 
regardless of their relative values. Thus, the final regulations 
continue to provide that, for CRUTs, post-contribution capital gains 
may be included in the definition of income under the terms of the 
governing instrument or applicable local law, but not pursuant to a 
trustee's discretionary power granted by the trust instrument, rather 
than by state statute, to allocate capital gains to income.

Capital Gains and Distributable Net Income

    Section 643(a)(3) provides that gains from the sale or exchange of 
capital assets generally are excluded from distributable net income 
(DNI) to the extent that these gains are allocated to corpus. However, 
capital gains allocated to corpus are included in DNI if they are 
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. In certain situations it is easily ascertained 
whether capital gains are paid to a beneficiary. For example, if the 
trust instrument provides that the proceeds from the sale of a certain 
asset are to be paid to a beneficiary upon sale, then any capital gain 
recognized upon the sale of that asset is paid to the beneficiary and 
is includible in DNI. However, the circumstances in which recognized 
capital gain determines the amount to be distributed to a beneficiary 
during the year are relatively rare.
    More frequently, the trustee is authorized by the trust instrument 
to make discretionary distributions of principal or, by the recently-
enacted state statutes, to pay the income beneficiary a unitrust 
amount. In these circumstances, the amount of realized capital gain 
during the year does not affect the amount distributed to a 
beneficiary, and because money is fungible, it is difficult to 
ascertain whether capital gains are actually paid to the beneficiary. 
With respect to these situations, the proposed regulations attempt to 
clarify the circumstances in which capital gains are treated as 
distributed to a beneficiary and therefore are includable in DNI. The 
proposed regulations provide that capital gains will be treated as part 
of a distribution to a beneficiary, if the trustee allocates capital 
gains to the distribution pursuant to a discretionary power granted by 
local law or by the governing instrument (if not inconsistent with 
local law) to treat capital gains in this manner, provided the 
allocation power is exercised in a reasonable and consistent manner, 
and

[[Page 16]]

is evidenced on the trust's books, records, and tax returns.
    Commentators requested guidance on several issues concerning the 
treatment of capital gains as part of a distribution to a beneficiary. 
These issues include clarification that one trustee may exercise the 
discretion differently for different trusts and that the treatment of 
capital gains from the sale of different types of assets may be 
different. Examples have been added to the final regulations to address 
these situations. In addition, some commentators were concerned about 
how a trustee may show consistency in the first year, whether the 
treatment in future years may be changed based on something other than 
a change in the definition of income, and whether existing trusts may 
establish a different treatment based on the rules in the final 
regulations.
    In some respects, the proposed regulations merely clarify how a 
trustee may demonstrate that capital gain has been paid to a 
beneficiary and therefore is includible in DNI under section 643(a)(3). 
This determination is relevant when distributions are made to 
beneficiaries that exceed the amount of DNI determined without regard 
to the capital gains. In the past this situation arose when mandatory 
or discretionary payments of principal were made. Because of the 
changes to the definition of income under state statutes, the number 
and variety of situations in which this determination is relevant are 
increasing. In implementing a different method for determining income 
under a state statute, the trustee may establish a pattern for 
including or not including capital gains in DNI to the extent that the 
amount of income so determined is greater than the amount of DNI 
determined without regard to the capital gains. This choice may be made 
irrespective of the trustee's practice under a prior legal definition 
of income regarding the treatment of capital gains as part of DNI when 
discretionary or mandatory distributions of principal were made from 
the trust.
    Two commentators requested examples of the inclusion of capital 
gains in DNI when the trustee exercises a power to adjust between 
income and principal under applicable local law. The circumstances in 
which a power to adjust is exercisable may vary among states and may be 
determined by the powers of the trustee to make distributions of income 
and principal under the terms of the governing instrument. For example, 
if a trust instrument does not permit the trustee to distribute any 
corpus and the power to adjust under local law may be exercised only 
with respect to receipts from the sale of trust assets, the amount 
allocated to income under the power to adjust may have to be from the 
realized appreciation in the value of the assets that were sold. On the 
other hand, if the trust instrument permits discretionary distributions 
of principal and the power to adjust under local law may be exercised 
only with respect to appreciation in the value of trust assets, the 
power to adjust may be similar to a unitrust amount that is payable 
irrespective of whether appreciated assets are sold during the year. 
Because of the potential variations in the circumstances and 
ramifications of exercising a power to adjust under applicable state 
statutes, additional examples would be unlikely to provide meaningful 
or complete guidance; thus, the final regulations contain no additional 
examples concerning inclusion of capital gains in DNI when the trustee 
exercises a power to adjust.
    It has been pointed out that Examples 6 through 8 in Sec.  
1.643(a)-3(e) of the proposed regulations, which are essentially 
identical to examples in the existing regulations, may no longer be 
consistent with the rules in the proposed regulations. In the final 
regulations, the corresponding examples, now Examples 7 through 10, 
have been updated to take into account the new rules. One commentator 
requested examples of the effect on DNI of capital gains from a 
passthrough entity and income from a passthrough entity that is more or 
less than the trust accounting income from that entity. These issues 
are beyond the scope of this project.

