Why the 65-Day Rule & March 6 Is Important to Complex Trusts

Hello again everybody. Tom O’Saben coming to you from the University of Illinois Tax School with our continuing installments of short vignettes for you to listen to during the tax season. And we try to make these as timely and as appropriate as possible. Before we get started in today’s installment, I will again remind you that my name is Tom O’Saben. I’m an enrolled agent. I am the Assistant Director of Professional Education and Outreach for the Tax School. I’m a Fall Tax School instructor, and author and reviewer of the University of Illinois Federal Tax Workbook. I also participate in a lot of webinars and these weekly blogs. And I’m also a tax practitioner with over 30 years of experience. So it’s great to do these little vignettes, as I describe them, and hopefully help you get through some things you might be thinking about during the current tax season.So what we’re going to concentrate on today is the upcoming March 6 date. And why is March 6 important? Where it’s important, and I can’t believe the first two months of the year are already gone, is dealing with trustees who are in control of complex trusts. March 6 becomes a very important date for that trustee to consider and for us to advise on. So the statement or the lead in that I’m talking about is – we’re going to make reference to the movie Jerry Maguire and that famous line from the movie – “Show me the money.” So the question becomes, are we going to show me the money, or our beneficiaries the money? Or are we going to show our uncle the money? Show me the money. And I’ll tell you who pays tax. But before we get into the crux of it, I think we need to give a little background to you on simple versus complex trusts. A simple trust has these requirements: that income is supposed to be distributed to those beneficiaries annually. Corpus or principle is not to be distributed from that trust. Distributions are also not permitted to charities. Income is taxable to the beneficiaries –  this is the important part to consider -it is taxable to those beneficiaries, regardless of whether or not it’s actually been distributed. So imagine those beneficiaries who receive a K-1, but no money. And we as tax professionals get to tell them, you’re going to pay tax. Oh, that makes for some pretty happy beneficiaries. But nonetheless, those are the rules of a simple trust. If there are any capital gains, they’re actually to be allocated or stay with the trust; meaning they’re going to be allocated to corpus. And that’s the confusing part when we deal with trusts in that capital gains certainly generate taxable income. But they don’t represent (in most cases unless the trust document says otherwise) income that can be sent out to the beneficiaries. So let’s contrast this with a complex trust. Well, now we get into who’s in control of who gets the money. In this case, it’s going to be the trustee. Because in a complex trust, income distributions are at the discretion of the trustee. Principal can also be distributed, the corpus of that trust can be distributed. There can also be charitable distributions with regard to capital gains. Capital gains normally, again, by state law, are allocated to principal, so they could be coming out of that principal portion. But again, most of the time, capital gains are considered to be part of the corpus, even though they could be taxable. So how can you tell the difference between whether or not a trust is a simple trust or a complex trust? Look at the return that was generated last year? Probably not the best answer. More importantly, get the trust document. And while you might not be an attorney, you can read the language should be in the trust pretty quickly, to talk about whether or not income has to be distributed annually, or whether or not it’s going to be at the discretion of the trustee. If it’s going to be at the discretion of the trustee, then we have a complex trust, as I just described to you. And that’s where March 6th becomes a very important date in the life of that complex trust and the handling of that trust by the trustee. The complex trust has control over distributions, right? So it’s going to owe tax, if it doesn’t distribute it by the last calendar day of the previous year, the end of its fiscal year, unless… show me the money. Show me where the distributions were. And you think, well, the taxpayer trustee didn’t make any distributions from this complex trust because they didn’t know what to do. And they were waiting until their appointment with you. So that appointment’s not happening until today, March 1st. So we think, hmm, what can we do? Did you bring me the document and let’s talk about what we can do with that complex trust. You’re the trustee of that trust you, Mr. Client or Mrs. Client or Ms. Client, whatever the case may be. And you’re not sure what exactly to do, let’s look at that document together. We find out that the distributions are, in fact, at the discretion of the trustee. So we say that income distributions, if they’re made by the 65th day after the end of the year, which again, normally in a trust is December 31. If those distributions are made by the 65th day, they can be treated as though they happened last year. What’s that going to do? That’s going to reduce the taxable income of the trust (but isn’t going to go away) and it’s going to be passed out to the beneficiary. So that’s why I say, show me the money. It becomes very important that we know where that money is going. So we can have that conversation with the trustee (and I’ve done this many, many times myself with clients) that here we are on March 1st, and we talk about well, distributions are at your discretion, that trust has income, that trust is going to owe tax, unless we follow the 65-day elections by the 65th day, and go ahead and make that distribution. We treat it as though what happened last year, and then the income is