Hiking through the 65-day trust distribution rule
So much can happen in 65 days. The pilgrims sailed to America on the Mayflower in 65 days, you could briskly hike the Appalachian Trail in that time (the record is currently 45 days and 12 hours) and it takes about that long for a house cat or wolf to be born. Trust and estate fiduciaries also can do something interesting in the first 65 days of a new year: make distributions of taxable income and have them attributed to the preceding tax year. If a trust is used to hold a business interest or transfer wealth to future generations, the 65-day rule presents a window of opportunity for tax planning each year. This article will consider its scope, benefits, mechanics and continuing relevance after tax reform.
Despite its name, the “65-day rule” is really a tax election and can be made by the fiduciary of a trust or an estate (though only trusts will be referred to here for clarity). Among the many types of trusts, the election applies only to complex trusts — those for which the trustee has discretion over how much, if any, trust income to distribute in a given year. It is that discretion to distribute that makes the rule possible; by contrast, all income of a simple trust is required to be distributed each year.
In a business world defined by due dates, deadlines and difficult decisions, hindsight is a rare luxury. Hindsight, however, is exactly what is offered by the 65-day rule. The tax year of most trusts ends on Dec. 31, but under Section 663(b) of the Internal Revenue Code, fiduciaries have another 65 days to make distributions to beneficiaries (through March 6 or March 5 in a leap year), which are then treated for tax purposes as having occurred in the prior year. The extra time after year-end makes it possible to determine the beneficiary’s income from other sources and consider future income. The trustee can evaluate the prior year’s activity, look forward to the current year’s goals and decide how much to distribute and in which tax year the distribution will be taxed.
We must often choose between time and money, but the 65-day rule provides a choice about both. Not only can the fiduciary decide in which of two years the distribution will be taxed, he or she also can decide whether the income in question is taxed at the trust or individual rates, and the difference can be significant. The distinction here is that any income not distributed to beneficiaries remains in the trust and is taxed at trust rates. Distributed income, alternatively, is passed out to individual beneficiaries and taxed at their personal rates.
Whereas the individual tax table includes seven moderately even brackets, trusts have only four tax brackets that are highly compressed. For example, under the 2017 tax reform legislation, 37 percent is the highest marginal tax rate for both trusts and married individuals who file a joint tax return. Individuals do not reach the 37 percent rate until taxable income exceeds $600,000, but trusts reach the same 37 percent rate when taxable income exceeds a mere $12,500. All other considerations aside, distributed income is likely to generate less tax than undistributed income. Having the option to distribute or retain income in a trust, and a choice of separate tax years, makes the 65-day rule a powerful tax-planning tool.
As with most provisions of the Internal Revenue Code, the 65-day rule comes with requirements and limitations. First, the Section 663(b) election itself must be affirmatively made. If a trust files a tax return, the election is made on the return; otherwise, if a return is not required for a year, the election is made by filing a statement with the IRS.
Next, the timing of the election is important; it must be made by the tax return due date (usually April 15 for a tax year ended the previous Dec. 31) but can be extended if the tax return is extended. The amount the election applies to is limited to the greater of trust accounting income or distributable net income. Also, if several distributions are made within the election period, the election can apply to any or all of them. Furthermore, the election is effective for only one year at a time.
Finally, a practical consideration is to maintain thorough records of distributions so they are not counted twice. For example, a distribution made on Jan. 31, 2018 and applied to the 2017 tax year by the 65-day rule is no longer available for the 2018 tax year.
Congress passed the 2017 tax reform legislation in fewer than 65 days, and the election still is available under the new law and provides the same options and benefits. It remains a valuable tax-planning tool and is worth considering in early 2018 for those with family business interests or other income-producing assets held in trusts. If you plan ahead, there might even be time left in those 65 days for the Appalachian Trail (this time of year, it’s probably best to start at the Georgia side).
Jeff Sayers is a manager for BDO USA, LLP, which is an underwriter of the Family Business Alliance.