Trusts Qualifying for Gift and Estate Tax Marital Deductions

    The proposed regulations provide that a spouse will be treated as 
entitled to receive all net income from a trust, as required for the 
trust to qualify for the gift and estate tax marital deductions under 
Sec.  20.2056(b)-5(a)(1) of the Estate Tax Regulations and Sec.  
25.2523(e)-1(f)(1) of the Gift Tax Regulations, if the trust is 
administered under applicable state law 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. Thus, a spouse who, as the income beneficiary, is entitled 
in accordance with the state statute and the governing instrument to a 
unitrust amount of no less than 3% and no more than 5% would be 
entitled to all the income from the trust for purposes of qualifying 
the trust for the marital deduction.
    Several commentators suggested that a trust that provides for a 
unitrust payment to the spouse should satisfy the income standard even 
in states that have not enacted legislation defining income as a 
unitrust amount or providing that a right to income may be satisfied by 
such a payment. The income distribution requirement that must be 
satisfied for a trust to qualify for the gift and estate tax marital 
deductions ensures that the spouse receives what is traditionally 
considered to be income from the assets held in trust. As previously 
discussed, the IRS and the Treasury Department believe that only if 
applicable state law has authorized a departure from traditional 
concepts of income and principal should such a departure be respected 
for Federal tax purposes. A state statute specifically authorizing 
certain unitrust amounts in satisfaction of an income interest or 
certain powers to adjust in conformance with the provisions of Sec.  
1.643(b)-1 would meet this standard. However, in the absence of a state 
statute, or, for example, a decision of the highest court of the state 
applicable to all trusts administered under that state's law, the 
applicable state law requirement will not be satisfied.
    It has also been suggested that, in some circumstances, the 
proposed regulations would allow the spouse to receive less than all 
the traditional trust income, and therefore would conflict with the 
section 2056 statutory requirement that the spouse receive all trust 
income. For example, a spouse who, in accordance with the state 
statute, receives a 4% unitrust amount would receive less than all the 
traditional income generated by the trust, if the trust's total 
dividends, interest, rents, etc. for the year exceed 4%. However, that 
spouse would receive more than the amount of traditional income earned 
by the trust in any year that the trust's total dividends, interest, 
rents, etc. do not exceed 4%. The regulations are intended to strike a 
reasonable balance between the marital deduction statutory requirements 
and the many state statutes intended to facilitate the investment of 
trust assets while ensuring equitable treatment for the income and 
remainder beneficiaries. Indeed, Congress contemplated that, in 
appropriate circumstances, an annuity could be treated as satisfying 
the statutory income distribution requirement. The flush language 
following section 2056(b)(7)(B)(ii) specifically authorizes regulations 
that treat an annuity ``in a manner similar to an income interest in 
property.'' The IRS and Treasury Department believe that these 
regulations implement this statutory authorization in a reasonable

[[Page 17]]

manner by recognizing allocations under state statutes that provide for 
a reasonable apportionment of the total return of the trust.

