Trusts are the preferred mode of estate planning for most estates but not all trusts are created equally. Certain trusts generate income through the sale of assets as well as holding assets that generate interest. Proceeds from the sale of assets and income gained on assets held are both considered income that must be taxed.
Those tax implications stem from the distribution of income to a beneficiary designated by the trust. This can have far-reaching impacts not just on beneficiaries, but trustees and the trust itself. When a trust is facing litigation, it can delay income distributions but the necessary taxes must still be addressed. This leaves beneficiaries with a large tax bill in circumstances where the income never actually got paid out to them.
Under U.S. Code § 652, when a simple trust requires net income distributions to a beneficiary, the trustee must allocate the income to that beneficiary which then makes the beneficiary liable for the income tax on that amount in the current fiscal year even if the distributions are delayed or paid out over a longer period of time.
For example, consider a hypothetical Doe Family Trust which is a simple trust that requires all income distributions to go to Johnny Doe. Johnny is owed $150,000 in net income distributions but the trustee plans to distribute that total in three $50,000 installments over the course of three years. The trustee would still be deemed to have distributed the $150,000 total in year one of the distribution, even if Johnny has not and will not receive a large portion of the money until years two and three. The Doe Family Trust can also claim a distribution deduction in year one even if the income was never actually distributed.
This “deemed distribution” necessitates an effective tax strategy to avoid an insurmountable tax bill while the actual income remains in the hands of the trust. When we look at case law such as Polt v. Commissioner, an extra layer is added to include situations where a trust is held up in litigation.
Polt v. Commissioner dictates that a beneficiary will still have to pay income taxes on income designated for them through a trust even if the trustee has refused to distribute that income to the beneficiary because of pending litigation. This means a total of $0 in income could be distributed yet the beneficiary could still have a tax bill as if they received the full amount of income.
For trustees, this provides additional leverage to settle litigation quicker and cheaper. The courts have thus far ignored the risk of undue economic hardship caused by the delayed distribution from the trust during litigation. However, a trustee can leverage this in the event that the litigation has been filed by the beneficiary or a related party. It would likely not be in the best interest of the beneficiary to further delay the distribution of income they are already being held responsible for by the IRS.
Case law like Polt v. Commissioner and other similar decisions display the importance of effective tax strategy for estate plans and their beneficiaries. Contact our team at The Law Offices of Tyler Q. Dahl to get ahead of problems like this and protect yourself and your estate from overwhelming tax liabilities.
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