going to pass through to the beneficiaries. We refer to this exactly as what I’ve been describing the 65-day rule. So after December 31, count 65 days, and you know what you’re going to get to (when it’s not a leap year)? March 6th. If you happen to be someone who wants to look at regulations…it’s Code Section 663(b)1. And I’ve given you a link to the Cornell Law Library, if you want to see the chapter and verse of the law we’re dealing with. So you might be thinking this is too good to be true, because normally don’t taxpayers have to act by the end of the year in order to take advantage of tax laws? True. So the first thing you might be asking is, well, if my client decides that this is what’s going to happen (that we want to go ahead and pass the income on to the beneficiaries), how do I tell the IRS that we’ve done this? Well, for those of you who know me, I’m a forms guy. And there’s a form for that. In this case, what I’ve put here on the slide for you is the 1041 for 2020. And this is page three. This really hasn’t changed that I know of in many, many years. But nonetheless, I’ve highlighted for you line six, and I’ve also circled a little box. The statement says “is this an estate or complex trust that’s going to use the section 663(b) election. If so, check the box here.” Remember, we don’t need this for a simple trust. A simple trust treats the income as though it were distributed, even if it wasn’t. But in a complex trust, since it’s at the discretion of the trustee, then it is totally up to the trustee to either make this distribution…By the way, we’re not going to treat distributions as though they were made by the 65th day, they still have to happen. So they have to happen, but they can still be treated as though they happened at the end of last year. So the question you might think of is well should a trust always use the 65-day rule? You know, I’ve run into many, many of you out there who’ve come to our webinar sessions or our live events that we’ve done, and I’ve been at sessions all over the country. And most of us have in our minds that a trust should never owe tax. You know, I understand where you’re coming from, because it doesn’t take a whole lot of income to get to the maximum tax rates for a trust. But is that the best answer? You know, I always say – and I’m not an attorney – that a trust is established to address an agenda. Sometimes many people don’t know why they have a trust, except that their neighbor got one, or they went to a luncheon at Red Lobster and they said you ought to have a trust so you can bypass the probate process. Well, I don’t know that that’s a good enough reason. And we’re not going to get into “why have a trust” since I want to concentrate on this vignette so we can just talk about the 65-day rule. But it may be more important what the terms of the trust say. You know, I have a trust provision in my will that was established a long time ago when my daughter was 18. My son was 15. My biggest concern for them was making sure that they or their friends didn’t squander what little bit of inheritance they would get. I left the discretion of the money to the trustee. Someone who I thought could make decisions in an intelligent manner when I believe my children weren’t competent to make that decision. I don’t have one iota of language in my trust, which says manage this to minimize tax. No, I said manage it to retain principal. Now, again, you could make an argument that well, it doesn’t make any sense to go ahead and have the trust pay tax. Isn’t that going to leave the beneficiaries with less money? Maybe. Maybe not. So does the trust have reasons to retain the income just like I’m explaining? Are we worried what’s going to happen with those distributions? Furthermore, would the beneficiaries possibly be in a higher tax bracket than the trust? It depends on the trust income, wouldn’t it? It also depends on the beneficiary’s income. We as practitioners may not be privy to all of that information if we don’t know all of the beneficiaries. And I can say many times, I’ve sat there with a client, just like you, on March 1… March 2… March 3 appointment and this client of ours is representing or responsible for filing that trust return. And they’ve said, “you know what, I don’t want to get the beneficiaries upset. Let’s just go ahead and have the trust pay the tax.” Okay, you can do that with a complex trust. And in that case, we’re not going to invoke the 65-day rule. But if we find that, “yes, I didn’t know what to do. I was waiting to have my appointment with you. And, yeah, I told my I told my beneficiaries, it could be my siblings, that’s what I was going to say, my siblings that there’s a possibility, they’re going to get a K-1 so don’t go file their returns too quickly. I talked to Tom, at the end of the year. And yeah, I think we’re going to go ahead and make a distribution, bring the taxable income of the trust possibly down to zero, and pass that income on to the beneficiaries.” So as I mentioned, one last thought in this area, be sure to remind the trustee to tell those beneficiaries that K-1s for the previous year are going to be coming. Think about the number of clients who by today, March 1, have already filed their returns. If they happen to be the beneficiary of a trust or an estate, they should really hold off and wait to file that return.

So I hope this gives you a little bit of guidance, maybe clears up some confusion you have. We’re one month in already, if you can believe that. I know the filing season acceptance didn’t begin until February 12. But certainly we’ve been working on returns prior to February 12. So think about it… we’re nearly to the halfway point. So hang in there. We’ll continue to give you timely advice as we can. So for all of us at the University of Illinois Tax School, this is Tom O’Saben saying goodbye for just a while and hang in there, my friends.
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