Trusts Exempt From Generation-Skipping Transfer Tax

    The proposed regulations expand the rules concerning changes that 
may be made to trusts that are exempt from the generation-skipping 
transfer tax because they were irrevocable on September 25, 1985, 
without causing the loss of the trusts' exempt status. If such an 
exempt trust is administered in conformance with applicable state law 
that permits a unitrust amount to be paid to the income beneficiary or 
permits adjustments between income and principal to ensure 
impartiality, and that meets the requirements of Sec.  1.643(b)-1, its 
exempt status will not be affected.
    One commentator requested that the final regulations also provide 
that administration of an exempt trust as described in these 
regulations will not cause any trust beneficiary to be treated as 
making a gift and will not result in any taxable exchange by the trust 
or any of its beneficiaries. Another commentator requested that the 
final regulations clarify that changing the situs of a trust from a 
state with only a traditional definition of income to a state that 
permits unitrusts or powers to adjust will not affect the exempt status 
of the trust. Examples 11 and 12 have been revised to address these and 
similar concerns. The same conclusions apply to a change of situs in 
the opposite direction, from a state that permits unitrusts or the 
power to adjust to a state that has only the traditional definition of 
income.

Effective Dates

    The proposed regulations provide that the final regulations apply 
for taxable years that begin on or after January 2, 2004. Commentators 
suggested that, as a number of states have already enacted statutes 
permitting the trustee to pay to the person entitled to the income a 
unitrust amount based on a fixed percentage of the fair market value of 
the trust assets or providing the trustee the discretion to make 
adjustments between income and principal to treat the beneficiaries 
impartially, the effective date provision should be changed to allow 
trustees to take advantage of these statutes for periods beginning 
before the date of the publication of the final regulations. As an 
alternative, one commentator suggested that the IRS issue guidance 
allowing trustees to rely on the proposed regulations prior to the 
publication of the final regulations.
    The final regulations, in general, will become effective for 
taxable years of trusts and estates ending after January 2, 2004. In 
addition, taxpayers may rely on the provisions of the final regulations 
for any taxable years in which a trust or estate is governed by a state 
statute authorizing a unitrust payment in satisfaction of the income 
interest of the income beneficiaries or granting the trustee a power to 
adjust between income and principal, in each case as described in the 
final regulations.
    With respect to CRUTs, the prohibition of a trustee's discretionary 
power, granted solely by the governing instrument and not by applicable 
state statute, to allocate to income sales proceeds attributable to 
appreciation in the value of the asset after the date it was 
contributed to the trust or purchased by the trust is applicable to 
trusts created after January 2, 2004.
    With respect to PIFs, the provision concerning the failure of net 
long-term capital gain to qualify for the charitable deduction if the 
income beneficiaries, under the terms of the governing instrument and 
the state statute, may receive a unitrust amount or an amount based on 
unrealized appreciation in the value of the fund's assets is applicable 
to taxable years of PIFs beginning after January 2, 2004. However, 
provided income has not already been determined in such a manner, the 
fund's governing instrument may be amended or reformed to eliminate 
this possibility. A judicial proceeding to reform the fund's governing 
instrument must be commenced, or a nonjudicial reformation that is 
valid under state law must be completed, by the date that is nine 
months after the later of January 2, 2004 or the effective date of the 
state statute authorizing determination of income in such a manner.

Special Analyses

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

Drafting Information

    The principal authors of these regulations are Bradford R. Poston 
and Mary Berman of the Office of Associate Chief Counsel (Passthroughs 
and Special Industries), IRS. However, other personnel from the IRS and 
the Treasury Department participated in their development.

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

    Generation-skipping transfer taxes, Reporting and recordkeeping 
requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1, 20, 25, and 26 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.642(c)-2 is amended as follows:
0
1. Paragraph (c) is amended by adding two sentences after the first 
sentence.
0
2. Paragraph (e) is added immediately following paragraph (d).
    The additions 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, under the 
terms of the fund's governing instrument and applicable local law, the 
trustee has the power, whether or not exercised, to satisfy the income 
beneficiaries' right to income by the payment of either: an amount 
equal to a fixed percentage of the fair market value of the fund's 
assets (whether determined annually or averaged on a multiple year 
basis); or any amount that takes into account unrealized appreciation 
in the value of

[[Page 18]]

the fund's assets. In addition, no amount of net long-term capital gain 
shall be considered permanently set aside for charitable purposes to 
the extent the trustee distributes proceeds from the sale or exchange 
of the fund's assets as income within the meaning of Sec.  1.642(c)-
5(a)(5)(i). * * *
* * * * *
    (e) Effective dates. Generally, the second sentence of paragraph 
(c) of this section, concerning the loss of any charitable deduction 
for long-term capital gains if the fund's income may be determined by a 
fixed percentage of the fair market value of the fund's assets or by 
any amount that takes into account unrealized appreciation in the value 
of the fund's assets, applies for taxable years beginning after January 
2, 2004. In a state whose statute permits income to be determined by 
reference to a fixed percentage of, or the unrealized appreciation in, 
the value of the fund's assets, net long-term capital gain of a pooled 
income fund may be considered to be permanently set aside for 
charitable purposes if the fund's governing instrument is amended or 
reformed to eliminate the possibility of determining income in such a 
manner and if income has not been determined in this manner. For this 
purpose, a judicial proceeding to reform the fund's governing 
instrument must be commenced, or a nonjudicial reformation that is 
valid under state law must be completed, by the date that is nine 
months after the later of January 2, 2004 or the effective date of the 
state statute authorizing determination of income in such a manner.
* * * * *

0
Par. 3. In Sec.  1.642(c)-5, paragraph (a)(5)(i) is revised to read as 
follows:


Sec.  1.642(c)-5  Definition of pooled income fund.

    (a) * * *
    (5) * * *
    (i) The term income has the same meaning as it does under section 
643(b) and the regulations thereunder, except that income generally may 
not include any long-term capital gains. However, in conformance with 
the applicable state statute, income may be defined as or satisfied by 
a unitrust amount, or pursuant to a trustee's power to adjust between 
income and principal to fulfill the trustee's duty of impartiality, if 
the state statute both 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. In exercising a power 
to adjust, the trustee must allocate to principal, not to income, the 
proceeds from the sale or exchange of any assets contributed to the 
fund by any donor or purchased by the fund at least to the extent of 
the fair market value of those assets on the date of their contribution 
to the fund or of the purchase price of those assets purchased by the 
fund. This definition of income applies for taxable years beginning 
after January 2, 2004.
* * * * *

0
Par. 4. 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 
paragraph (b) of this section, gains from the sale or exchange 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 impartial exercise of discretion by the fiduciary (in 
accordance with a power granted to the fiduciary by applicable local 
law or by the governing instrument if not prohibited by applicable 
local law)--
    (1) Allocated to income (but if income under the state statute is 
defined as, or consists of, a unitrust amount, a discretionary power to 
allocate gains to income must also be exercised consistently and the 
amount so allocated may not be greater than the excess of the unitrust 
amount over the amount of distributable net income determined without 
regard to this subparagraph Sec.  1.643(a)-3(b));
    (2) Allocated to corpus but treated consistently 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 actually distributed to the beneficiary 
or utilized by the fiduciary in determining the amount that 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. In future years, Trustee must treat all discretionary 
distributions as not being made from any realized capital gains.
    Example 2. The facts are the same as in Example 1, except that 
Trustee intends to follow a regular practice of treating 
discretionary distributions of principal 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 
Trustee intends to follow a regular practice of treating 
discretionary distributions of principal as being paid from any net 
capital gains realized by Trust during the year from the sale of 
certain specified assets or a particular class of investments. This 
treatment of capital gains is a reasonable exercise of Trustee's 
discretion.
    Example 4. The facts are the same as in Example 1, except that 
pursuant to the terms of the governing instrument (in a provision 
not prohibited by 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.

[[Page 19]]

    Example 5. 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 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 6. 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 7. 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. Because all the assets of the trust, including all capital 
gains, will be actually distributed to the beneficiary at the 
termination of Trust, 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 8. The facts are the same as Example 7, except Trustee 
is directed to pay B $10,000 before distributing the remainder of 
Trust assets to A. Because the distribution to B is a gift of a 
specific sum of money within the meaning of section 663(a)(1), none 
of Trust's distributable net income that includes all of the capital 
gains realized during the year of termination is allocated to B's 
distribution.
    Example 9. The facts are the same as Example 7, except Trustee 
is directed to distribute one-half of the principal to A when A 
reaches 35 and the balance to A when A reaches 45. Trust assets 
consist entirely of stock in corporation M with a fair market value 
of $1,000,000 and an adjusted basis of $300,000. When A reaches 35, 
Trustee sells one-half of the stock and distributes the sales 
proceeds to A. All the sales proceeds, including all the capital 
gain attributable to that sale, are actually distributed to A and 
therefore all the capital gain is included in distributable net 
income.
    Example 10. The facts are the same as Example 9, except when A 
reaches 35, Trustee sells all the stock and distributes one-half of 
the sales proceeds to A. If authorized by the governing instrument 
and applicable state statute, Trustee may determine to what extent 
the capital gain is distributed to A. The $500,000 distribution to A 
may be treated as including a minimum of $200,000 of capital gain 
(and all of the principal amount of $300,000) and a maximum of 
$500,000 of the capital gain (with no principal). Trustee evidences 
the treatment by including the appropriate amount of capital gain in 
distributable net income on Trust's federal income tax return. If 
Trustee is not authorized by the governing instrument and applicable 
state statutes to determine to what extent the capital gain is 
distributed to A, one-half of the capital gain attributable to the 
sale is included in distributable net income.
    Example 11. The applicable state statute provides that a trustee 
may make an election to pay an income beneficiary an amount equal to 
four percent of the fair market value of the trust assets, as 
determined at the beginning of each taxable year, in full 
satisfaction of that beneficiary's right to income. State statute 
also provides that this unitrust amount shall be considered paid 
first from ordinary and tax-exempt 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 statute. Trustee 
makes the unitrust election under state statute. 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 ordering rule of the state 
statute and is included in distributable net income for the taxable 
year.
    Example 12. The facts are the same as in Example 11, except that 
neither state statute 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, other than capital 
gain, as distributed to the beneficiary to the extent that the 
unitrust amount exceeds Trust's ordinary and tax-exempt 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 of not allocating realized capital gains to income.
    Example 13. The facts are the same as in Example 11, except that 
neither state statutes 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 and tax-exempt 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 and tax-exempt 
income.
    Example 14. Trustee is a corporate fiduciary that administers 
numerous trusts. State statutes provide that a trustee may make an 
election to distribute to 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. Neither 
state statutes nor the governing instruments of any of the trusts 
administered by Trustee has an ordering rule for the character of 
the unitrust amount, but leaves such a decision to the discretion of 
Trustee. With respect to some trusts, Trustee intends to follow a 
regular practice of treating principal, other than capital gain, as 
distributed to the beneficiary to the extent that the unitrust 
amount exceeds the trust's ordinary and tax-exempt income. Trustee 
will evidence this treatment by not including any capital gains in 
distributable net income on the Federal income tax returns for those 
trusts. With respect to other trusts, Trustee intends to follow a 
regular practice of treating any net capital gains as distributed to 
the beneficiary to the extent the unitrust amount exceeds the 
trust's ordinary and tax-exempt income. Trustee will evidence this 
treatment by including net capital gains in distributable net income 
on the Federal income tax returns filed for these trusts. Trustee's 
decision with respect to each trust is a reasonable exercise of 
Trustee's discretion and, in future years, Trustee must treat the 
capital gains realized by each trust consistently with the treatment 
by that trust in prior years.

    (f) Effective date. This section applies for taxable years of 
trusts and estates ending after January 2, 2004.

0
Par. 5. Section 1.643(b)-1 is revised to read as follows:


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 will generally not be 
recognized. For example, if a trust instrument directs that all the 
trust income shall be paid to the income beneficiary but defines 
ordinary dividends and interest as principal, the trust will not be 
considered one that under its governing instrument is required to 
distribute all its income currently for purposes of section 642(b) 
(relating to the personal exemption) and section 651 (relating to 
simple trusts). Thus, items such as dividends, interest, and rents are 
generally allocated to income and proceeds from the sale or exchange of 
trust assets are generally allocated to principal. However, an 
allocation of amounts between income and principal

[[Page 20]]

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 and tax-exempt income, capital gains, and 
appreciation. For example, a state statute providing that income is a 
unitrust amount of no less than 3% and no more than 5% of the fair 
market value of the trust assets, whether determined annually or 
averaged on a multiple year basis, is a reasonable apportionment of the 
total return of the trust. Similarly, a state statute that permits the 
trustee to make 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. Generally, these adjustments are permitted by 
state statutes when the trustee invests and manages the trust assets 
under the state's prudent investor standard, the trust describes the 
amount that may or must be distributed to a beneficiary by referring to 
the trust's income, and the trustee after applying the state statutory 
rules regarding the allocation of receipts and disbursements to income 
and principal, is unable to administer the trust impartially. 
Allocations pursuant to methods prescribed by such state statutes for 
apportioning the total return of a trust between income and principal 
will be respected regardless of whether the trust provides that the 
income must be distributed to one or more beneficiaries or may be 
accumulated in whole or in part, and regardless of which alternate 
permitted method is actually used, provided the trust complies with all 
requirements of the state statute for switching methods. A switch 
between methods of determining trust income authorized by state statute 
will not constitute a recognition event for purposes of section 1001 
and will not result in a taxable gift from the trust's grantor or any 
of the trust's beneficiaries. A switch to a method not specifically 
authorized by state statute, but valid under state law (including a 
switch via judicial decision or a binding non-judicial settlement) may 
constitute a recognition event to the trust or its beneficiaries for 
purposes of section 1001 and may result in taxable gifts from the 
trust's grantor and beneficiaries, based on the relevant facts and 
circumstances. In addition, an allocation to income of all or a part of 
the gains from the sale or exchange of trust assets will generally be 
respected if the allocation is made either pursuant to the terms of the 
governing instrument and applicable local law, or pursuant to a 
reasonable and impartial exercise of a discretionary power granted to 
the fiduciary by applicable local law or by the governing instrument, 
if not prohibited by applicable local law. This section is effective 
for taxable years of trusts and estates ending after January 2, 2004.

0
Par. 6. 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. This 
paragraph (d) applies for taxable years of trusts ending after January 
2, 2004.

0
Par. 7. 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). This paragraph applies for taxable years of trusts and estates 
ending after January 2, 2004.

0
Par. 8. Section 1.664-3 is amended as follows:
0
1. Paragraphs (a)(1)(i)(b)(3) and (4) are revised.
0
2. Paragraph (a)(1)(i)(b)(5) is removed.
    The revisions 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, notwithstanding any contrary provision in applicable 
state law. Proceeds from the sale or exchange of any assets contributed 
to the trust by the donor must be allocated to principal and not to 
trust income at least to the extent of the fair market value of those 
assets on the date of their contribution to the trust. Proceeds from 
the sale or exchange of any assets purchased by the trust must be 
allocated to principal and not to trust income at least to the extent 
of the trust's purchase price of those assets. Except as provided in 
the two preceding sentences, proceeds from the sale or exchange of any 
assets contributed to the trust by the donor or purchased by the trust 
may be allocated to income, pursuant to the terms of the governing 
instrument, if not prohibited by applicable local law. A discretionary 
power to make this allocation may be granted to the trustee under the 
terms of the governing instrument but only to the extent that the state 
statute permits the trustee to make adjustments between income and 
principal to treat beneficiaries impartially.
    (4) The rules in paragraph (a)(1)(i)(b)(1) and (2) of this section 
are applicable for taxable years ending after April 18, 1997. The rule 
in the first sentence of paragraph (a)(1)(i)(b)(3) is applicable for 
taxable years ending after April 18, 1997. The rules in the second, 
fourth, and fifth sentences of paragraph (a)(1)(i)(b)(3) are applicable 
for taxable years ending after January 2, 2004. The rule in the third 
sentence of paragraph (a)(1)(i)(b)(3) is applicable for sales or 
exchanges that occur after April 18, 1997. The rule in the sixth 
sentence of paragraph (a)(1)(i)(b)(3) is applicable for trusts created 
after January 2, 2004.
* * * * *

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

0
Par. 9. The authority citation for part 20 continues to read in part as 
follows:

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


0
Par. 10. 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.

* * * * *

[[Page 21]]

    (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 determined by applicable local 
law 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 this chapter.
* * * * *

0
Par. 11. 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 local 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.
* * * * *

0
Par. 12. 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 effect on the spouse's right to income 
if applicable local law 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 
ending after January 2, 2004.

0
Par. 13. 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 applicable local law that 
defines the term income as a unitrust amount (or permits a right to 
income to be satisfied by such an amount), or that 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 applicable local law 
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. * * *
* * * * *

0
Par. 14. 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 Sec. Sec.  
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)(2) regarding unitrusts and 
distributions of income to the surviving spouse in conformance with 
applicable local law is applicable to trusts for taxable years ending 
after January 2, 2004.

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

0
Par. 15. The authority citation for part 25 continues to read in part 
as follows:

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

0
Par. 16. 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 or determined by applicable 
local law 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 this chapter.
* * * * *

0
Par. 17. 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 last sentence of Sec.  
25.2523(e)-1(f)(1) regarding the determination of income under 
applicable local law applies to trusts for taxable years ending after 
January 2, 2004.

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

0
Par. 18. The authority citation for part 26 continues to read in part 
as follows:

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


0
Par. 19. Section 26.2601-1 is amended as follows:
0
1. The second and third sentences of paragraph (b)(4)(i) are revised to 
read as follows.
0
2. Paragraph (b)(4)(i)(D)(2) is amended by adding a new sentence to the 
end of the paragraph.
0
3. Paragraph (b)(4)(i)(E) is amended by adding Examples 11 and 12.
0
4. 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) * * * In general, unless specifically provided 
otherwise, the rules contained in this paragraph are applicable only 
for purposes of determining whether an exempt trust retains its exempt 
status for generation-skipping transfer tax purposes. Thus (unless 
specifically noted), the rules do not apply in determining, for 
example, whether the transaction results in a gift subject to gift tax, 
or may cause the trust to be included in the gross estate of a 
beneficiary, or may result in the realization of gain for purposes of 
section 1001.
* * * * *
    (D) * * *
    (2) * * * In addition, administration of a trust in conformance 
with applicable local law that defines the term income as a unitrust 
amount (or permits a right to income to be satisfied by such an amount) 
or that 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 applicable local law 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

[[Page 22]]

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. Further, under these facts, no trust beneficiary will be 
treated as having made a gift for federal gift tax purposes, and 
neither the trust nor any trust beneficiary will be treated as 
having made a taxable exchange for federal income tax purposes. 
Similarly, the conclusions in this example would be the same if the 
beneficiaries' consent was not required, or, if the change in 
administration of the trust occurred because the situs of the trust 
was changed to State X from a state whose statute does not define 
income as a unitrust amount or if the situs was changed to such a 
state from State X.
    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 
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 receipts between income and principal is unable to 
administer the trust impartially. The provision permitting the 
trustees to make these 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. Further, under these facts, no trust beneficiary will 
be treated as having made a gift for federal gift tax purposes, and 
neither the trust nor any trust beneficiary will be treated as 
having made a taxable exchange for federal income tax purposes. 
Similarly, the conclusions in this example would be the same if the 
change in administration of the trust occurred because the situs of 
the trust was changed to State X from a state whose statute does not 
authorize the trustee to make adjustments between income and 
principal or if the situs was changed to such a state from State X.

    (ii) Effective dates. The rules in this paragraph (b)(4) are 
generally applicable on and after December 20, 2000. However, the rule 
in the last sentence of paragraph (b)(4)(i)(D)(2) of this section and 
Example 11 and Example 12 in paragraph (b)(4)(i)(E) of this section 
regarding the administration of a trust and the determination of income 
in conformance with applicable state law applies to trusts for taxable 
years ending after January 2, 2004.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: December 16, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-31614 Filed 12-30-03; 8:45 am]
BILLING CODE 4830-01-P